Hatteras Financial (HTS) 10-Q 2012 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the Quarterly Period Ended September 30, 2012

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                to                .

Commission file number 001-34030

HATTERAS FINANCIAL CORP.

(Exact name of registrant as specified in its charter)

Maryland	26-1141886
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)
110 Oakwood Drive, Suite 340 Winston Salem, North Carolina	27103
(Address of principal executive offices)	(Zip Code)

(336) 760-9347

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate 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  x    No  ¨

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

Large accelerated filer	x	Accelerated filer	¨
Non-accelerated filer	¨  (Do not check if a smaller reporting company)	Smaller reporting company	¨

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

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

Class	Outstanding at October 24, 2012
Common Stock ($0.001 par value)	98,809,404

TABLE OF CONTENTS

		Page
PART I	Financial Information
Item 1.	Financial Statements		1
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		22
Item 3.	Quantitative and Qualitative Disclosures about Market Risk		44
Item 4.	Controls and Procedures		47
PART II	Other Information
Item 1.	Legal Proceedings		48
Item 1A.	Risk Factors		48
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		48
Item 3.	Defaults Upon Senior Securities		48
Item 4.	Mine Safety Disclosures		48
Item 5.	Other Information		48
Item 6.	Exhibits		48
	Signatures		49

Hatteras Financial Corp.

Balance Sheets

(Dollars in thousands, except share amounts)	(Unaudited)
	September 30, 2012		December 31, 2011
Assets
Mortgage-backed securities, at fair value (including pledged assets of $24,857,784 and $17,012,472 at September 30, 2012 and December 31, 2011, respectively)	$	26,375,137	$	17,741,873
Cash and cash equivalents		150,846		347,045
Restricted cash		302,180		237,014
Unsettled purchased mortgage-backed securities, at fair value		120,478		49,630
Accrued interest receivable		80,056		63,025
Principal payments receivable		182,195		105,333
Debt security, held to maturity, at cost		15,000		15,000
Other assets		49,795		27,799
Total assets	$	27,275,687	$	18,586,719
Liabilities and shareholders’ equity
Repurchase agreements	$	23,583,180	$	16,162,375
Payable for unsettled securities		118,925		48,999
Accrued interest payable		4,729		4,596
Interest rate hedge liability		273,120		219,167
Dividend payable		81,118		69,141
Accounts payable and other liabilities		2,059		2,253
Total liabilities	$	24,063,131	$	16,506,531
Shareholders’ equity:
7.625% Series A Cumulative Redeemable Preferred stock, $.001 par value, 25,000,000 shares authorized, 11,500,000 and 0 shares issued and outstanding at September 30, 2012 and December 31, 2011, respectively ($287,500 aggregate liquidation preference)		278,263		—
Common stock, $.001 par value, 200,000,000 shares authorized, 98,809,404 and 76,823,220 shares issued and outstanding at September 30, 2012 and December 31, 2011, respectively		99		77
Additional paid-in capital		2,493,704		1,904,748
Retained earnings		5,266		2,041
Accumulated other comprehensive income		435,224		173,322
Total shareholders’ equity		3,212,556		2,080,188
Total liabilities and shareholders’ equity	$	27,275,687	$	18,586,719

See accompanying notes.

1

Hatteras Financial Corp.

Statements of Income

(Unaudited)

(Dollars in thousands, except per share amounts)	Three months		Three months		Nine months		Nine months
	Ended		Ended		Ended		Ended
	September 30, 2012		September 30, 2011		September 30, 2012		September 30, 2011
Interest income:
Interest income on mortgage-backed securities	$	131,940	$	110,125	$	373,420	$	310,248
Interest income on other investments		387		380		1,160		1,051
Interest income		132,327		110,505		374,580		311,299
Interest expense		52,767		40,259		140,045		102,363
Net interest income		79,560		70,246		234,535		208,936
Operating expenses:
Management fee		4,557		3,572		12,711		10,195
Share based compensation		447		334		1,301		735
General and administrative		1,040		688		3,269		1,992
Total operating expenses		6,044		4,594		17,281		12,922
Other income:
Gain on sale of mortgage-backed securities		10,534		13,330		25,244		17,735
Net income		84,050		78,982		242,498		213,749
Dividends on preferred stock		2,070		0		2,070		0
Net income available to common shareholders	$	81,980	$	78,982	$	240,428	$	213,749
Earnings per share - common stock, basic	$	0.83	$	1.04	$	2.63	$	3.05
Earnings per share - common stock, diluted	$	0.83	$	1.04	$	2.63	$	3.05
Dividends per share of common stock	$	0.80	$	1.00	$	2.60	$	3.00
Weighted average common shares outstanding, basic		98,233,589		75,743,002		91,296,338		70,057,263
Weighted average common shares outstanding, diluted		98,233,589		75,743,002		91,296,338		70,057,263

See accompanying notes.

2

Hatteras Financial Corp

Statements of Comprehensive Income

(Unaudited)

(Dollars in thousands)
	For the three			For the three			For the nine			For the nine
	months ended			months ended			months ended			months ended
	September 30, 2012			September 30, 2011			September 30, 2012			September 30, 2011
Net income	$	84,050		$	78,982		$	242,498		$	213,749
Other comprehensive income:
Net unrealized gains on securities available for sale		222,946			85,953			295,018			182,904
Net unrealized losses on derivative instruments		(1,382	)		(116,032	)		(33,116	)		(171,600	)
Other comprehensive income		221,564			(30,079	)		261,902			11,304
Comprehensive income	$	305,614		$	48,903		$	504,400		$	225,053

See accompanying notes.

3

Hatteras Financial Corp.

Statements of Changes in Shareholders’ Equity

For the nine months ended September 30, 2012

(Unaudited)

(Dollars in thousands)	7.625% Series A Cumulative Redeemable Preferred		Common		Additional					Accumulated Other
	Stock Amount		Stock Amount		Paid-in Capital		Retained Earnings			Comprehensive Income		Total
Balance at December 31, 2011	$	0	$	77	$	1,904,748	$	2,041		$	173,322		2,080,188
Issuance of preferred stock		278,263		—		—		—			—		278,263
Issuance of common stock		—		22		587,655		—			—		587,677
Share based compensation expense		—		—		1,301		—			—		1,301
Dividends declared on common stock		—		—		—		(237,203	)		—		(237,203	)
Dividends declared on preferred stock		—		—		—		(2,070	)		—		(2,070	)
Net income		—		—		—		242,498			—		242,498
Other comprehensive income		—		—		—		—			261,902		261,902
Balance at September 30, 2012	$	278,263	$	99	$	2,493,704	$	5,266		$	435,224		3,212,556

See accompanying notes.

4

Hatteras Financial Corp.

Statements of Cash Flows

(Unaudited)

(Dollars in thousands)
	For the nine			For the nine
	months ended			months ended
	September 30, 2012			September 30, 2011
Operating activities
Net income	$	242,498		$	213,749
Adjustments to reconcile net income to net cash provided by operating activities:
Net amortization of premium related to mortgage-backed securities		112,736			60,719
Amortization related to interest rate swap agreements		275			253
Share based compensation expense		1,301			735
Hedge ineffectiveness		321			516
Net gain on sale of mortgage-backed securities		(25,244	)		(17,735	)
Changes in operating assets and liabilities:
Increase in accrued interest receivable		(17,031	)		(25,900	)
Increase in other assets		(1,907	)		(1,199	)
(Decrease) increase in accrued interest payable		133			(849	)
(Decrease) increase in accounts payable and other liabilities		(194	)		165
Net cash provided by operating activities		312,888			230,454
Investing activities
Purchases of mortgage-backed securities		(15,160,173	)		(11,327,766	)
Principal repayments of mortgage-backed securities		3,978,718			2,360,742
Sale of mortgage-backed securities		2,678,086			1,037,064
Net cash used in investing activities		(8,503,369	)		(7,929,960	)
Financing activities
Issuance of preferred stock, net of cost of issuance		278,263			—
Issuance of common stock, net of cost of issuance		587,677			853,441
Cash dividends paid		(227,297	)		(179,280	)
Increase in restricted cash on swap arrangements		(65,166	)		(204,114	)
Proceeds from repurchase agreements		170,030,964			118,620,023
Principal repayments on repurchase agreements		(162,610,159	)		(111,414,852	)
Net cash provided by financing activities		7,994,282			7,675,218
Net decrease in cash and cash equivalents		(196,199	)		(24,288	)
Cash and cash equivalents, beginning of period		347,045			112,626
Cash and cash equivalents, end of period	$	150,846		$	88,338
Supplemental disclosure of cash flow information
Cash paid during the period for interest	$	140,012		$	103,211
Supplemental schedule of non-cash investing activities
Obligation to brokers for purchase of unsettled mortgage-backed securities	$	1,527,972		$	1,395,612
Supplemental schedule of non-cash financing activities
Dividends declared on preferred stock, not yet paid	$	2,070		$	—
Dividends declared on common stock, not yet paid	$	79,048		$	76,547

See accompanying notes.

5

Hatteras Financial Corp.

Notes to Financial Statements

September 30, 2012

(Dollars in thousands except per share amounts)

1. Organization and Business Description

Hatteras Financial Corp. (the “Company”) was incorporated in Maryland on September 19, 2007, and commenced its planned business activities on November 5, 2007, the date of the initial closing of a private issuance of common stock. The Company was formed to invest in residential mortgage-backed securities (“MBS”), issued or guaranteed by the U.S. Government or U.S. Government sponsored agencies such as the Government National Mortgage Association (“Ginnie Mae”), the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) (“agency securities”). The Company is externally managed by Atlantic Capital Advisors LLC (“ACA”).

The Company has elected to be taxed as a real estate investment trust (“REIT”). As a result, the Company does not pay federal income taxes on taxable income distributed to shareholders if certain REIT qualification tests are met. It is the Company’s policy to distribute 100% of its taxable income, after application of available tax attributes, within the time limits prescribed by the Internal Revenue Code of 1986, as amended (the “Code”), which may extend into the subsequent taxable year.

2. Summary of Significant Accounting Policies

Basis of Presentation and Use of Estimates

The accompanying unaudited financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. 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 three and nine months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the calendar year ending December 31, 2012. These unaudited financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2011.

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 financial statements include the valuation of agency securities and derivative instruments.

6

Financial Instruments

The Company considers its cash and cash equivalents, restricted cash, agency securities (settled and unsettled), forward purchase commitments, debt security held to maturity, accrued interest receivable, principal payment receivable, payable for unsettled securities, derivative instruments, repurchase agreements and accrued interest payable to meet the definition of financial instruments. The carrying amount of cash and cash equivalents, restricted cash, accrued interest receivable and payable for unsettled securities approximate their fair value due to the short maturities of these instruments and are valued using Level 1 inputs. The carrying amount of the repurchase agreements are deemed to approximate their fair value since the agreements are based upon a variable rate of interest and are valued using Level 2 inputs. See Note 4 for discussion of the fair value of agency securities and forward purchase commitments. See Note 5 for discussion of the fair value of the held to maturity debt security. See Note 7 for discussion of the fair value of derivatives.

Since inception through September 30, 2012, the Company has limited its exposure to credit losses on its portfolio of securities by purchasing agency securities guaranteed by Fannie Mae and Freddie Mac. The portfolio is diversified to avoid undue exposure to loan originator, geographic and other types of concentration. The Company manages the risk of prepayments of the underlying mortgages by creating a diversified portfolio with a variety of prepayment characteristics. See Note 4 for additional information on MBS.

The Company is engaged in various trading and brokerage activities including derivative interest rate swap agreements in which counterparties primarily include broker-dealers, banks, and other financial institutions. In the event counterparties do not fulfill their obligations, the Company may be exposed to risk of loss. The risk of default depends on the creditworthiness of the counterparty and/or issuer of the instrument. It is the Company’s policy to review, as necessary, the credit standing for each counterparty. See Note 7 for additional information on interest rate swap agreements.

Mortgage-Backed Securities

The Company invests in agency securities representing interests in or obligations backed by pools of single-family mortgage loans. Guidance under the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 820 on Investments requires the Company to classify its 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. The Company currently classifies all of its agency securities as available-for-sale. All assets that are classified as available-for-sale are carried at fair value and unrealized gains and losses are included in other comprehensive income. The estimated fair values of agency securities are determined by management by obtaining valuations for its agency securities from independent sources and averaging these valuations. Security purchase and sale transactions are recorded on the trade date. Gains or losses realized from the sale of securities are included in income and are

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determined using the specific identification method. Firm purchase commitments to acquire “when issued” or to-be-announced (“TBA”) securities are recorded at fair value in accordance with ASC Topic 815,Derivatives and Hedging.The fair value of these purchase commitments is included in other assets or liabilities in the accompanying balance sheets.

The Company assesses its investment securities for other-than-temporary impairment on at least a quarterly basis. When the fair value of an investment is less than its amortized cost at the balance sheet date of the reporting period for which impairment is assessed, the impairment is designated as either “temporary” or “other-than-temporary.” In deciding on whether or not a security is other than temporarily impaired, the Company uses a two step evaluation process. First, the Company determines whether it has made any decision to sell a security that is in an unrealized loss position, or, if not, the Company determines whether it is more likely than not that the Company will be required to sell the security prior to recovering its amortized cost basis. If the answer to either of these questions is “yes” then the security is considered other-than-temporarily impaired. There were no such impairment losses recognized during the periods presented.

Repurchase Agreements

The Company finances the majority of its agency securities purchases using repurchase agreements. Under a repurchase agreement, an asset is sold to a counterparty to be repurchased at a future date at a predetermined price, which represents the original sales price plus interest. The Company accounts for these repurchase agreements as financings under ASC 860-10-40. Under this standard, for these transactions to be treated as financings, they must be separate transactions and not linked. None of the Company’s repurchase agreements are accounted for as linked transactions.

Interest Income

Interest income is earned and recognized based on the outstanding principal amount of the investment securities and their contractual terms. Premiums and discounts associated with the purchase of the investment securities are amortized or accreted into interest income over the actual lives of the securities using the effective interest method.

Income Taxes

The Company has elected to be taxed as a REIT under the Code. The Company will generally not be subject to Federal income tax to the extent that it distributes 100% of its taxable income, after application of available tax attributes, within the time limits prescribed by the Code and as long as it satisfies the ongoing REIT requirements including meeting certain asset, income and stock ownership tests.

Share-Based Compensation

Share-based compensation is accounted for under the guidance included in the ASC Topic on stock compensation. For share and share-based awards issued to employees, a compensation

8

charge is recorded in earnings based on the fair value of the award. For transactions with non-employees in which services are performed in exchange for the Company’s common stock or other equity instruments, the transactions are recorded on the basis of the fair value of the service received or the fair value of the equity instruments issued, whichever is more readily measurable at the date of issuance. The Company’s share-based compensation transactions resulted in compensation expense of $447 and $334 for the three months ended September 30, 2012 and 2011, respectively. The Company’s share-based compensation transactions resulted in compensation expense of $1,301 and $735 for the nine months ended September 30, 2012 and 2011, respectively.

Earnings Per Common Share (EPS)

Basic EPS is computed by dividing net income less preferred stock dividends to arrive at net income available to holders of common stock by the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed using the two class method, as described in the ASC Topic on Earnings Per Share, which takes into account certain adjustments related to participating securities. Net income available to holders of common stock after deducting dividends on unvested participating securities if antidilutive, is divided by the weighted average shares of common stock and common equivalent shares outstanding during the period. For the diluted EPS calculation, common equivalent shares outstanding includes the weighted average number of shares of common stock outstanding adjusted for the effect of dilutive unexercised stock options.

Recent Accounting Pronouncements

In October 2011, the FASB issued a proposed ASU 2011-20,Financial Services-Investment Companies: Amendments to the Scope, Measurement, and Disclosure Requirements (“ASU 2011-20”), which would amend the criteria in ASC Topic 946 on Investment Companies (“ASC 946”) for determining whether an entity qualifies as an investment company. As proposed, ASU 2011-20 would affect the measurement, presentation and disclosure requirements for Investment Companies, as defined, amend the investment company definition in ASC 946, and remove the current exemption for real estate investment trusts from this topic. If promulgated in its current form, this proposal may result in a material modification to the presentation of the Company’s financial statements. The Company is monitoring developments related to this proposal and is evaluating the effects it would have on the Company’s financial statements.

3. Financial Instruments

The Company’s valuation techniques for financial instruments are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect the Company’s market assumptions. The ASC Topic on Fair Value Measurements classifies these inputs into the following hierarchy:

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

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

Level 3 Inputs – Instruments with primarily unobservable value drivers.

9

All of the Company’s agency securities and hedging assets and liabilities were valued using Level 2 inputs at September 30, 2012 and December 31, 2011. See Notes 4 and 7, respectively for a discussion on how agency securities and hedging assets and liabilities were valued. The carrying values and fair values of all financial instruments as of September 30, 2012 and December 31, 2011 were as follows:

	September 30, 2012				December 31, 2011
	Carrying		Fair		Carrying		Fair
	Value		Value		Value		Value
Assets
Mortgage-backed securities	$	26,375,137	$	26,375,137	$	17,741,873	$	17,741,873
Unsettled purchased mortgage backed securities		120,478		120,478		49,630		49,630
Cash and cash equivalents		150,846		150,846		347,045		347,045
Restricted cash		302,180		302,180		237,014		237,014
Accrued interest receivable		80,056		80,056		63,025		63,025
Principal payments receivable		182,195		182,195		105,333		105,333
Debt Security		15,000		13,816		15,000		13,811
Short term investment*		20,132		20,132		20,221		20,221
Forward purchase commitments*		26,843		26,843		6,327		6,327
Liabilities
Repurchase agreements	$	23,583,180	$	23,583,180	$	16,162,375	$	16,162,375
Payable for unsettled securities		118,925		118,925		48,999		48,999
Accrued interest payable		4,729		4,729		4,596		4,596
Interest rate hedge liability		273,120		273,120		219,167		219,167

* These lines are included in Other Assets on the balance sheets

4. Mortgage-Backed Securities

All of the Company’s agency securities were classified as available-for-sale and, as such, are reported at their estimated fair value. The agency securities market is primarily an over-the-counter market. As such, there are no standard, public market quotations or published trading data for individual agency securities. The Company estimates the fair value of the Company’s agency securities based on a market approach obtaining values for its securities primarily from third-party pricing services and dealer quotes. To ensure the Company’s fair value determinations are consistent with the ASC Topic on Fair Value Measurements and Disclosures, the Company regularly reviews the prices obtained and the methods used to derive those prices. The Company evaluates the pricing information it receives taking into account factors such as coupon, prepayment experience, fixed/adjustable rate, annual and life caps, coupon index, time to next reset and issuing agency, among other factors to ensure that estimated fair values are appropriate. The Company reviews the methods and inputs used by providers of pricing data to determine that the fair value of its assets and liabilities are properly classified in the fair value hierarchy.

The third-party pricing services gather trade data and use pricing models that incorporate such factors as coupons, primary mortgage rates, prepayment speeds, spread to the U.S. Treasury and interest rate swap curves, periodic and life caps and other similar factors. Traders at broker-dealers

10

function as market-makers for these securities, and these brokers have a direct view of the trading activity. Brokers do not receive compensation for providing pricing information to the Company. The broker prices received are non-binding offers to trade. The brokers receive data from traders that participate in the active markets for these securities and directly observe numerous trades of securities similar to the securities owned by the Company. The Company’s analysis of fair value for these includes comparing the data received to other information, if available, such as repurchase agreement pricing or internal pricing models.

If the fair value of a security is not available using the Level 2 inputs as described above, or such data appears unreliable, the Company may estimate the fair value of the security using a variety of methods including, but not limited to, other independent pricing services, repurchase agreement pricing, discounted cash flow analysis, matrix pricing, option adjusted spread models and other fundamental analysis of observable market factors. At September 30, 2012, all of the Company’s agency securities values were based on third-party sources.

The Company’s agency securities portfolio consists solely of agency securities, which are backed by a U.S. Government agency or a U.S. Government sponsored entity. The following table presents certain information about the Company’s agency securities at September 30, 2012.

	Agency Securities		Gross		Gross
	Amortized		Unrealized		Unrealized		Estimated
	Cost		Loss		Gain		Fair Value
Agency Securities
Fannie Mae Certificates
ARMS	$	14,098,876	$	—	$	410,435	$	14,509,311
Fixed Rate		2,900,357		—		56,611	$	2,956,968
Total Fannie Mae		16,999,233		—		467,046	$	17,466,279
Freddie Mac Certificates
ARMS		7,260,695		—		185,794	$	7,446,489
Fixed Rate		1,436,190		—		26,179	$	1,462,369
Total Freddie Mac		8,696,885		—		211,973	$	8,908,858
Total Agency Securities	$	25,696,118	$	—	$	679,019	$	26,375,137

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The following table presents certain information about the Company’s agency securities at December 31, 2011.

	Agency Securities Amortized		Gross Unrealized			Gross Unrealized		Estimated
	Cost		Loss			Gain		Fair Value
Agency Securities
Fannie Mae Certificates
ARMS	$	11,446,397	$	—		$	278,559	$	11,724,956
Fixed Rate		493,648		(132	)		1,076		494,592
Total Fannie Mae		11,940,045		(132	)		279,635		12,219,548
Freddie Mac Certificates
ARMS		4,925,438		—			103,540		5,028,978
Fixed Rate		491,289		(6	)		2,064		493,347
Total Freddie Mac		5,416,727		(6	)		105,604		5,522,325
Total Agency Securities	$	17,356,772	$	(138	)	$	385,239	$	17,741,873

The components of the carrying value of available-for-sale agency securities at September 30, 2012 and December 31, 2011 are presented below.

	September 30, 2012			December 31, 2011
Principal balance	$	24,984,373		$	16,938,710
Unamortized premium		711,752			418,071
Unamortized discount		(7	)		(9	)
Gross unrealized gains		679,019			385,239
Gross unrealized losses		—			(138	)
Carrying value/estimated fair value	$	26,375,137		$	17,741,873

The Company monitors the performance and market value of its agency securities portfolio on an ongoing basis. At September 30, 2012, the Company did not have any securities in an unrealized loss position. As of December 31, 2011, the Company had the following securities in a loss position presented below:

	Less than 12 months
	as of December 31, 2011
	Fair Market		Unrealized
	Value		Loss
Fannie Mae Certificates
ARMS	$	—	$	—
Fixed Rate		210,743		(132	)
Freddie Mac Certificates
ARMS		—		—
Fixed Rate		23,012		(6	)
Total temporarily impaired securities	$	233,755	$	(138	)

The Company did not make the decision to sell the above securities as of December 31, 2011, nor was it deemed more likely than not the Company would be required to sell these securities before recovery of their amortized cost basis.

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The following table presents components of interest income on the Company’s agency securities portfolio for the three and nine months ended September 30, 2012 and 2011:

	Three Months Ended						Nine Months Ended
	September 30, 2012			September 30, 2011			September 30, 2012			September 30, 2011
Coupon interest on MBS	$	179,202		$	140,234		$	486,156		$	370,967
Net premium amortization		(47,262	)		(30,109	)		(112,736	)		(60,719	)
Interest income on MBS, net	$	131,940		$	110,125		$	373,420		$	310,248

The contractual maturity of the Company’s agency securities ranges from 15 to 30 years. Because of prepayments on the underlying mortgage loans, the actual weighted-average maturity is expected to be significantly less than the stated maturity.

Unsettled Agency Securities Purchases

While most of the Company’s purchases of agency securities are accounted for using trade date accounting, some forward purchases, such as certain TBA’s do not qualify for trade date accounting and are considered derivatives for financial statement purposes. Pursuant to ASC Topic 815, the Company accounts for these derivatives as all-in-one cash flow hedges. The net fair value of the forward commitment is reported on the balance sheet as an asset (or liability), with a corresponding unrealized gain (or loss) recognized in other comprehensive income. The following table shows the agency securities forward purchase commitments shown as a net asset on the balance sheet as of September 30, 2012.

					Fair Market		Due to		Net
	Face		Cost		Value		Brokers (1)		Asset
September 30, 2012	$	1,358,000	$	1,409,047	$	1,423,058	$	1,409,047	$	14,011

The following table shows the agency securities forward purchase commitments shown as a net asset on the balance sheet as of December 31, 2011.

					Fair Market		Due to		Net
	Face		Cost		Value		Brokers (1)		Asset
December 31, 2011	$	340,000	$	348,937	$	351,249	$	348,937	$	2,312

(1) Amounts due to brokers are usually settled within 30-90 days after period end.

Since the Company purchases forward for the purposes of holding the securities for investment, the Company considers all its agency securities, settled or unsettled, as part of its portfolio for the purposes of cash flow and interest rate sensitivity, and consequently hedging, duration measurement, and other related investment management activity.

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5. Debt Security, Held to Maturity

The Company owns a $15,000 debt security from a repurchase lending counterparty that matures October 31, 2016. The debt security pays interest quarterly at the rate of 4.0% above the three-month London Interbank Offered Rate (“LIBOR”). The Company estimates the fair value of this note to be approximately $13,816 which was determined by present valuing the projected future cash flows using a discount rate from a similar issuer.

6. Repurchase Agreements

At September 30, 2012 and December 31, 2011, the Company had repurchase agreements in place in the amount of $23,583,180 and $16,162,375, respectively, to finance agency securities purchases. At September 30, 2012 and December 31, 2011, the weighted average interest rate on these borrowings was 0.40% and 0.37%, respectively. The Company’s repurchase agreements are collateralized by the Company’s agency securities and typically bear interest at rates that are closely related to LIBOR. At September 30, 2012 and December 31, 2011, the Company had repurchase agreements outstanding with 24 and 23 counterparties, respectively with a weighted average contractual maturity of 23 days. The following table presents the contractual repricing information regarding the Company’s repurchase agreements:

	September 30, 2012					December 31, 2011
	Balance		Weighted Average Contractual Rate			Balance		Weighted Average Contractual Rate
Within 30 days	$	20,060,323		0.40	%	$	16,162,375		0.37	%
30 days to 3 months		3,522,857		0.41			—		—
3 months to 36 months		—		—			—		—
	$	23,583,180		0.40	%	$	16,162,375		0.37	%

The fair value of securities, cash, and accrued interest the Company had pledged under repurchase agreements at September 30, 2012 and December 31, 2011 was $24,933,286 and $17,061,970 respectively.

7. Derivatives – Interest Rate Swap Agreements

Risk Management Objective of Using Derivatives

The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its debt funding. The Company’s primary source of debt funding is repurchase agreements. Since the interest rates on repurchase agreements usually

14

change on a monthly basis, the Company is exposed to changing interest rates and the cash flows associated with these rates. To mitigate the effect of changes in these interest rates, the Company enters into interest rate swap agreements which help to manage the volatility in the interest rate exposures and their related cash flows.

Cash Flow Hedges of Interest Rate Risk

The Company finances its activities primarily through repurchase agreements, which are generally settled on a short-term basis, usually from one to three months. At each settlement date, the Company refinances each repurchase agreement at the market interest rate at that time. Since the interest rates on its repurchase agreements change on a monthly basis, the Company is constantly exposed to changing interest rates. The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company currently uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. The effect of these hedges is to synthetically lock up interest rates on a portion of the Company’s outstanding debt for the terms of the swaps. Although the Company’s objective is to hedge the risk associated with changing repurchase agreement rates, the Company’s hedges are benchmark interest rate hedges which perform with reference to LIBOR. Therefore, the Company remains at risk to the variability of the spread between repurchase agreement rates and LIBOR interest rates.

For qualifying derivatives under cash flow hedge accounting, effective hedge gains or losses are initially recorded in accumulated other comprehensive income and subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During the three months ended September 30, 2012 and 2011, these effective hedge losses totaled $51,883 and $150,557, respectively. During the nine months ended September 30, 2012 and 2011, these effective hedge losses totaled $85,842 and $260,244, respectively. Ineffective hedge gains/(losses) are recorded on a current basis in earnings and for the three months ended September 30, 2012 and 2011, the Company recorded $17 and ($130), respectively. For the nine months ended September 30, 2012 and 2011, the Company recorded ($321) and ($515), respectively, of hedge ineffectiveness gains/(losses) in earnings. The hedge ineffectiveness is attributable primarily to differences in the reset dates on the Company’s swaps versus the refinancing dates of its repurchase agreements.

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest is accrued and paid on the Company’s repurchase agreements. During the next 12 months, the Company estimates that an additional $120,235 will be reclassified as an increase to interest expense.

The Company is hedging its exposure to the variability in future cash flows for forecasted transactions over an average period of 34 months. The table below shows the remaining term of the Company’s interest rate swaps as of September 30, 2012.

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Maturity	Notional Amount		Remaining Term in Months		Weighted Average Fixed Interest Rate in Contract
12 months or less	$	900,000		7		2.00	%
Over 12 months to 24 months		1,600,000		20		1.92	%
Over 24 months to 36 months		4,000,000		31		1.70	%
Over 36 months to 48 months		2,400,000		42		1.10	%
Over 48 months to 60 months		2,000,000		53		0.88	%
Total	$	10,900,000		34		1.48	%

The fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts). The variable cash payments (or receipts) are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves. The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheets as of September 30, 2012 and December 31, 2011, respectively.

Asset Derivatives

Liability Derivatives

As of September 30, 2012

As of December 31, 2011

As of September 30, 2012

As of December 31, 2011

Balance Sheet

Fair Value

Balance Sheet

Fair Value

Balance Sheet

Fair Value

Balance Sheet

Fair Value

Interest rate hedge

Interest rate hedge asset

—

Interest rate hedge asset

—

Interest rate hedge liability

$

273,120

Interest rate hedge liability

$

219,167

Forward purchase commitment

Other assets

26,843

Other Assets

6,327

Account payable and other liabilities

—

Account payable and other liabilities

—

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The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three months ended September 30, 2012.

Derivative type for cash flow hedge	Amount of loss recognized in OCI on derivative (effective  portion)		Location of loss reclassified from accumulated OCI into income (effective portion)	Amount of loss reclassified from accumulated OCI into income  (effective portion)		Location of loss recognized in income on derivative (ineffective portion)	Amount of gain recognized in income on derivative (ineffective  portion)
Interest Rate	$	51,833	Interest Expense	$	29,679	Interest Expense	$	17

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three months ended September 30, 2011.

Derivative type for cash flow hedge	Amount of loss recognized in OCI on derivative (effective  portion)		Location of loss reclassified from accumulated OCI into income (effective portion)	Amount of loss reclassified from accumulated OCI into income  (effective portion)		Location of loss recognized in income on derivative (ineffective portion)	Amount of loss recognized in income on derivative (ineffective  portion)
Interest Rate	$	150,557	Interest Expense	$	30,694	Interest Expense	$	130

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the nine months ended September 30, 2012.

Derivative type for cash flow hedge	Amount of loss recognized in OCI on derivative (effective  portion)		Location of loss reclassified from accumulated OCI into income (effective portion)	Amount of loss reclassified from accumulated OCI into income  (effective portion)		Location of gain recognized in income on derivative (ineffective portion)	Amount of loss recognized in income on derivative (ineffective  portion)
Interest Rate	$	139,474	Interest Expense	$	85,842	Interest Expense	$	321

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the nine months ended September 30, 2011.

Derivative type for cash flow hedge	Amount of loss recognized in OCI on derivative (effective  portion)		Location of loss reclassified from accumulated OCI into income (effective portion)	Amount of loss reclassified from accumulated OCI into income  (effective portion)		Location of gain recognized in income on derivative (ineffective portion)	Amount of loss recognized in income on derivative (ineffective  portion)
Interest Rate	$	260,244	Interest Expense	$	75,106	Interest Expense	$	515

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The following table presents the impact of the Company’s interest rate swap agreements on the Company’s accumulated other comprehensive income for the nine months ended September 30, 2012 and the year ended December 31, 2011, respectively.

	September 30, 2012			December 31, 2011
Beginning balance	($	218,451	)	($	47,676	)
Unrealized loss on interest rate swaps		(139,474	)		(273,389	)
Reclassification of net losses included in income statement		85,842			102,614
Ending balance	$	(272,083	)	$	(218,451	)

Credit-risk-related Contingent Features

The Company has agreements with certain of its derivative counterparties that contain a provision where if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender then the Company could also be declared in default on its derivative obligations.

The Company has agreements with certain of its derivative counterparties that contain a provision where if the Company’s GAAP shareholders’ equity declines by a specified percentage over a specified time period, or if the Company fails to maintain a minimum shareholders’ equity threshold, then the Company could be declared in default on its derivative obligations. The Company has agreements with several of its derivative counterparties that contain provisions regarding maximum leverage ratios. The most restrictive of these leverage covenants is that if the Company exceeds a leverage ratio of 10 to 1 then the Company could be declared in default on its derivative obligations with that counterparty. At September 30, 2012, the Company was in compliance with these requirements.

As of September 30, 2012, the fair value of derivatives in a net liability position related to these agreements was $273,120. The Company has collateral posting requirements with each of its counterparties and all interest rate swap agreements were fully collateralized as of September 30, 2012.

8. Preferred Stock and Capital Stock

Issuance of Preferred Stock

On August 16, 2012, the Company amended its charter to increase the number of authorized shares of preferred stock, par value $0.001 per share, from 10,000,000 to 25,000,000 shares.

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On August 27, 2012, the Company issued 11,500,000 shares (including 1,500,000 shares issued pursuant to the full exercise of the underwriters’ overallotment option) of its 7.625% Series A Cumulative Redeemable Preferred Stock (“Series A Preferred Stock”), with a par value of $0.001 per share and a liquidation preference of $25.00 per share (total liquidation preference of $287,500) plus accrued and unpaid dividends (whether or not declared). Holders of shares of the Series A Preferred Stock are entitled to receive cumulative cash dividends at the rate of 7.625% per year of the $25.00 liquidation preference per share (equivalent to the fixed annual rate of $1.90625 per share). The Company may not redeem the Series A Preferred Stock before August 27, 2017, except in limited circumstances relating to the Company’s ability to qualify as a REIT and except as described in the Company’s articles supplementary upon the occurrence of a change of control (as defined in the articles supplementary). After August 27, 2017, the shares are redeemable at the Company’s option. The Series A Preferred Stock ranks senior to the Company’s common stock with respect to dividend rights and rights upon the voluntary or involuntary liquidation, dissolution, or winding-up of the Company’s affairs. Holders of shares of the Series A Preferred stock generally have no voting rights unless dividends are in arrears for six or more consecutive quarters. Through September 30, 2012, the Company has declared and paid all required quarterly dividend on the Series A Preferred Stock.

Issuance of Common Stock – “At the Market” Programs

From time to time, the Company may sell shares of its common stock in “at-the-market” offerings. Sales of the shares of common stock, if any, may be made in private transactions, negotiated transactions or any method permitted by law deemed to be an “at the market” offering as defined in Rule 415 under the Securities Act of 1933, as amended, including sales made directly on the New York Stock Exchange (“NYSE”) or to or through a market maker other than on an exchange.

On February 29, 2012, the Company entered into sales agreements (the “2012 Sales Agreements”) with Cantor Fitzgerald & Co. (“Cantor”) and JMP Securities LLC (“JMP”) to establish a new “at-the-market” program (the “2012 Program”). Under the terms of the 2012 Sales Agreements, the Company may offer and sell up to 10,000,000 shares of its common stock from time to time through Cantor or JMP, each acting as agent and/or principal. The shares of common stock issuable pursuant to the 2012 Program are registered with the Securities and Exchange Commission (“SEC”) on the Company’s Registration Statement on Form S-3 (No. 333-179805), which became effective upon filing on February 29, 2012.

For the three months ended September 30, 2012, the Company issued 595,000 shares of common stock in at-the-market transactions, raising net proceeds to the Company, after sales commissions and fees, of $17,087. For the nine months ended September 30, 2012, the Company issued 1,713,900 shares of common stock in at-the-market transactions, raising net proceeds to the Company, after sales commissions and fees, of $48,357. The total commissions and fees charged to additional paid in capital in connection with the issuance of these shares was $268 and $810 for the three and nine months ended September 30, 2012, respectively.

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10. Earnings per Share

	For the three months ended					For the nine months ended
	September 30, 2012			September 30, 2011		September 30, 2012			September 30, 2011
Basic earnings per share:
Net income	$	84,050		$	78,892	$	242,498		$	213,749
Less preferred stock dividends		(2,070	)		—		(2,070	)		—
Net income available to common shareholders	$	81,980		$	78,892	$	240,428		$	213,749
Weighted average shares		98,233,589			75,743,002		91,296,338			70,057,263
Basic earnings per share	$	0.83		$	1.04	$	2.63		$	3.05
Diluted earnings per share:
Net income	$	84,050		$	78,892	$	242,498		$	213,749
Less preferred stock dividends for antidilutive shares		(2,070	)		—		(2,070	)		—
Net income available to common shareholders	$	81,980		$	78,892	$	240,428		$	213,749
Weighted average shares		98,233,589			75,743,002		91,296,338			70,057,263
Potential dilutive shares from exercise of stock options		—			—		—			—
Diluted weighted average shares		98,233,589			75,743,002		91,296,338			70,057,263
Diluted earnings per share	$	0.83		$	1.04	$	2.63		$	3.05

There are not any potentially dilutive shares for the three and nine months ended September 30, 2012 and 2011, respectively.

11. Transactions with Related Parties

Management Fees

The Company is externally managed by ACA pursuant to a management agreement (the “Management Agreement”). All of the Company’s executive officers are also employees of ACA. ACA manages the Company’s day-to-day operations, subject to the direction and oversight of the Company’s board of directors which includes four independent directors. The Management Agreement expires on February 23, 2015 and is thereafter automatically renewed for an additional one-year term unless terminated under certain circumstances. ACA must be provided 180 days prior notice of any such termination and will be paid a termination fee equal to four times the average annual management fee earned by ACA during the two year period immediately preceding termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination.

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Under the terms of the Management Agreement, the Company reimburses ACA for certain operating expenses of the Company that are borne by ACA. ACA is entitled to receive a management fee payable monthly in arrears in an amount equal to 1/12th of an amount determined as follows:

• for the Company’s equity up to $250 million, 1.50% (per annum) of equity; plus

• for the Company’s equity in excess of $250 million and up to $500 million, 1.10% (per annum) of equity; plus

• for the Company’s equity in excess of $500 million and up to $750 million, 0.80% (per annum) of equity; plus

• for the Company’s equity in excess of $750 million, 0.50% (per annum) of equity.

For purposes of calculating the management fee, equity is defined as the value, computed in accordance with GAAP, of shareholders’ equity, adjusted to exclude the effects of unrealized gains or losses. The following table presents amounts paid for management fee and reimbursable expenses.

	Three months ended				Nine months ended
	September 30, 2012		September 30, 2011		September 30, 2012		September 30, 2011
Management Fee	$	4,557	$	3,572	$	12,711	$	10,195
Reimbursable Expenses		407		—		1,033		—
Total	$	4,964	$	3,572	$	13,744	$	10,195

None of the reimbursement payments were specifically attributable to the compensation of the Company’s executive officers. At September 30, 2012 and December 31, 2011, the Company owed ACA $1,762 and $1,171, respectively, for the management fee and reimbursable expenses, which is included in accounts payable and other liabilities.

12. Accumulated Other Comprehensive Income

Accumulated other comprehensive income consists of the following components:

	September 30, 2012			December 31, 2011
Unrealized gain on agency securities, net	$	679,019		$	385,101
Unrealized gain (loss) on unsettled securities		1,553			631
Unrealized loss on short term investment*		(109	)		(287	)
Unrealized loss on derivative instruments		(245,239	)		(212,123	)
Accumulated other comprehensive income		435,224			173,322

* This line item is included in Other Assets on the Balance Sheet.

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The Company records unrealized gains and losses on its agency securities and swap positions as is described in Notes 4 and 7, respectively. Reclassification adjustment for realized gains and losses on the sale of securities included in unrealized gains and losses on available-for-sale securities at September 30, 2012 and December 31, 2011 was approximately $25,244 and $20,576, respectively.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

In this Quarterly Report on Form 10-Q, we refer to Hatteras Financial Corp. as “we,” “us,” “our company,” or “our,” unless we specifically state otherwise or the context indicates otherwise. The following defines certain of the commonly used terms in this quarterly report on Form 10-Q: “MBS” refers to mortgage-backed securities; and “agency securities” refer to our residential MBS that are issued or guaranteed by a U.S. Government sponsored entity, such as the Federal National Mortgage Association (“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”), or an agency of the U.S. Government, such as the Government National Mortgage Association (“Ginnie Mae”); “ARMs” refer to adjustable-rate mortgage loans which typically either 1) at all times have interest rates that adjust periodically to an increment over a specified interest rate index; or 2) have interest rates that are fixed for a specified period of time and, thereafter, generally adjust annually to an increment over a specified interest rate index.

The following discussion should be read in conjunction with our financial statements and accompanying notes included in Part 1, Item 1 of this Quarterly Report on Form 10-Q as well as our Annual Report on Form 10-K for the year ended December 31, 2011, filed with the Securities and Exchange Commission (“SEC”) on February 23, 2012.

Forward-Looking Statements

When used in this Quarterly Report on Form 10-Q, in future filings with the SEC or in press releases or other written or oral communications, statements which are not historical in nature, including those containing words such as “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” or similar expressions, are intended to identify “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and, as such, may involve known and unknown risks, uncertainties and assumptions.

Forward-looking statements 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. The following factors could cause actual results to vary from our forward-looking statements: changes in our investment financing and hedging strategy; the adequacy of our cash flow from operations and borrowings to meet our short-term liquidity requirements; the liquidity of our portfolio; unanticipated changes in our industry, the credit markets, the general economy or the real estate market; changes in interest rates and the market value of our agency securities; changes in the prepayment rates on the mortgage loans securing our agency securities; our ability to borrow to finance our assets; changes in government regulations affecting our business; our ability to maintain our qualification as a real estate investment trust (“REIT”) for federal income tax purposes; our ability to maintain our exemption from registration under the Investment Company Act of 1940, as amended (the “Investment Company Act”); and risks associated with investing in real estate assets, including changes in business conditions and the general economy. These and other risks, uncertainties and factors, including those described in our annual report on Form 10-K for the year ended December 31, 2011, including those set forth under the section captioned “Risk Factors” in our quarterly and current reports that we file with the SEC, could cause our actual results to differ materially from those projected in any forward-looking statements we make. All forward-looking statements speak only as of the date on which they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Overview

We are an externally-managed mortgage REIT that invests primarily in single-family residential mortgage pass-through securities guaranteed or issued by a U.S. Government agency (such as Ginnie Mae), or by a U.S. Government-sponsored entity (such as Fannie Mae and Freddie Mac). We refer to these securities as “agency securities.” We were incorporated in Maryland in September 2007 and commenced operations in November 2007. Our common stock is listed on the New York Stock Exchange (“NYSE”) under the symbol “HTS.”

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We are externally-managed and advised by our manager, Atlantic Capital Advisors LLC.

We are organized and conduct our operations to qualify as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”), and generally are not subject to federal taxes on our income to the extent we distribute our income to our shareholders and maintain our qualification as a REIT.

Our principal goal is to generate net income for distribution to our shareholders, through regular quarterly dividends, from the difference between the interest income on our investment portfolio and the interest costs of our borrowings and hedging activities, which we refer to as our net interest income, and other expenses. In general, our strategy is to manage interest rate risk while trying to eliminate any exposure to credit risk. We believe that the best approach to generating a positive net interest income is to manage our liabilities in relation to the interest rate risks of our investments. To help achieve this result, we employ repurchase financing, generally short-term, and combine our financings with hedging techniques, relying primarily on interest rate swaps. We may, subject to maintaining our REIT qualification, also employ other hedging instruments from time to time, including interest rate caps, collars and swaptions to protect against adverse interest rate movements.

We focus on agency securities consisting of mortgage loans with relatively short effective durations, which we believe limits the impact of changes in interest rates on the market value of our portfolio and on our net interest income. However, because our investments vary in interest rate, prepayment speed and maturity, the leverage or borrowings that we employ to fund our asset purchases will never exactly match the terms or performance of our assets, even after we have employed our hedging techniques. Based on our manager’s experience, the interest rates of our assets will change more slowly than the corresponding short-term borrowings used to finance our assets. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net income and shareholders’ equity.

Our manager’s approach to managing our portfolio is to take a longer term view of assets and liabilities; accordingly, our periodic earnings and mark-to-market valuations at the end of a period will not significantly influence our strategy of providing stable cash distributions to shareholders over the long term. Our manager has invested and seeks to invest in agency securities that it believes are likely to generate attractive risk-adjusted returns on capital invested, after considering (1) the amount and nature of anticipated cash flows from the asset, (2) our ability to borrow against the asset, (3) the capital requirements resulting from the purchase and financing of the asset, and (4) the costs of financing, hedging, and managing the asset.

Since our formation, all of our invested assets have been in agency securities, and we currently intend that our investment assets will continue to be agency securities. These agency securities currently consist of mortgages that have principal and interest payments guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac. We invest in both fixed-rate and adjustable-rate agency securities. ARMs are mortgages that have floating interest rates that reset on a specific time schedule, such as monthly, quarterly or annually, based on a specified index, such as the 12-month moving average of the one-year constant maturity U.S. Treasury rate (“CMT”) or LIBOR. The ARMs we generally invest in, sometimes referred to as hybrid ARMS, have interest rates that are fixed for an initial period (typically three, five, seven or 10 years) and then reset annually thereafter to an increment over a pre-determined interest rate index. As of September 30, 2012, our portfolio consisted of approximately $27.9 billion in market value of agency securities, consisting of $23.5 billion of adjustable-rate securities and $4.4 billion of fixed rate securities.

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The following table represents key data regarding our company since December 31, 2009:

(Dollars in thousands except per share amounts)

As of	Agency Securities (1)		Repurchase Agreements		Equity		Shares Outstanding		Book Value Per Share		Quarterly Weighted Average Earnings Per Share
September 30, 2012	$	27,931,504	$	23,583,180	$	3,212,556		98,809	$	29.60	$	0.83
June 30, 2012	$	24,535,118	$	20,152,860	$	2,692,261		98,074	$	27.45	$	0.91
March 31, 2012	$	22,562,895	$	16,556,630	$	2,669,300		97,779	$	27.30	$	0.89
December 31, 2011	$	18,146,767	$	16,162,375	$	2,080,188		76,823	$	27.08	$	0.92
September 30, 2011	$	19,014,997	$	15,886,231	$	2,015,003		76,547	$	26.32	$	1.04
June 30, 2011	$	16,678,511	$	14,800,594	$	2,006,606		75,092	$	26.72	$	1.04
March 31, 2011	$	14,811,137	$	11,495,749	$	1,894,540		72,572	$	26.11	$	0.96
December 31, 2010	$	10,418,764	$	8,681,060	$	1,145,484		46,116	$	24.84	$	0.99
September 30, 2010	$	9,581,916	$	6,678,426	$	1,190,313		46,085	$	25.83	$	1.12
June 30, 2010	$	7,651,266	$	5,982,998	$	965,619		37,388	$	25.83	$	1.01
March 31, 2010	$	7,125,065	$	6,102,661	$	929,433		36,472	$	25.48	$	1.21
December 31, 2009	$	7,038,987	$	6,346,518	$	931,713		36,200	$	25.74	$	1.28

(1) Includes unsettled purchases and forward commitments to purchase agency securities.

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, and recent events, including those discussed below, can affect our business in ways that are difficult to predict, and produce results outside of typical operating variances. Our net interest income varies primarily as a result of changes in interest rates. Changes in interest rates affect directly our assets coupons and borrowing costs. Because changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our ability to manage interest rate and prepayment risks effectively while maintaining our status as a REIT.

We anticipate that, for any period during which changes in the interest rates earned on our assets do not coincide with interest rate changes on our borrowings, such asset coupon rates will reprice more slowly than the corresponding liabilities used to finance those assets. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net interest income. With the maturities of our assets generally being 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 shareholders.

Prepayments on agency securities and the underlying mortgage loans may be influenced by changes in market interest rates and a variety of economic, geographic and other factors beyond our control; and consequently, such prepayment rates cannot be predicted with certainty. To the extent we have acquired agency securities 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 these prepayments at comparable yields, our net interest income may suffer. The current climate of government intervention in the mortgage market significantly increases the risk associated with prepayments.

While we intend to use hedging to mitigate 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 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 portfolio.

In addition, 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;

• our borrowing costs;

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• our hedging activities;

• the market value of our agency securities; and

• the REIT requirements, the requirements to qualify for an exemption under the Investment Company Act and other regulatory and accounting policies related to our business.

Our manager is entitled to receive a management fee that is based on our equity (as defined in our management agreement), regardless of the performance of our portfolio. Accordingly, the payment of our management fee may not decline in the event of a decline in our profitability and may cause us to incur losses.

For a discussion of additional risks relating to our business see the section captioned “Risk Factors” in Part II, Item 1A of this Quarterly Report on Form 10-Q, and in our Annual Report on Form 10-K for the year ended December 31, 2011.

Market and Interest Rate Trends and the Effect on our Portfolio

Credit Market Disruption

Since 2007, the residential housing and mortgage markets in the United States have experienced a variety of difficulties and challenging economic conditions including historically high loan defaults and credit losses, as well as decreased liquidity. Recently, the financial weakness of some of the European Union sovereign nations has renewed concerns of the stability of financial systems worldwide. Further increased volatility and deterioration in the overall financial markets may adversely affect the performance and market value of the agency securities in which we invest. In addition, we rely on the availability of financing to acquire agency securities on a leveraged basis. If market conditions deteriorate further, our lenders may exit the repurchase market, further tighten lending standards, or increase the amount of equity capital (or “haircut”) required to obtain financing, any of which could make it more difficult or costly for us to obtain financing.

Developments at Fannie Mae and Freddie Mac

Payments 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 have been considered to present low credit risk. In 2008, Fannie Mae and Freddie Mac were placed under the conservatorship of the U.S. government due to the significant weakness of their financial condition. The turmoil in the residential mortgage sector and concern over the future role of Fannie Mae and Freddie Mac at the time generally increased credit spreads and decreased price stability of agency securities. In response to the credit market disruption and the deteriorating financial condition of Fannie Mae and Freddie Mac, Congress and the U.S. Department of the Treasury (the “U.S. Treasury”) undertook a series of actions in 2008 aimed at stabilizing the financial markets in general, and the mortgage market in particular. These actions include the large-scale buying of mortgage-backed securities, significant equity infusions into banks and aggressive monetary policy.

In February 2011, the U.S. Treasury along with the U.S. Department of Housing and Urban Development released a report entitled “Reforming America’s Housing Finance Market” to Congress outlining alternatives for reforming the U.S. housing system, specifically Fannie Mae and Freddie Mac, and transforming the government’s involvement in the housing market. Other industry groups, such as the Mortgage Bankers Association and the National Association Home Builders, have also issued proposals outlining their views of the path for housing reform. 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 government support for residential mortgages, we may not be able to execute our current business model in an efficient manner.

On October 4, 2012, the Federal Housing Finance Authority (the “FHFA”) released its white paper entitled “Building a New Infrastructure for the Secondary Mortgage Market” (the “FHFA White Paper”). This release follows up on the FHFA’s February 21, 2012 Strategic 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.

The FHFA White Paper proposes a new infrastructure for Fannie Mae and Freddie Mac that has two basic goals. The first 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.

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U.S. Treasury and Agency MBS Market Intervention

One of the main factors impacting market prices has been the U.S. Federal Reserve System’s (the “U.S. Federal Reserve”) programs to purchase U.S. Treasury and agency securities in the open market. The most significant of these programs commenced in January 2009 and was terminated on June 30, 2010. In total, $1.25 trillion of agency securities was purchased. In November 2010, the U.S. Federal Reserve announced another program to purchase an additional $600 billion of longer-term U.S. Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. On September 21, 2011, the U.S. Federal Reserve, in a program dubbed “Operation Twist,” announced that it intended to sell $400 billion shorter term U.S. Treasury securities by the end of June 2012, and reinvest the proceeds to purchase longer term U.S. Treasury securities with a goal of further monetary stimulus as a result of flattening the shape of the U.S. Treasury yield curve. This program is intended to extend the average maturity of the securities in the U.S. Federal Reserve’s portfolio. By reducing the available supply of longer term U.S. Treasury securities in the market, this action should put downward pressure on longer term interest rates, including rates on financial assets that investors consider to be close substitutes for longer term U.S. Treasury securities, like certain types of agency securities. The reduction in longer term interest rates, in turn, may contribute to a broad easing in financial market conditions that the U.S. Federal Reserve hopes will provide additional stimulus to support the economic recovery. In June 2012, the U.S Federal Reserve announced it was adding another $267 billion and extending the duration of the program aimed at lengthening the maturity of its portfolio through the end of 2012 in an effort to put additional downward pressure on long-term interest rates. The U.S. Federal Reserve also reaffirmed its policy to reinvest principal repayments from its holdings of agency securities into agency securities.

In September 2012, the U.S. Federal Reserve announced a third round of “quantitative easing” aimed to improve the employment outlook and increase growth in the U.S. economy. To accomplish this goal, it announced that it would purchase at least $40 billion of agency securities per month, on an “open-ended” timeline, in addition to the reinvestment of the proceeds of principal repayments from its existing MBS holdings. Additionally, it pledged to keep short-term interest rates near zero for an extended period of time, currently estimated by the U.S. Federal Reserve to be at least mid - 2012.

These programs have had many effects on our assets. One effect of these purchases has been an increase in the prices of agency securities, which has contributed to the decreased our net interest margin. The unpredictability of these programs has also injected additional volatility into the pricing and availability of our assets. It is difficult to quantify the impact, as there are many factors at work at the same time which affects the price of our 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. We believe the largest risk is that if the government decides to sell significant portions of its portfolio, then we may see meaningful price declines.

U.S. Government Credit Rating

The U.S. debt ceiling and budget deficit concerns in mid-2011 led to the downgrade by Standard & Poor’s of the U.S. government’s credit rating for the first time in history. Assets backed by Fannie Mae and Freddie Mac are considered to have the credit of the U.S. government, and thus were also downgraded at that time. While the other rating agencies have not downgraded the U.S. government’s rating, if they were to do so it would likely impact the perceived credit risk associated with agency securities and, therefore, decrease the value of the agency securities in our portfolio. In addition, further downgrades of the U.S. government’s credit rating or the credit ratings of certain European countries would likely create broader financial turmoil and uncertainty, which could have a serious negative impact on the global banking system. This could have an adverse impact on our business, financial condition and results of operations.

Regulatory Concerns

We believe that we conduct our business in a manner that allows us to avoid being regulated as an investment company under the Investment Company Act pursuant to the exemption provided by Section 3(c)(5)(C) 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-Related Instruments) pursuant to which

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it is reviewing whether certain companies that invest in MBS and rely on the exemption from registration under Section 3(c)(5)(C) of the Investment Company Act (such as us) should continue to be allowed to rely on such exemption from registration. If we fail to continue to qualify for this exemption 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, 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 Investment Company Act, either of which could negatively affect the value of shares of our common stock and our ability to make distributions to our shareholders.

Certain programs initiated by the U.S. Government, through the Federal Housing Administration 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 and (ii) lower interest and principal payments.

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“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 U.S. Federal Reserve for systemically important financial institutions (including nonbank financial companies), as well as the implementation of the FDIC resolution procedures for liquidation of large financial companies to avoid market disruption;

• 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 U.S. Federal Reserve’s emergency authority to lend to nondepository institutions to facilities with broad-based eligibility, and authorizing the FDIC to establish an emergency financial stabilization fund for solvent depository institutions and their holding companies, subject to the approval of Congress, the Secretary of the U.S. Treasury and the U.S. Federal Reserve;

• 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 swaps as much of the bill’s implementation has not yet been defined by the regulators.

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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 leaders 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.

In September 2011, the Administration announced it was working on a major plan 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-value ratio above 125%. However, this would only apply to mortgages guaranteed by the U.S. government-sponsored entities. 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-value ratio of 125% qualifies as a mortgage or an unsecured consumer loan. The chances of this initiative’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 U.S. Federal Reserve released a report titled “The U.S. Housing Market: Current Conditions and Policy Considerations” to Congress providing a framework for thinking about certain issues and tradeoffs that policy makers might consider. 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.

Exposure to European Financial Counterparties

We have no direct exposure to any European sovereign credit. We do finance the acquisition of our agency securities with repurchase agreements, some of which are provided by European banks. In connection with these financing arrangements, we pledge our securities as collateral to secure the borrowing. The amount of collateral pledged will typically exceed the amount of the financing with the extent of over-collateralization ranging from 3%-5% of the amount borrowed. While repurchase agreement financing results in us recording a liability to the counterparty in our consolidated balance sheet, we are exposed to the counterparty, if during the term of the repurchase agreement financing, a lender should default on its obligation and we are not able to recover our pledged assets. The amount of this exposure is the difference between the amount loaned to us plus interest due to the counterparty and the fair value of the collateral pledged by us to the lender including accrued interest receivable on such collateral.

In addition, we use interest rate swaps to manage interest rate risk exposure in connection with our repurchase agreement financings. We will make cash payments or pledge securities as collateral as part of a margin arrangement in connection with interest rate swaps that are in an unrealized loss position. In the event that a counterparty were to default on its obligation, we would be exposed to a loss to a swap counterparty to the extent that the amount of cash or securities pledged exceeded the unrealized loss on the associated swaps and we were not able to recover the excess collateral.

During the past several years, several large European banks have experienced financial difficulty and have been either rescued by government assistance or by other large European banks. Some of these banks have U.S. banking subsidiaries, which have provided financing to us, particularly repurchase agreement financing for the acquisition of agency securities. At September 30, 2012, we had entered into repurchase agreements and/or interest

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rate swaps with seven financial institution counterparties that are either domiciled in Europe or a U.S.-based subsidiary of a European domiciled financial institution. Our total exposure to these banks was 10.4% of our equity at September 30, 2012. At September 30, 2012, we did not use credit default swaps or other forms of credit protection to hedge these exposures, although we may in the future. The following table shows our exposure by country to European banks.

(Dollars in thousands)	Number of Counterparties	Exposure (1)		Exposure as a percentage of equity
England	1	$	53,462		1.7	%
France	1		48,017		1.5	%
Germany	2		123,926		3.9	%
Netherlands	1		20,138		0.6	%
Scotland	1		30,650		0.9	%
Switzerland	1		58,270		1.8	%
	7	$	334,463		10.4	%

(1) Exposure represents our total assets pledged as collateral in excess of our obligations, including any accrued interest receivable on the pledged assets.

Management monitors our exposure to our repurchase agreement and swap counterparties on a regular basis, using various methods, including review of recent rating agency actions or other developments and by monitoring the amount of cash and securities collateral pledged and the associated loan amount under repurchase agreements and/or the fair of swaps with our counterparties. We intend to make reverse margin calls on our counterparties to recover excess collateral as permitted by the agreements governing our financing arrangements, or take other necessary actions to reduce the amount of our exposure to a counterparty when such actions are considered necessary.

Interest Rates

Mortgage markets in general, and our strategy in particular, are interest rate sensitive. The relationship between several interest rates is generally determinant of the performance of our company. Our borrowings in the repurchase market have historically closely tracked LIBOR and the U.S. Federal Funds Target Rate. Significant volatility in these rates or a divergence from the historical relationship among these rates could negatively impact our ability to manage our portfolio. The agency securities we buy are affected by the shape of the yield curve, particularly along the area between two year Treasury rate and 10 year Treasury rates. The following table shows the 30-day LIBOR as compared to these rates at each period end:

	30-day LIBOR			U.S. Federal Funds			Two-Year Treasury			10-Year Treasury
September 30, 2012		0.21	%		0.09	%		0.23	%		1.63	%
June 30, 2012		0.25	%		0.09	%		0.30	%		1.65	%
March 31, 2012		0.24	%		0.09	%		0.33	%		2.21	%
December 31, 2011		0.30	%		0.04	%		0.24	%		1.88	%
September 30, 2011		0.24	%		0.06	%		0.25	%		1.92	%
June 30, 2011		0.19	%		0.07	%		0.46	%		3.16	%
March 31, 2011		0.24	%		0.10	%		0.83	%		3.47	%
December 31, 2010		0.26	%		0.13	%		0.60	%		3.30	%
September 30, 2010		0.26	%		0.15	%		0.43	%		2.51	%
June 30, 2010		0.35	%		0.09	%		0.61	%		2.93	%
March 31, 2010		0.25	%		0.09	%		1.02	%		3.83	%
December 31, 2009		0.23	%		0.05	%		1.14	%		3.84	%

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Principal Repayment Rate

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 assets at a premium to par, the main item that can affect the yield on our assets 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’ regular monthly payments, are fairly predictable, the unscheduled repayments, which are generally refinancing of the mortgage, are less so. Estimates of repayment rates are critical to the management of our portfolio, not only for estimating current yield but also to consider the rate of reinvestment of those proceeds into new securities, the yields which those new securities may add to our portfolio, as well as the extent to which we extend the duration of our liabilities in connection with hedging activities. The following table shows the weighted average principal repayment rate and the one-month constant prepayment rate (“CPR”) for the periods presented:

Quarter ended	Weighted Average Principal Repayment Rate (1)	Weighted Average Principal Repayment Rate Annualized (2)	One-Month CPR (3)
September 30, 2012	6.90%	27.61%	20.5
June 30, 2012	6.36%	25.42%	19.7
March 31, 2012	6.42%	25.67%	19.6
December 31, 2011	6.85%	27.39%	20.8
September 30, 2011	7.14%	28.55%	21.7
June 30, 2011	4.64%	18.54%	14.9
March 31, 2011	5.61%	22.44%	17.5
December 31, 2010	7.81%	31.26%	23.9
September 30, 2010	8.48%	33.91%	25.5
June 30, 2010	11.27%	45.08%	29.1

(1) Scheduled and unscheduled principal payments as a percentage of the weighted average portfolio.

(2) Weighted average principal repayment rate annualized.

(3) CPR measures one month of unscheduled repayments as a percentage of principal on an annualized basis.

Investing the Proceeds of our Offerings

Due to the regulation requiring the distribution of REIT income, our ability to grow our company is based on raising additional equity capital. We have issued both common and preferred equity during 2012. On March 30, 2012, we issued 20,125,000 shares of common stock for net proceeds of $539.4 million. On August 27, 2012, we issued 11,500,000 shares of our 7.625% Series A Cumulative Redeemable Preferred Stock (“Series A Preferred Stock”) for net proceeds of $278.3 million. During 2012, we also issued 1,713,900 shares of common stock under our at-the-market offering programs for net proceeds of $48.4 million.

While our operations are affected in many ways by the issuance of additional shares, the most significant immediate earnings impact is that we generally do not invest all of the proceeds immediately. Depending on market conditions, and the fact that normal trade settlement on agency securities is not based on the trade date, we have averaged around two months to invest the proceeds from these offerings. Since each capital raise was individually significant to the size of our portfolio, our results from operations, and some statistics regarding such results, may not be meaningful or portray the underlying fundamentals of our investment portfolio.

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Book Value per Share

As of September 30, 2012, our book value per share of common stock (total shareholders’ equity less aggregate liquidation preference for Series A Preferred Stock divided by shares of common stock outstanding) was $29.60, an increase of $2.52, from $27.08 at December 31, 2011. The unrealized gain per share on our agency securities increased and the unrealized loss per share on our interest rate swaps decreased. Although we attempt to structure our interest rate swap portfolio to offset the changes in asset prices, the price movements of the swaps and mortgage-backed securities are not perfectly correlated, and depend on a variety of market forces. The following table shows the components of our book value on a per share basis at each period end:

As of	Common Equity		Undistributed Earnings	Unrealized Gain/(Loss) on MBS	Unrealized Gain/(Loss) on Interest Rate Swaps	Book Value Per Share
September 30, 2012	$	25.14	0.05	7.16	(2.75)	$	29.60
June 30, 2012	$	25.25	0.02	4.73	(2.55)	$	27.45
March 31, 2012	$	25.23	0.01	4.29	(2.23)	$	27.30
December 31, 2011	$	24.79	0.03	5.11	(2.85)	$	27.08
September 30, 2011	$	24.79	0.01	4.56	(3.04)	$	26.32
June 30, 2011	$	24.79	(0.03)	3.47	(1.51)	$	26.72
March 31, 2011	$	24.67	(0.06)	1.67	(0.17)	$	26.11
December 31, 2010	$	22.62	(0.08)	3.33	(1.03)	$	24.84
September 30, 2010	$	22.63	(0.07)	5.66	(2.39)	$	25.83
June 30, 2010	$	21.50	0.12	6.36	(2.15)	$	25.83
March 31, 2010	$	21.32	0.24	5.25	(1.33)	$	25.48
December 31, 2009	$	21.28	0.24	5.21	(0.99)	$	25.74

Investment in Agency Securities

We invest in both adjustable and fixed-rate agency securities. At September 30, 2012 and December 31, 2011, we owned $26.4 billion and $17.7 billion, respectively, of agency securities. While our strategy focuses on ARM securities, we also own fixed-rate securities with estimated durations that we believe are beneficial to the overall mix of our assets. As of September 30, 2012 and December 31, 2011, our agency securities portfolio was purchased at a net premium to par, or face value, with a weighted-average amortized cost of 102.85 and 102.47, respectively, of face value. As of September 30, 2012 and December 31, 2011, we had approximately $711.7 million and $418.1 million, respectively, of unamortized premium included in the cost basis of our agency securities.

During the quarter ended September 30, 2012, we purchased approximately $5.2 billion of agency securities with a weighted average coupon of 2.40%. During the nine months ended September 30, 2012, we purchased approximately $14.2 billion of agency securities with a weighted average coupon of 2.53%.

We typically want to own a higher percentage of Fannie Mae ARMs, than Freddie Mac ARMs as Fannie Mae has better cash flow to the security holder because Fannie Mae pays principal and interest sooner after accrual (45 days) as compared to Freddie Mac (75 days).

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Our investment portfolio consisted of the following types of Fannie Mae and Freddie Mac securities at September 30, 2012:

	MBS Amortized Cost		Gross Unrealized Loss			Gross Unrealized Gain		Estimated Fair Value		% of Total
Agency Securities
Fannie Mae Certificates
ARMS	$	14,098,876	$	—		$	410,435	$	14,509,311		55.0	%
Fixed Rate		2,900,357		—			56,611	$	2,956,968		11.2	%
Total Fannie Mae		16,999,233		—			467,046	$	17,466,279
Freddie Mac Certificates
ARMS		7,260,695		—			185,794	$	7,446,489		28.2	%
Fixed Rate		1,436,190		—			26,179	$	1,462,369		5.6	%
Total Freddie Mac		8,696,885		—			211,973	$	8,908,858
Total Agency Securities	$	25,696,118	$	—		$	679,019	$	26,375,137
Our investment portfolio consisted of the following types of Fannie Mae and Freddie Mac securities at December 31, 2011:
(Dollars in thousands)	MBS Amortized Cost		Gross Unrealized Loss			Gross Unrealized Gain		Estimated Fair Value		% of Total
Agency Securities
Fannie Mae Certificates
ARMS	$	11,446,397	$	—		$	278,559	$	11,724,956		66.1	%
Fixed Rate		493,648		(132	)		1,076		494,592		2.8	%
Total Fannie Mae		11,940,045		(132	)		279,635		12,219,548
Freddie Mac Certificates
ARMS		4,925,438	$	—			103,540		5,028,978		28.3	%
Fixed Rate		491,289		(6	)		2,064		493,347		2.8	%
Total Freddie Mac		5,416,727		(6	)		105,604		5,522,325
Total Agency Securities	$	17,356,772	$	(138	)	$	385,239	$	17,741,873

Adjustable-rate securities

As of September 30, 2012, our investment portfolio consisted of ARM securities as follows:

(Dollars in thousands, except weighted average price amounts)
Months to Reset	% of ARM Portfolio			Current Face value (1)		Weighted Avg. Coupon (2)			Weighted Avg. Amortized Purchase  Price (3)		Amortized Cost (4)		Weighted Avg. Market Price (5)		Market Value (6)
0-12		5.0	%	$	1,023,762		4.40	%	$	101.28	$	1,036,872	$	107.17	$	1,097,137
13-24		2.0	%		419,020		3.99	%	$	101.63		425,862	$	106.68		447,006
25-36		10.9	%		2,252,591		3.83	%	$	102.32		2,304,796	$	105.96		2,386,779
37-48		16.5	%		3,445,028		3.13	%	$	102.43		3,528,608	$	105.10		3,620,883
49-60		16.8	%		3,508,827		2.70	%	$	102.82		3,607,928	$	105.03		3,685,378
61-72		15.4	%		3,193,506		3.32	%	$	102.51		3,273,586	$	106.04		3,386,420
73-84		30.6	%		6,366,502		2.57	%	$	103.26		6,573,917	$	105.41		6,710,844
85-96		0.3	%		70,091		3.55	%	$	103.81		72,763	$	106.47		74,625
97-108		0.1	%		17,793		3.64	%	$	103.50		18,416	$	106.20		18,897
109-120		2.4	%		499,404		2.85	%	$	103.49		516,823	$	105.69		527,831
Total ARMS		100.0	%	$	20,796,524		3.07	%	$	102.71	$	21,359,571	$	105.57	$	21,955,800

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As of December 31, 2011, our investment portfolio consisted of ARM securities as follows:

(Dollars in thousands, except weighted average price amounts)
Months to Reset	% of ARM Portfolio			Current Face value (1)		Weighted Avg. Coupon (2)			Weighted Avg. Amortized Purchase  Price (3)		Amortized Cost (4)		Weighted Avg. Market Price (5)		Market Value (6)
0-12		4.1	%	$	650,586		4.56	%	$	101.32	$	659,186	$	106.25	$	691,225
13-24		4.6	%		721,594		4.93	%		101.30		730,975		106.60		769,239
25-36		5.9	%		940,651		3.93	%		102.02		959,684		105.55		992,880
37-48		21.9	%		3,495,234		3.65	%		102.42		3,579,660		104.98		3,669,359
49-60		26.5	%		4,253,901		3.06	%		102.46		4,358,429		104.36		4,439,416
61-72		12.4	%		1,980,929		3.41	%		102.83		2,036,946		104.58		2,071,610
73-84		23.7	%		3,795,037		3.28	%		102.61		3,894,106		104.48		3,965,045
85-96		0.1	%		9,330		4.33	%		101.83		9,501		105.74		9,866
97-108		0.8	%		138,314		3.93	%		103.64		143,349		105.05		145,294
Total ARMs		100.0	%	$	15,985,576		3.49	%	$	102.42	$	16,371,836	$	104.81	$	16,753,934

(1) The current face value is the current monthly remaining dollar amount of principal of a mortgage security. We compute current face value by multiplying the original face value of the security by the current principal balance factor. The current principal balance factor is essentially a fraction, where the numerator is the current outstanding balance and the denominator is the original principal balance.

(2) For a pass-through certificate, the coupon reflects the weighted average nominal rate of interest paid on the underlying mortgage loans, net of fees paid to the servicer and the agency. The coupon for a pass-through certificate may change as the underlying mortgage loans are prepaid. The percentages indicated in this column are the nominal interest rates that will be effective through the interest rate reset date and have not been adjusted to reflect the purchase price we paid for the face amount of security.

(3) Amortized purchase price is the dollar amount, per $100 of current face, of our purchase price for the security, adjusted for amortization as a result of scheduled and unscheduled principal paydowns.

(4) Amortized cost is our total purchase price for the mortgage security, adjusted for amortization as a result of scheduled and unscheduled principal paydowns.

(5) Market price is the dollar amount of market value, per $100 of nominal, or face value, of the mortgage security. Under normal conditions, we compute market value by obtaining valuations for the mortgage security from separate and independent sources and averaging these valuations.

(6) Market value is the total market value for the mortgage security.

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As of September 30, 2012 and December 31, 2011, the ARMs underlying our adjustable rate agency securities had fixed interest rates for an average period of approximately 58 months and 51 months, respectively after which time the interest rates reset and become adjustable annually. At September 30, 2012, approximately 3.9% of our agency ARMs will reach the end of their initial fixed-rate period in the next 12 months. At September 30, 2012, 98.9% of our agency ARMs were still in their initial fixed-rate period and 1.1% of our agency ARMs have already reached their initial reset period and will reset annually for the life of the security.

After the reset date, interest rates on our agency ARMs float based on spreads over various indices, usually LIBOR or the one-year CMT. These interest rate adjustments 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. Our agency ARMs typically have a maximum initial one-time adjustment of five percentage points, and the average annual interest rate increase (or decrease) to the interest rates on our agency securities is two percentage points per year. The average lifetime cap on increases (or decreases) to the interest rates on our agency securities is five percentage points from the initial stated rate.

Fixed-rate securities

In addition to adjustable-rate securities, we also invest in fixed-rate securities. All of our fixed-rate agency securities purchased to date have been 15-year amortizing fixed rate securities. At September 30, 2012, we owned $4.4 billion of 15-year fixed-rate agency securities with a weighted average life, assuming a constant prepayment rate of 10, of 4.1 years. The following table details our fixed rate portfolio at September 30, 2012.

	% of Fixed Rate Portfolio			Current Face value (1)		Weighted Avg. Coupon (2)			Amortized Purchase Price (3)		Amortized Cost (4)		Weighted Avg. Market Price (5)		Market Value (6)
Wtd Avg Months to Maturity
155-167		3.8	%	$	112,552		3.00	%	$	103.58	$	116,579	$	106.27	$	119,609
168-180		96.2	%		4,075,297		2.62	%	$	103.55		4,219,968	$	105.51		4,299,728
		100.0	%	$	4,187,849		2.63	%	$	103.55	$	4,336,546	$	105.53	$	4,419,337

The following table details our fixed rate portfolio at December 31, 2011.

	% of Fixed Rate Portfolio			Current Face value (1)		Weighted Avg. Coupon (2)			Weighted Avg. Amortized Purchase Price (3)		Amortized Cost (4)		Weighted Avg. Market Price (5)		Market Value (6)
Wtd Avg Months to Maturity
168-180		100.0	%	$	953,134		3.05	%	$	103.34	$	984,936	$	103.65	$	987,939

(1) The current face value is the current monthly remaining dollar amount of principal of a mortgage security. We compute current face value by multiplying the original face value of the security by the current principal balance factor. The current principal balance factor is essentially a fraction, where the numerator is the current outstanding balance and the denominator is the original principal balance.

(2) For a pass-through certificate, the coupon reflects the weighted average nominal rate of interest paid on the underlying mortgage loans, net of fees paid to the servicer and the agency. The coupon for a pass-through certificate may change as the underlying mortgage loans are prepaid. The percentages indicated in this column have not been adjusted to reflect the purchase price we paid for the face amount of security.

(3) Amortized purchase price is the dollar amount, per $100 of current face, of our purchase price for the security, adjusted for amortization as a result of scheduled and unscheduled principal paydowns.

(4) Amortized cost is our total purchase price for the mortgage security, adjusted for amortization as a result of scheduled and unscheduled principal paydowns.

(5) Market price is the dollar amount of market value, per $100 of nominal, or face value, of the mortgage security. Under normal conditions, we compute market value by obtaining valuations for the mortgage security from separate and independent sources and averaging these valuations.

(6) Market value is the total market value for the mortgage security.

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Forward Purchases

While most of our purchases of agency securities are accounted for using trade date accounting, some forward purchases, such as certain TBAs, do not qualify for trade date accounting and are considered derivatives for financial statement purposes. Pursuant to ASC Topic 815, we account for these derivatives as all-in-one cash flow hedges. The net fair value of the forward commitment is reported on the balance sheet as an asset (or liability), with a corresponding unrealized gain (or loss) recognized in other comprehensive income. Since we purchase forward for the purposes of holding the securities for investment, we consider all of our agency securities, settled or unsettled, as part of our portfolio for the purposes of cash flow and interest rate sensitivity, and consequently hedging, duration measurement, and other related investment management activity.

Liabilities

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 LIBOR. As of September 30, 2012 and December 31, 2011, we had established 30 and 29 borrowing relationships, respectively, with various investment banking firms and other lenders. We had outstanding balances under our repurchase agreements at September 30, 2012 and December 31, 2011 of $23.6 billion and $16.2 billion, respectively.

Hedging Instruments

We generally intend to hedge as much of our interest rate risk as our manager deems prudent in light of market conditions. No assurance can be given that our hedging activities will have the desired beneficial impact on our results of operations or financial condition. Our policies do not contain specific requirements as to the percentages or amount of interest rate risk that our manager is required to hedge.

Interest rate hedging may fail to protect or could adversely affect us because, among other things:

• available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;

• the duration of the hedge may not match the duration of the related liability;

• fair value accounting rules could foster adverse valuation adjustments due to credit quality considerations that could impact both earnings and shareholder equity;

• the party owing money in the hedging transaction may default on its obligation to pay;

• the credit quality of the party owing money on the hedge 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 used for hedging may be adjusted from time to time in accordance with accounting rules to reflect changes in fair value. Downward adjustments, or “mark-to-market losses,” would reduce our shareholders’ equity.

As of September 30, 2012, we had entered into 84 interest rate swap agreements with 14 counterparties to hedge a benchmark interest rate – LIBOR. This portfolio of hedges is designed to lock in funding costs for specific

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funding activities associated with specific assets as a way to realize attractive net interest margins. This hedging strategy incorporates an assumed prepayment schedule, which, if not realized, will cause our results to differ from expectations. These swap agreements provide for fixed interest rates indexed off of one-month LIBOR and effectively fix the floating interest rates on $10.9 billion of borrowings under our repurchase agreements. If the rates on our repurchase agreements do not move in tandem with LIBOR, we will be less effective at fixing this cost and our results will differ from expectations.

Summary Financial Data

(in thousands, except per share amounts)
	Three months ended (unaudited)						Nine months ended (unaudited)
	September 30, 2012			September 30, 2011			September 30, 2012			September 30, 2011
Statement of Income Data
MBS Interest income	$	131,940		$	110,125		$	373,420		$	310,248
Other Interest income		387			380			1,160			1,051
Total Interest income		132,327			110,505			374,580			311,299
Interest Expense		(52,767	)		(40,259	)		(140,045	)		(102,363	)
Net Interest Income		79,560			70,246			234,535			208,936
Gain on sale of mortgage-backed securities		10,534			13,330			25,244			17,735
Operating Expenses		(6,044	)		(4,594	)		(17,281	)		(12,922	)
Net Income		84,050			78,982			242,498			213,749
Dividends on Preferred Stock		(2,070	)		—			(2,070	)		—
Net income available to common shareholders	$	81,980		$	78,982		$	240,428		$	213,749
Earnings per share – common stock, basic	$	0.83		$	1.04		$	2.63		$	3.05
Earnings per share – common stock, diluted	$	0.83		$	1.04		$	2.63		$	3.05
Weighted average shares outstanding		98,234			75,743			91,296			70,057
Cash dividends declared per common share	$	0.80		$	1.00		$	2.60		$	3.00
Key Portfolio Statistics*
Average MBS (1)	$	24,414,506		$	16,192,903		$	20,953,733		$	14,030,450
Average Repurchase Agreements (2)	$	22,541,260		$	14,884,196		$	19,385,880		$	12,820,514
Average Equity (3)	$	2,889,126		$	2,035,296		$	2,589,482		$	1,851,482
Average Portfolio Yield (4)		2.16	%		2.72	%		2.38	%		2.95	%
Average Cost of Funds (5)		0.94	%		1.08	%		0.96	%		1.06	%
Interest Rate Spread (6)		1.22	%		1.64	%		1.42	%		1.89	%
Return on Average Equity (7)		11.64	%		15.52	%		12.49	%		15.39	%
Average Annual Portfolio Repayment Rate (8)		27.61	%		28.55	%		26.32	%		23.37	%
Debt to Equity(at period end) (9)		7.3:1			7.9:1			7.3:1			7.9:1
Debt to Additional Paid in Capital(at period end) (10)		8.5:1			8.4:1			8.5:1			8.4:1

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(in thousands, except per share amounts)
	Three months ended (unaudited)				Nine months ended (unaudited)
	September 30, 2012		September 30, 2011		September 30, 2012		September 30, 2011
Selected Balance Sheet Data
Mortgage-backed securities	$	26,375,137	$	17,614,374	$	26,375,137	$	17,614,374
Total Assets		27,275,687		18,358,202		27,275,687		18,358,202
Repurchase Agreements		23,583,180		15,886,231		23,583,180		15,886,231
Stockholder’s Equity		3,212,556		2,015,003		3,212,556		2,015,003

^*  Average numbers for each period are weighted based on days on our books and records. All percentages are annualized.

(1) Our daily average investment in MBS was calculated by dividing the sum of our daily MBS investments during the period by the number of days in the period.

(2) Our daily average balance outstanding under our repurchase agreements was calculated by dividing the sum of our daily outstanding balances under our repurchase agreements during the period by the number of days in the period.

(3) Our daily average common shareholders’ equity was calculated by dividing the sum of our daily common shareholders’ equity during the period by the number of days in the period.

(4) Our average portfolio yield was calculated by dividing our interest income on mortgage-backed securities, net of amortization, by our average MBS.

(5) Our average cost of funds was calculated by dividing our total interest expense (including hedges) by our average balance outstanding under our repurchase agreements.

(6) Our interest rate spread was calculated by subtracting our average cost of funds from our average portfolio yield.

(7) Our return on average common equity was calculated by dividing net income by average common equity.

(8) Our average annual principal repayment rate was calculated by dividing our total principal payments received during the year (scheduled and unscheduled) by our average MBS.

(9) Our debt to equity ratio was calculated by dividing the amount outstanding under our repurchase agreements at period end by total shareholders’ equity at period end.

(10) Our debt to additional paid in capital ratio was calculated by dividing the amount outstanding under our repurchase agreements at period end by additional paid in capital at period end.

Results of Operations

Three months ended September 30, 2012 and 2011

Our primary source of income is the interest income we earn on our investment portfolio. Our interest income for the quarter ended September 30, 2012 was $132.3 million, as compared to $110.5 million for the quarter ended September 30, 2011. The most significant factor in this increase was the larger securities portfolio. Our average agency securities for the quarter ended September 30, 2012 was $24.4 billion as compared to $16.2 billion for the quarter ended September 30, 2011. The changes in our interest income generally is not exactly proportionate to the increase in our average agency securities because the coupon rate on our recent purchases will be at different rates than in the portfolio in the comparable period. Our weighted average coupon at September 30, 2012 was 2.99%, as compared to 3.54% at September 30, 2011, so although the portfolio was approximately 50% larger, our average earning rate was materially less. Since mortgage rates fluctuate, they will increase or decrease our overall average coupon rate as we replace and/or add securities in our portfolio. The difference between our interest income and interest expense is more important than the absolute level of rates.

Our annualized yield on average assets for the quarter ended September 30, 2012 was 2.16% as compared to 2.72% for the quarter ended September 30, 2011. After the stated coupon rate, the yield on our assets is most directly affected by the rate of repayments on our agency securities. Our yield decreased both due to a lower average coupon rate and owning our assets at a higher premium to par than the previous periods. Our annualized rate of portfolio repayment for the three months ended September 30, 2012 was 27.61%, which was slightly lower than the rate of 28.55% for the three months ended September 30, 2011.

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Our interest expense for the quarter ended September 30, 2012 was $52.8 million as compared to $40.3 million for the quarter ended September 30, 2011. Our average borrowings increased from $14.9 billion for the quarter ended September 30, 2011 to $22.5 billion for the quarter ended September 30, 2012, due to the increase in portfolio size. Our annualized weighted average cost of funds, including hedges, was 0.94% for the quarter ended September 30, 2012, as compared to 1.08% for the quarter ended September 30, 2011. The components of our cost of funds are 1) rates on our repurchase agreements, 2) rates on our interest rate swaps compared to LIBOR and 3) the total notional amount of the interest rate swaps.

Our net interest income for the quarter ended September 30, 2012 was $79.6 million, and our net interest margin, or “spread”, was 1.22%. For the quarter ended September 30, 2011, our net interest income was $70.2 million and our spread was 1.64%. This decrease in our spread was directly due to our decreased portfolio yield, as described above. While the dollar figure is influenced significantly by the size of our portfolio and overall interest rate levels, we believe our spread is the more important indicator of our performance.

We occasionally sell securities as part of normal portfolio adjusting. We typically will selectively sell certain of our MBS when we think they are likely to underperform in the future as compared with other investment opportunities. We sold $741.5 million of securities in the third quarter of 2012, realizing gains of $10.5 million. We sold $678 million of securities in the third quarter of 2011, realizing gains of $13.3 million.

Our total operating expenses for the quarters ended September 30, 2012 and 2011 were $6.0 million and $4.6 million, respectively. The majority of this increase was due to the increase in the fee we pay our manager. The management fee is based on our equity, which grew significantly from the prior year. This equates to an annualized expense ratio of 84 and 90 basis points, respectively, of average shareholder’s equity for the quarters ended September 30, 2012 and 2011. While our expenses increased, the increase in our average equity, which was due to the additional equity capital raised in our offering, kept the ratio modestly flat as compared to a year ago. The scalability of our business model means that growth in assets is not closely correlated to growth in operating expenses.

Our net income available to common shareholders for the quarter ended September 30, 2012 was $82.0 million or $0.83 per weighted average share. This represents an annualized return on average equity of 11.64% for the period. For the quarter ended September 30, 2011, our net income was $79.0 million or $1.04 per weighted average share, and the annualized return on average equity was 15.52%. While many factors may affect these numbers, the decrease in the per share earnings was due primarily to a lower yielding portfolio as we experienced spread compression from investing in increasingly lower coupon securities while our costs of funding decreased at a lesser pace.

Nine months ended September 30, 2012 and 2011

In general, most of the items influencing our operating results for the nine month periods ended September 30, 2012 and 2011 were similar to the items affecting the quarterly results described above. For the nine month period ended September 30, 2012, we had interest income of $374.6 million compared to $311.3 million for the same period in 2011. Due to the investment of the proceeds of our common and preferred stock offerings, our portfolio was significantly larger during 2012, as we had average earning assets of $21.0 billion for the nine months ended September 30, 2012 compared to $14.0 billion for the nine months ended September 30, 2011. Offsetting this increase in earning assets was a lower yield on the portfolio. Our yield dropped from 2.95% for the nine months ended September 30, 2011 to 2.38% for the nine months ended September 30, 2012. This was the result of buying lower coupon agency securities with our offering proceeds and replacing repayments of principal on our agency securities. The portfolio prepayment rate increased on an annualized basis, from 23.37% for the first nine months of 2011 to 26.32% for the same period in 2012.

Our interest expense for the nine months ended September 30, 2012 was $140.0 million as compared to $102.4 million for the nine months ended September 30, 2011. While our average borrowings increased proportionately along with our assets, the interest rates we pay on these borrowing were lower on average during 2012. Our average cost of funds, including hedges, fell from 1.06% for the nine months ended September 30, 2011 to 0.96% for the same period in 2012. We realized gains on sale of our agency securities of $25.2 million for the nine months ended September 30, 2012 as compared to $17.7 million for the nine months ended September 30, 2011.

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Our net interest income for the nine months ended September 30, 2012 was $234.5 million, and our spread was 1.42%. For the nine months ended September 30, 2011, our net interest income was $208.9 million and our spread was 1.89%. We incurred expenses for the nine months ended September 30, 2012 and 2011 of $17.3 million and $12.9 million, respectively. We earned net income available to common shareholders of $240.4 million, or $2.63 per weighted average share for common shareholders, for the nine months ended September 30, 2012. For the nine months ended September 30, 2011, we earned net income of $213.7 million, or $3.05 per weighted average share for common shareholders. Our per share income for the nine months ended September 30, 2012 was lower than the nine months ended September 30, 2011 due mainly to decreasing yield on our securities.

Contractual Obligations and Commitments

We had the following contractual obligations under repurchase agreements as of September 30, 2012 and December 31, 2011:

	September 30, 2012
(dollars in thousands)	Balance		Weighted Average Contractual Rate			Contractual Interest Payments		Total Contractual Obligation
Within 30 days	$	20,060,323		0.40	%	$	4,947	$	20,065,270
30 days to 3 months		3,522,857		0.41	%		1,201		3,524,058
3 months to 36 months		—		—			—		—
	$	23,583,180		0.40	%	$	6,148	$	23,589,328

	December 31, 2011
(Dollars in thousands)	Balance		Weighted Average Contractual Rate			Contractual Interest Payments		Total Contractual Obligation
Within 30 days	$	16,162,375		0.37	%	$	3,820	$	16,166,195
30 days to 3 months		—		—			—		—
3 months to 36 months		—		—			—		—
	$	16,162,375		0.37	%	$	3,820	$	16,166,195

From time to time we may make forward commitments to purchase our agency securities. The commitments require physical settlement with the sellers on settlement date, usually between 30 and 90 days from the date of trade. The following table shows the agency securities forward purchase commitments on the balance sheet as of September 30, 2012.

(Dollars in thousands) Face	Cost		Fair Market Value		Due to Brokers
$1,358,000	$	1,409,047	$	1,423,058	$	1,409,047

In addition, we had contractual commitments under interest rate swap agreements as of September 30, 2012. These agreements were for a total notional amount of $10.9 billion, had a weighted average rate of 1.48% and a weighted average term of 34 months.

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Off-Balance Sheet Arrangements

As of September 30, 2012 and December 31, 2011, 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, as of September 30, 2012 and December 31, 2011, we had not guaranteed any obligations of unconsolidated entities or entered into any commitment or intent to provide funding to any such entities.

Liquidity and Capital Resources

Our primary sources of funds are borrowings under repurchase arrangements and monthly principal and interest payments on our investments. Other sources of funds may include proceeds from debt and equity 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 these borrowings can be adjusted on a daily basis, the level of cash and cash equivalents carried on the balance sheet is significantly less important than our potential liquidity available under our borrowing arrangements. We currently believe that we have sufficient liquidity and capital resources available for the acquisition of additional investments, repayments on borrowings and the payment of cash dividends as required for continued qualification as a REIT.

In response to the growth of our agency securities portfolio and to recent turbulent market conditions, we have aggressively pursued additional lending counterparties in order to help increase our financial flexibility and ability to withstand periods of contracting liquidity in the credit markets. At September 30, 2012, we had uncommitted repurchase facilities with 30 lending counterparties to finance this portfolio, subject to certain conditions, and have borrowings outstanding with 24 of these counterparties.

Liquidity Sources – Repurchase Facilities

With repurchase facilities being an integral part of our financing strategy, and thus our financial condition, full understanding of the repurchase market is necessary to understand the risks and drivers of our business. For example, we anticipate that, upon repayment of each borrowing under a repurchase agreement, we will use the collateral immediately for borrowing under a new repurchase agreement. And while we have borrowing capacity under our repurchase facilities well in excess of what is required for our operations, these borrowing lines are uncommitted and generally do not provide long term excess liquidity. Currently, we have not entered into any commitment agreements under which the lender would be required to enter into new repurchase agreements during a specified period of time, nor do we presently plan to have liquidity facilities with commercial banks.

The table below sets forth the average amount of repurchase agreements outstanding during each quarter and the amount of these repurchase agreements outstanding as of the end of each quarter for the last two years. The amounts at a period end can be both above and below the average amounts for the quarter. We do not manage our portfolio to have a pre-designated amount of borrowings at quarter end. These numbers will differ as we implement our portfolio management strategies and risk management strategies over changing market conditions.

(Dollars in thousands)	Average Daily Repurchase Agreements		Repurchase Agreements at Period End		Highest Daily Repurchase Balance During Quarter		Lowest Daily Repurchase Balance During Quarter
September 30, 2012	$	22,541,260	$	23,583,180		$24,299,580		$20,152,860
June 30, 2012		19,599,942		20,152,860		21,086,250		16,449,862
March 31, 2012		15,981,764		16,556,630		16,691,652		15,566,983
December 31, 2011		16,280,835		16,162,375		16,807,220		15,886,231
September 30, 2011		14,884,196		15,886,231		15,907,289		14,334,014
June 30, 2011		13,540,291		14,800,594		14,800,594		11,401,240
March 31, 2011		9,983,197		11,495,749		11,495,749		8,566,200
December 31, 2010		7,326,776		8,681,060		8,681,060		6,633,989
September 30, 2010		6,302,601		6,678,426		6,736,759		5,934,419
June 30, 2010		6,092,328		5,982,998		6,218,628		5,956,811
March 31, 2010		6,222,923		6,102,661		6,346,518		6,047,628

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As of September 30, 2012 and December 31, 2011, the weighted average margin requirement, or the percentage amount by which the collateral value must exceed the loan amount, which we also refer to as the haircut, under all our repurchase agreements, was 4.4% (weighted by borrowing amount). This rate remained constant as lending conditions have been stable. We commonly receive margin calls from our lenders. We may receive margin calls daily, although we typically receive them once or twice per month. We receive margin calls under our repurchase agreements for two reasons. One of these is what is known as a “factor call” which occurs each month when the new factors (amount of principal remaining on the security) are published by the issuing agency, such as Fannie Mae. The second type of margin call we may receive is a valuation margin call. Both factor and valuation margin calls occur whenever the total value of our assets pledged as collateral drops beyond a threshold amount, which is usually between $100,000 and $250,000. This threshold amount is generally set by each counterparty and does not vary based on the notional amount of the repurchase agreements outstanding with that counterparty. Both of these margin calls require a dollar for dollar restoration of the margin shortfall. The total amount of our unrestricted cash and cash equivalents, plus any unpledged securities, is available to satisfy margin calls, if necessary. As of September 30, 2012 and December 31, 2011, we had approximately $1.7 billion and $1.1 billion, respectively, in agency securities, short term investments, cash and cash equivalents available to satisfy future margin calls. To date, we have maintained sufficient liquidity to meet margin calls, and we have never been unable to satisfy a margin call, although no assurance can be given that we will be able to satisfy requests from our lenders to post additional collateral in the future.

An event of default or termination event under the standard master repurchase agreement would give our counterparty the option to terminate all repurchase transactions existing with us and require any amount due by us to the counterparty to be payable immediately. Our agreements for our repurchase facilities generally conform to the terms in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association (SIFMA) as to repayment, margin requirements and the segregation of all purchased securities covered by the repurchase agreement. In addition, each lender may require that we include supplemental terms and conditions to the standard master repurchase agreement that are generally required by the lender. Some of the typical terms which are included in such supplements and which supplement and amend terms contained in the standard agreement include changes to the margin maintenance requirements, purchase price maintenance requirements, the addition of a requirement that all controversies related to the repurchase agreement be litigated in a particular jurisdiction and cross default provisions. These provisions differ for each of our lenders.

As discussed above under “ – Market and Interest Rate Trends and the Effect on our Portfolio,” over the last few years the residential mortgage market in the United States has experienced difficult conditions including:

• increased volatility of many financial assets, including agency securities and other high-quality MBS assets, due to news of potential security liquidations;

• increased volatility and deterioration in the broader residential mortgage and MBS markets; and

• significant disruption in financing of MBS.

Although these conditions have lessened of late, if they increase and persist, our lenders may be forced to exit the repurchase market, become insolvent or further tighten lending standards or increase the amount of haircut, any of which could make it more difficult or costly for us to obtain financing.

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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 loan 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 paydowns are announced monthly.

Similar to the valuation margin calls that we receive on our repurchase agreements, we also receive margin calls on our interest rate swaps when the value of a hedge position declines. This typically occurs when prevailing market rates decrease, with the severity of the decrease also dependent on the term of the hedges involved. The amount of any margin call will be dollar for dollar, with a minimum transfer amount of between $100,000 and $250,000. Our posting of collateral with our hedge counterparties can be done in cash or securities, and is generally bilateral, which means that if the value of our interest rate hedges increases, our counterparty will post collateral with us.

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, we experience margin calls at least monthly and often more frequently. In seeking to manage effectively 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, we will experience margin calls, and we will use our liquidity to meet the 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. In addition, if we increase our borrowings, our liquidity will decrease by the amount of additional haircut on the increased level of indebtedness.

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 liquidate assets into unfavorable market conditions and harm our results of operations and financial condition.

As of September 30, 2012, the weighted average haircut under our repurchase facilities was approximately 4.4%, and our leverage (defined as our debt-to-shareholders equity ratio) was approximately 7.3:1.

Liquidity Sources – Capital Offerings

In addition to our repurchase borrowings, we also rely on secondary securities offerings as a source of both short-term and long-term liquidity. During the nine months ended September 30, 2012, we received funds from sales of our common stock under an “at-the-market” offering program and from a fully underwritten offering we completed in March and August. In order to assure the continued availability of liquidity from capital offerings, we amended our charter on March 30, 2012, raising the total authorized shares of common stock to 200,000,000, as authorized under Maryland General Corporate Law Section 2-105(a)(13). In addition, we amended the charter again in August 2012, raising the total authorized shares of preferred stock to 25,000,000.

From time to time, we may sell shares of our common stock in “at the market” offerings. Sales of the shares of common stock, if any, may be made in private transactions, negotiated transactions or any method permitted by law deemed to be an “at the market” offering as defined in Rule 415 under the Securities Act of 1933, as amended, including sales made directly on the NYSE or to or through a market maker other than on an exchange.

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On February 29, 2012, we entered into sales agreements (the “2012 Sales Agreements”) with Cantor Fitzgerald & Co. (“Cantor”) and JMP Securities LLC (“JMP”) to establish a new “at-the-market” program (the “2012 Program”). Under the terms of the 2012 Sales Agreements, we may offer and sell up to 10,000,000 shares of our common stock from time to time through Cantor or JMP, each acting as agent and/or principal. The shares of our common stock issuable pursuant to the 2012 Program are registered with the SEC on our Registration Statement on Form S-3 (No. 333-179805), which became effective upon filing on February 29, 2012.

During the three months ended September 30, 2012, we issued 595,000 shares of common stock in at-the-market transactions at an average price of $29.17 per share raising net proceeds, after sales commissions and expenses, of approximately $17.1 million. We paid $0.2 million in sales commissions to Cantor and JMP during the three months ended September 30, 2012. During the nine months ended September 30, 2012, we issued 1,713,900 shares of common stock in at-the-market transactions at an average price of $28.69 per share raising net proceeds after sales commissions and expenses of approximately $48.3 million. We paid $0.5 million in sales commissions to Cantor and JMP during the nine months ended September 30, 2012.

On March 30, 2012, we completed a secondary public offering of 20,125,000 shares of common stock, including 2,625,000 shares pursuant to the underwriters’ overallotment option, at a price to us of $26.81 per share, and received net proceeds of approximately $539.4 million after the payment of underwriting discounts and expenses.

On August 27, 2012, we issued 11,500,000 shares of our Series A Preferred Stock, including 1,500,000 shares pursuant to the underwriters’ overallotment option, at a price of $25.00 per share and received net proceeds of $278.3 million after the payment of underwriting discounts and expenses.

We used the proceeds of our stock offerings to purchase additional agency securities, provide working capital, and to provide liquidity for our hedging strategy.

Forward-Looking Statements Regarding Liquidity

Based on our current portfolio, leverage rate and available borrowing arrangements, we believe that the net proceeds of our common equity offerings, combined with cash flow from operations and available borrowing capacity, will be sufficient to enable us to meet anticipated short-term (one year or less) liquidity requirements such as to fund our investment activities, to pay fees under our management agreement, to fund our distributions to shareholders and for general corporate expenses.

Our ability to meet our long-term (greater than one year) liquidity and capital resource requirements will be subject to obtaining additional debt financing and equity capital. We may increase our capital resources by obtaining long-term credit facilities or making public or private offerings of equity or debt securities, possibly including classes of preferred stock, common stock, and senior or subordinated notes. Such financing will depend on market conditions for capital raises and for the investment of any proceeds. If we are unable to renew, replace or expand our sources of financing on substantially similar terms, it may have an adverse effect on our business and results of operations.

We generally seek to borrow (on a recourse basis) between eight and 12 times the amount of our shareholders’ equity. At September 30, 2012 and December 31, 2011, our total borrowings were approximately $23.6 billion and $16.2 billion (excluding accrued interest), respectively, which represented a leverage ratio of approximately 7.3:1 and 7.8:1, respectively.

Inflation

Virtually all of our assets and liabilities are interest rate sensitive in nature. As a result, interest rates and other factors directly influence our performance far more than inflation. Although inflation is a primary factor in any interest rate, changes in interest rates do not necessarily correlate with changes in inflation rates, and these affects may be imperfect or lagging. Our financial statements are prepared in accordance with GAAP and any distributions we may make will be determined by our board of directors 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.

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Item 3. Quantitative and Qualitative Disclosures About 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 shareholders 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 Risk

Interest rate risk is the primary component of our market risk. Interest rates are highly sensitive to many factors, including fiscal and monetary policies and domestic and international economic and political considerations, as well as other factors beyond our control. We will be subject to interest rate risk in connection with our investments and our related financing obligations.

Interest Rate Effect on Net Interest Income

Our operating results depend in large part on differences between the yields earned on our investments and our cost of borrowing and hedging activities. The cost of our borrowings will generally be based on prevailing market interest rates. During periods of rising interest rates, the borrowing costs associated with agency securities tend to increase while the income earned on agency securities may remain substantially unchanged until the interest rates reset. This results in a narrowing of the net interest spread between the assets and related borrowings and may even result in losses. The severity of any such decline would depend on our asset/liability composition at the time as well as the magnitude and duration of the interest rate increase. Further, an increase in short-term interest rates could also have a negative impact on the market value of our investments. If any of these events happen, we could experience a decrease in net income or incur a net loss during these periods, which could adversely affect our liquidity and results of operations.

We seek to mitigate interest rate risk through utilization of longer term repurchase agreements and hedging instruments, primarily interest rate swap agreements. Interest rate swap agreements are intended to serve as a hedge against future interest rate increases on our variable rate borrowings. As of September 30, 2012, we had entered into interest rate swap agreements designed to mitigate the effects of increases in interest rates under $10.9 billion of our repurchase agreements.

Hedging techniques are partly based on assumed levels of prepayments of our agency securities. If prepayments are slower or faster than assumed, the life of the agency securities will be longer or shorter, which would reduce the effectiveness of any hedging strategies we may use and may cause losses on such transactions. Hedging strategies involving the use of derivative securities are highly complex and may produce volatile returns. Hedging techniques are also limited by the rules relating to REIT qualification. In order to preserve our REIT status, we may be forced to terminate a hedging transaction at a time when the transaction is most needed.

Interest Rate Cap Risk

The ARMs that underlie our agency securities are typically subject to periodic and lifetime interest rate caps and floors, which limit the amount by which the security’s interest rate may change during any given period. However, our borrowing costs pursuant to our financing agreements will not be subject to similar restrictions. Therefore, in a period of increasing interest rates, interest rate costs on our borrowings could increase without limitation, while the interest-rate increases on our adjustable-rate agency and hybrid securities could effectively be limited by caps. Agency securities backed by ARMs may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. This could result in our receipt of less cash from such investments than we would need to pay the interest cost on our related borrowings. These factors could lower our net interest income or cause a net loss during periods of rising interest rates, which would harm our financial condition, cash flows and results of operations.

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Interest Rate Mismatch Risk

We fund a substantial portion of our acquisition of agency securities with borrowings that are based on, or move similarly to, LIBOR, while the interest rates on these agency securities may be indexed to LIBOR or another index rate, such as the one-year CMT rate. Accordingly, any increase in our borrowing rate relative to LIBOR or one-year CMT rates may result in an increase in our borrowing costs that is not matched by a corresponding increase in the interest earnings on these investments. Any such interest rate index mismatch could adversely affect our profitability, which may negatively impact distributions to our shareholders. To seek to mitigate interest rate mismatches, we may utilize the hedging strategies discussed above.

Our analysis of risks is based on our manager’s experience, estimates and assumptions, including estimates of fair value and interest rate sensitivity. Actual economic conditions or implementation of investment decisions by our manager may produce results that differ significantly from our manager’s estimates and assumptions.

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. 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, substantially all of our agency securities have been purchased at a premium.

For financial accounting purposes, interest income is accrued based on the outstanding principal balance of the investment securities and their contractual terms. In general, purchase premiums on investment securities are amortized against interest income over the lives of the securities using the effective yield method, adjusted for actual prepayment and cash flow activity. An increase in the principal repayment rate will typically accelerate the amortization of purchase premiums and a decrease in the repayment rate will typically slow the accretion of purchase discounts, thereby reducing the yield/interest income earned on such assets.

When we receive repayments of principal on our agency securities from prepayments and scheduled payments, to maintain a similar rate of earnings per share, we may want to reinvest the proceeds from these repayments in similar yielding investments. In addition, due to standard settlement conventions, it may take time to reinvest these proceeds and leave a gap in earnings until we can find and settle on suitable investment assets. In times of market illiquidity or tight supply, we may have periods where similar types of assets are not available to replace those assets repaid to us. A decrease in earnings could be significant in periods of high prepayments.

Extension Risk

We invest in agency securities that are either fixed-rate or backed by ARMs which have interest rates that are fixed for the early years of the loan (typically three, five, or seven years) and thereafter reset periodically, on the same basis as agency securities backed by ARMs. We compute the projected weighted-average life of our agency securities based on assumptions regarding the rate at which the borrowers will prepay the underlying mortgage loans. In general, when agency securities are acquired with borrowings, we may, but are not required to, enter into an interest rate swap agreement or other hedging instrument that effectively fixes our borrowing costs for a period close to the anticipated weighted-average life of the fixed-rate portion of the related agency securities. This strategy is designed to protect us from rising interest rates by fixing our borrowing costs for the duration of the fixed-rate period of the mortgage loans underlying the related agency securities.

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We may structure our interest rate swap agreements to expire in conjunction with the estimated weighted average life of the fixed period of the mortgage loans underlying our agency securities. However, in a rising interest rate environment, the weighted average life of the mortgage loans underlying our agency securities could extend beyond the term of the swap agreement or other hedging instrument. This could have a negative impact on our results from operations, as borrowing costs would no longer be fixed after the term of the hedging instrument while the income earned on the remaining agency securities would remain fixed for a period of time. This situation may also cause the market value of our agency securities to decline, with little or no offsetting gain from the related hedging transactions. In extreme situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses.

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 hedging instruments.

We primarily assess our interest rate risk 1) by estimating the effective duration of our assets and the effective duration of our liabilities, and 2) 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 show 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, 2012 and December 31, 2011, assuming a static portfolio. When evaluating the impact of changes in interest rates, prepayment assumptions and principal reinvestment rates are adjusted based on our manager’s expectations. The analysis presented utilized assumptions, models and estimates of the manager based on the manager’s judgment and experience.

September 30, 2012

Change in Interest rates	Percentage Change in Projected Net Interest Income	Percentage Change in Projected Portfolio Value
+ 1.00%	(8.45%)	(0.41%)
+ 0.50%	(2.13%)	(0.20%)
- 0.50%	4.30%	(0.04%)
- 1.00%	(6.81%)	0.03%

December 31, 2011

Change in Interest rates	Percentage Change in Projected Net Interest Income	Percentage Change in Projected Portfolio Value
+ 1.00%	(10.37%)	(0.40%)
+ 0.50%	(4.76%)	(0.05%)
- 0.50%	(0.27%)	(0.30%)
- 1.00%	(5.91%)	(0.80%)

While the tables above reflect the estimated immediate impact of interest rate increases and decreases on a static portfolio, we rebalance our 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

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income from our interest rate-sensitive investments and hedging instruments, such as the shape of the yield curve, market expectations as to future interest rate changes and other market conditions. Accordingly, interest income would likely differ from that shown above, and such difference might be material and adverse to our shareholders.

The above table quantifies the potential changes in net interest income and portfolio value, which includes the value of swaps, should interest rates immediately change. Given the low level of interest rates at September 30, 2012 and December 31, 2011, we applied a floor of 0%, for all anticipated interest rates included in our assumptions. Due to 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.

Risk Management

To the extent consistent with maintaining our REIT status, we seek to manage our interest rate risk exposure to protect our portfolio of agency securities and related debt against the effects of major interest rate changes. We generally seek to manage our interest rate risk by:

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

• using derivatives, financial futures, swaps, options, caps, floors and forward sales to adjust the interest rate sensitivity of our agency securities and our borrowings;

• actively managing, on an aggregate basis, the interest rate indices, interest rate adjustment periods, interest rate caps and gross reset margins of our agency securities and the interest rate indices and adjustment periods of our borrowings; and

• monitoring and managing, on an aggregate basis, our liquidity and leverage to maintain tolerance for market value changes.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures to ensure that material information relating to us is made known to the officers who certify our financial reports and to the members of senior management and the board of directors.

Based on management’s evaluation as of September 30, 2012, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Exchange Act) are effective to ensure that the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

Changes in Internal Control over Financial Reporting

There was no change to our internal control over financial reporting during the quarter ended September 30, 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. Other Information

Item 1. Legal Proceedings

Our company and our manager are not currently subject to any material legal proceedings.

Item 1A. Risk Factors

Other than the following, there have been no material changes from the risk factors disclosed in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2011 filed with the SEC on February 23, 2012.

We cannot predict the impact of “QE3” on the prices and liquidity of agency securities, although the U.S. Federal Reserve action could increase the prices of our target assets and reduce the spread on our investments.

On November 25, 2008, the U.S. Federal Reserve announced a program to purchase agency securities in the open market. The most significant of these programs commenced in January 2009 and was terminated on June 30, 2010. In total, $1.25 trillion of agency securities was purchased. In November 2010, the U.S. Federal Reserve announced another program to purchase an additional $600 billion of longer-term U.S. Treasury securities by the end of the second quarter of 2011, at a pace of about $75 billion per month. In September 2012, the U.S. Federal Reserve announced a third round of “quantitative easing” aimed to increase growth in the U.S. economy. To accomplish this goal, it announced that it would be buying $40 billion of agency securities per month, as well as continuing to reinvest the proceeds of principal repayments from its agency securities holdings. This program, which is referred to as QE3, is expected to increase the U.S. Federal Reserve’s holdings of longer-term securities by approximately $85 billion each month through the end of 2012.

The U.S. Federal Reserve also announced that it will keep the target range for the U.S. Federal Funds Target Rate between zero and 0.25% through at least mid-2015, which is six months longer than previously expected. The U.S. Federal Reserve expects these measures to put downward pressure on long-term interest rates. While the U.S. Federal Reserve hopes that QE3 will expedite an economic recovery, stabilize prices, reduce unemployment and restart business and household spending, we cannot predict the impact of these programs or any future actions by the U.S. Federal Reserve on the prices and liquidity of agency securities, although the U.S. Federal Reserve action could increase the prices of our target assets and reduce the spread on our investments.

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 became effective on October 12, 2012, funds that are now considered CPOs solely because of their use of swaps 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.

We use hedging instruments in conjunction with our investment portfolio and related borrowings to reduce or mitigate risks associated with changes in interest rates. We do not currently engage in any speculative derivatives activities or other non-hedging transactions using swaps, futures or options on futures. 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 aggregate net notional value of our hedging positions would exceed 100 percent of the fair market value of our total assets. Additionally, if we decided in the future to utilize retail foreign exchange transactions for hedging purposes, exemptive relief might limit our ability to enter into such transactions if the initial margin, premiums and security deposit of such transactions would 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 shareholders 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 its Strategic 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 entitled Building 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 shareholders.

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

None.

Item 6. Exhibits

Exhibit Number	Description of Exhibit
3.1	Articles of Incorporation (including all articles of amendment and articles supplementary)
4.1	Form of Specimen Certificate for the 7.625% Series A Cumulative Redeemable Preferred Stock (1)
31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002
32.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes – Oxley Act of 2002
32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes – Oxley Act of 2002
101.INS XBRL	Instance Document (2)
101.SCH XBRL	Taxonomy Extension Schema Document (2)
101.CAL XBRL	Taxonomy Extension Calculation Linkbase Document (2)
101.DEF XBRL	Additional Taxonomy Extension Definition Linkbase Document Created (2)
101.LAB XBRL	Taxonomy Extension Label Linkbase Document (2)
101.PRE XBRL	Taxonomy Extension Presentation Linkbase Document (2)

(1) Previously filed as an exhibit to the Registration Statement on Form 8-A filed with the SEC on August 23, 2012.

(2) Submitted electronically herewith. Attached as Exhibit 101 to this report are the following documents formatted in XBRL (Extensible Business Reporting Language): (i) Balance Sheets at September 30, 2012 (Unaudited) and December 31, 2011 (Derived from the audited balance sheet at December 31, 2011); (ii) Statements of Income (Unaudited) for the three and nine months ended September 30, 2012 and 2011; (iii) Statements of Comprehensive Income (Unaudited) for the three and nine months ended September 30, 2012 and 2011; (iv) Statements of Changes in Shareholders’ Equity (Unaudited) for the nine months ended September 30, 2012; (v) Statements of Cash Flows (Unaudited) for the nine months ended September 30, 2012 and 2011; and (vi) Notes to Financial Statements (Unaudited) for the nine months ended September 30, 2012. 

48

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	HATTERAS FINANCIAL CORP.
Dated: October 30, 2012	BY:	/s/ KENNETH A. STEELE
	Kenneth A. Steele
	Chief Financial Officer, Treasurer and Secretary (Principal Financial Officer and Principal Accounting Officer)

49

EXHIBIT INDEX

Exhibit Number	Description of Exhibit
3.1	Articles of Incorporation (including all articles of amendment and articles supplementary)
4.1	Form of Specimen Certificate for the 7.625% Series A Cumulative Redeemable Preferred Stock (1)
31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002
32.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes – Oxley Act of 2002
32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes – Oxley Act of 2002
101.INS XBRL	Instance Document (2)
101.SCH XBRL	Taxonomy Extension Schema Document (2)
101.CAL XBRL	Taxonomy Extension Calculation Linkbase Document (2)
101.DEF XBRL	Additional Taxonomy Extension Definition Linkbase Document Created (2)
101.LAB XBRL	Taxonomy Extension Label Linkbase Document (2)
PRE XBRL	Taxonomy Extension Presentation Linkbase Document (2)

⁽¹⁾  Previously filed as an exhibit to the Registration Statement on Form 8-A filed with the SEC on August 23, 2012.

⁽²⁾  Submitted electronically herewith. Attached as Exhibit 101 to this report are the following documents formatted in XBRL (Extensible Business Reporting Language): (i) Balance Sheets at September 30, 2012 (Unaudited) and December 31, 2011 (Derived from the audited balance sheet at December 31, 2011); (ii) Statements of Income (Unaudited) for the three and nine months ended September 30, 2012 and 2011; (iii) Statements of Comprehensive Income (Unaudited) for the three and nine months ended September 30, 2012 and 2011; (iv) Statements of Changes in Shareholders’ Equity (Unaudited) for the nine months ended September 30, 2012; (v) Statements of Cash Flows (Unaudited) for the nine months ended September 30, 2012 and 2011; and (vi) Notes to Financial Statements (Unaudited) for the nine months ended September 30, 2012.