Hatteras Financial (HTS) 10-K 2013 FY Annual report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2013
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)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Name of each exchange on which registered
Common stock, $0.001 par value	New York Stock Exchange
7.625% Series A Cumulative Redeemable Preferred stock, $0.001 par value	New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:  None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes [X ]  No [    ]

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes [   ]  No [ X ]

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  [   ]

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 [   ]	Smaller reporting company  [  ]
(Do not check if a smaller reporting company)

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

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $2,435,172,531 based on the closing price on the New York Stock Exchange as of June 28, 2013.

Number of the registrant’s common stock outstanding as of February 18, 2014:  96,615,027

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive Proxy Statement with respect to its 2014 Annual Meeting of Shareholders to be filed not later than 120 days after the end of the registrant’s fiscal year are incorporated by reference into Part II, Item 5 and Part III, Items 10,11,12,13 and 14 hereof as noted therein.

HATTERAS FINANCIAL CORP.

INDEX

Item No.		Form 10-K Report Page
	PART I
Item 1.	Business	3
Item 1A.	Risk Factors	6
Item 1B.	Unresolved Staff Comments	23
Item 2.	Properties	24
Item 3.	Legal Proceedings	24
Item 4.	Mine Safety Disclosures	24
	PART II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	24
Item 6.	Selected Financial Data	27
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	28
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	51
Item 8.	Financial Statements and Supplementary Data	53
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	54
Item 9A.	Controls and Procedures	54
Item 9B.	Other Information	54
	PART III
Item 10.	Directors, Executive Officers and Corporate Governance	55
Item 11.	Executive Compensation	55
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	55
Item 13.	Certain Relationships and Related Transactions, and Director Independence	55
Item 14.	Principal Accountant Fees and Services	55
	PART IV
Item 15.	Exhibits and Financial Statement Schedules	55

Cautionary Note Regarding Forward-Looking Statements

This report contains various “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”).  We intend such forward-looking statements to be covered by the safe harbor provisions contained in the Private Securities Litigation Reform Act of 1995 and include this statement for purposes of complying with these safe harbor provisions. Forward-looking statements relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts.  In some cases, you can identify forward-looking statements by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “would,” “could,” “should,” “seeks,” “approximately,” “intends,” “plans,” “projects,” “estimates” or “anticipates” or the negative of these words and phrases or similar words or phrases.  All forward-looking statements may be impacted by a number of risks and uncertainties, including statements regarding the following subjects:

· our business and investment strategy;

· our financing and hedging strategies;

· our anticipated results of operations;

· statements about future dividends;

· our ability to obtain financing arrangements;

· our understanding of our competition and ability to compete effectively;

· market, industry and economic trends;

· prepayments rates; and

· interest rates.

The forward-looking statements in this report are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us.  These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us.  If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements.  The following factors that could cause actual results to vary from our forward-looking statements:

(1) the factors referenced in this report, including those set forth under the sections captioned “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations;”

(2) the federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between Fannie Mae and Freddie Mac and the federal government;

(3) mortgage loan modification programs and future legislative action;

(4) availability, terms and deployment of capital;

(5) risks associated with investing in real estate assets, including changes in business conditions and the general economy;

(6) changes in interest rates, interest rate spreads, the yield curve or prepayment rates and the market value of our investments;

(7) general volatility of the financial markets, including markets for mortgage securities;

(8) inflation or deflation;

(9) changes in the prepayment rates on the mortgage loans securing our agency securities;

(10) availability of suitable investment opportunities;

(11) the degree and nature of our competition, including competition for agency securities from the U.S. Department of the Treasury (the “U.S. Treasury”);

(12) changes in our business and investment strategy;

(13) changes in our financing and hedging strategies;

(14) the adequacy of our cash flow from operations and borrowings to meet our short-term liquidity requirements;

(15) the liquidity of our portfolio;

(16) unanticipated changes in our industry, the credit markets, the general economy or the real estate market;

2

(17) our dependence on our manager and ability to find a suitable replacement if our manager were to terminate its management relationship with us;

(18) the existence of conflicts of interest in our relationship with our manager and certain of our directors and our officers, which could result in decisions that are not in the best interest of our shareholders;

(19) changes in personnel at our manager or the availability of qualified personnel at our manager;

(20) our ability to maintain our qualification as a real estate investment trust (“REIT”) for federal income tax purposes;

(21) our ability to maintain our exemption from registration under the Investment Company Act of 1940, as amended (the “Investment Company Act”);

(22) changes in generally accepted accounting principles (“GAAP”), including interpretations thereof; and

(23) changes in applicable laws and regulations.

We cannot guarantee future results, levels of activity, performance or achievements.  You should not place undue reliance on forward-looking statements, which apply only as of the date of this report.  We do not intend and disclaim any duty or obligation to update or revise any industry information or forward-looking statements set forth in this report to reflect new information, future events or otherwise, except as required under the U.S. federal securities laws.

PART I

Item 1. Business

In this report, unless the context suggests otherwise, references to “our company,” “we,” “us” and “our” refers to Hatteras Financial Corp., a Maryland corporation, and its consolidated subsidiaries, and “manager” refers to Atlantic Capital Advisors LLC, a North Carolina limited liability company (“ACA”).

Our Company

We are an externally-managed mortgage REIT that invests primarily in single-family residential mortgage real estate assets.  Typically these assets are pass-through securities consisting of mortgage loans and guaranteed or issued by a U.S. Government agency, such as Ginnie Mae, or by a U.S. Government-sponsored enterprise, such as Fannie Mae or Freddie Mac.  We refer to these securities as “agency securities.”  We were incorporated in Maryland in September 2007 and commenced operations in November 2007.  We listed our common stock on the New York Stock Exchange (“NYSE”) in April 2008 and trade under the symbol “HTS.”

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 Strategy

Our principal goal is to generate net income for distribution to our shareholders through regular quarterly dividends.  Our income is generated by the difference between the earnings on our investment portfolio and the costs of our borrowings and hedging activities and other expenses.  In general, our strategy focuses on managing the interest rate risk related to our mortgage assets with a bias towards minimizing our exposure to credit risk.  We believe that the best approach to generating a positive net income is to manage our liabilities in relation to the interest rate risks of our investments. To help achieve this result, we employ financing, generally short-term, and combine our financings with various hedging techniques, such as interest rate swaps and buying and selling futures contracts.  We may, subject to maintaining our REIT qualification, also employ other hedging instruments from time to time, including interest rate caps, collars, swaptions and MBS TBA pools to protect against adverse interest rate movements.

We focus on agency securities we identify as having 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 margin (interest income less financing costs). 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.

3

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 cash distributions to shareholders over the long term. Our manager has invested and seeks to invest in real estate mortgage assets 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.

Our Assets

Our focus is to own assets with short durations and predictable prepayment characteristics. Since our formation, all of our invested assets have been in agency securities, and we currently intend that the majority of 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 adjustable-rate and fixed-rate agency securities.  Adjustable rate mortgages (“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 the London Interbank Offered Rate (“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.  All of our fixed-rate agency securities purchased to date have been 10-year and 15-year amortizing fixed rate securities.  As of December 31, 2013, our portfolio consisted of approximately $17.6 billion in market value of agency securities, consisting of $16.4 billion of adjustable rate securities and $1.2 billion of fixed rate securities.

We purchase a substantial portion of our agency securities through delayed delivery transactions, including “to-be-announced” (“TBA”) securities.  At times when market conditions are conducive, we may choose to move the settlement of these securities out to a later date by entering into an offsetting position in the near month, which is then net settled for cash, and simultaneously entering into a similar TBA contract for a later settlement date.  Such a set of transactions is referred to as a “dollar roll” transaction.  Specified pools can also be the subject of a dollar roll transaction, when market conditions allow.  The agency securities purchased at the forward settlement date are typically priced at a discount to securities for settlement in the current month.  This difference is referred to as the “price drop.”  The price drop represents compensation to us for foregoing net interest margin and is referred to as “dollar roll income.”

Our Borrowings

We borrow against our agency securities using repurchase agreements.  Our borrowings generally have maturities that range from one month to one year, although occasionally we may enter into longer term borrowing agreements to more closely match the rate adjustment period of our securities.  We intend that our borrowings will generally be between six and 12 times the amount of our shareholders’ equity.  The level of our borrowings may vary periodically above or below this range depending on market conditions.  In addition, dollar roll transactions, as described above, represent a form of financing that can be either on or off balance sheet, depending on whether the security being rolled is a specified pool (results in on-balance sheet financing) or a TBA security (results in off-balance sheet financing).

Our Hedging

Our hedging strategies are designed to reduce the impact on our income and shareholders’ equity caused by the potential adverse effects of changes in interest rates on our assets and liabilities.  Subject to complying with REIT requirements, we use hedging techniques to mitigate the differences between the interest rate adjustments on our assets and borrowings as well as the risk of adverse changes in interest rates on the value of our assets.  These techniques primarily consist of entering into interest rate swap agreements and buying and selling futures contracts.  We may also enter into interest rate cap, floor or collar agreements, purchase put and call options on securities or securities underlying futures contracts, or enter into forward rate agreements.  We record our derivative and hedge transactions in accordance with GAAP.  As of September 30, 2013, we no longer pursue hedge accounting treatment for our interest rate swaps.  As a result, our operating results may suffer because losses on the derivatives we enter into may not be offset by changes in the cash flows or fair value of the related hedged transaction.  Consequently, any declines in the hedged interest rates would result in a charge to earnings.

Purpose of and Changes in Strategies

Our investment, financing and hedging strategies are designed to:

· limit credit risk;

· manage cash flows so as to provide for regular quarterly distributions to our shareholders;

· manage financing risks;

· mitigate the fluctuations in the market value of our securities due to changing interest rates;

4

· reduce the impact that changing interest rates have on our net interest margin;

· maintain our qualification as a REIT; and

· comply with available exemptions from regulation as an investment company under the Investment Company Act.

Our board of directors has adopted a policy that currently requires the majority of our investments to be agency securities.  Due to changes in market conditions, the market value and duration of our securities will fluctuate from time to time and may cause our portfolio allocations to be inconsistent with the investment strategies described in this report.  In such event, in consultation with our board of directors, our manager may recommend that we should reallocate our portfolio.  Subject to our intent to qualify for an exemption from registration under the Investment Company Act and to maintain our qualification as a REIT, our board of directors, with the approval of a majority of our independent directors, may vary our investment strategy, our financing strategy or our hedging strategy at any time.

Our Manager

We believe our relationship with our manager enables us to leverage our manager’s infrastructure, business relationships and management expertise to execute our investment strategy effectively.  We believe that our manager’s expertise in mortgage REIT operations, agency securities, and the mortgage-backed securities (“MBS”) and leveraged finance markets enhances our ability to acquire assets opportunistically and to finance those assets in a manner designed to generate consistent risk-adjusted returns for our shareholders.

Pursuant to the terms of the management agreement, our manager provides us with our management team, including a chief executive officer and a chief financial officer (each of whom also serves as an officer of our manager) along with appropriate support personnel.  Our manager is responsible for our operations and the performance of all services and activities relating to the management of our assets and operations, subject to the direction of our board of directors.

ACA manages both our company and ACM Financial Trust (“ACM”), a privately-held mortgage REIT founded in 1998.  Michael R. Hough, our chief executive officer, is also the chief executive officer of our manager and ACM.  Our president Benjamin M. Hough, chief financial officer Kenneth A. Steele and chief investment officer Frederick J. Boos, II are all also executives of our manager and of ACM.  As of December 31, 2013, ACM owned approximately $1.0 billion in agency securities.  We do not own any interest in ACM.  

The Management Agreement

Our management functions are provided by our manager, ACA.  Our relationship with ACA is controlled by a management agreement.  The management agreement requires our manager to manage our business affairs in conformity with policies and investment guidelines that are approved by a majority of our independent directors and monitored by our board of directors.  Our manager is subject to the direction and oversight of our board of directors.  Our manager is responsible for (1) the identification, selection, purchase and sale of our portfolio investments, (2) our financing and risk management activities, and (3) providing us with investment advisory services.  In addition, our manager is responsible for our day-to-day operations.

The term of the management agreement expires on February 23, 2015.  Under the terms of the agreement, it will automatically renew for an additional one year term on February 23 of each year thereafter unless terminated or otherwise renegotiated.

Our manager 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 our equity up to $250 million, 1.50% (per annum) of equity; plus

· for our equity in excess of $250 million and up to $500 million, 1.10% (per annum) of equity; plus

· for our equity in excess of $500 million and up to $750 million, 0.80% (per annum) of equity; plus

· for our equity in excess of $750 million, 0.50% (per annum) of equity.

For purposes of calculating the management fee, we define equity as the value, computed in accordance with GAAP, of our shareholders’ equity, adjusted to exclude the effects of unrealized gains or losses. Under the terms of the management agreement, we also reimburse ACA for certain of our operating expenses that are borne by ACA.

There is no incentive compensation payable to our manager pursuant to the management agreement.

5

Competition

Our success depends, in large part, on our ability to acquire assets at favorable spreads over our borrowing costs.  In acquiring agency securities, we compete with other mortgage REITs, mortgage finance and specialty finance companies, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, governmental bodies and other entities.  In addition, there are numerous mortgage REITs with similar asset acquisition objectives, including ACM, and others may be organized in the future.  The effect of the existence of additional REITs may be to increase competition for the available supply of mortgage assets suitable for purchase.

Employees

We are managed by ACA pursuant to the management agreement between ACA and us.  We do not have any employees whom we compensate directly with salaries or other cash compensation, although we may in the future.  Our manager had 16 employees as of the date of this report.

Additional Information

We have made available copies of the charters of the committees of our board of directors, our code of business ethics and conduct, our corporate governance guidelines, our whistleblower policy and any materials we file with the Securities and Exchange Commission (“SEC”), including our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports, on our website at www.hatfin.com free of charge. Copies of these documents are available in print to any shareholder who requests them.  Requests should be sent to Hatteras Financial Corp., 110 Oakwood Drive, Suite 340, Winston-Salem, North Carolina 27103, Attention:  Corporate Secretary.  However, the information located on, or accessible from, our website is not, and should not be deemed to be, part of this report or incorporated into any other filing that we submit to the SEC.

All reports filed with the SEC may also be read and copied at the SEC’s public reference room at 100 F Street, N.E., Washington, D.C. 20549.  Further information regarding the operation of the public reference room may be obtained by calling 1-800-SEC-0330.  In addition, all of our filed reports can be obtained at the SEC’s website at www.sec.gov.

Item 1A. Risk Factors

Investment in our stock involves significant risks.  If any of the risks discussed in this report occur, our business, financial condition, liquidity and results of operations could be materially and adversely affected.  The risk factors set forth below are not the only risks that may affect us.  Additional risks and uncertainties not presently known to us, or not identified below, may also materially affect our business, financial condition, liquidity and results of operations.  Some statements in this report, including statements in the following risk factors, constitute forward-looking statements.  Please refer to the section entitled “Cautionary Note Regarding Forward-Looking Statements.”

The risk factors below are broken into five broad categories:

· Risks Related to Our Management and Conflicts of Interest

· Risks Related to Our Business

· Risks Related to Debt Financing

· Risks Related to Our Corporate Structure

· Federal Income Tax Risks

Risks Related to Our Management and Conflicts of Interest

We are dependent upon key employees of our manager, and we may not find suitable replacements if these key personnel are no longer available to us.

Our success depends to a significant degree upon the contributions of Messrs. Michael and Benjamin Hough and Messrs. Steele and Boos, whose continued service is not guaranteed, and each of whom would be difficult to replace.  Because these key personnel collectively have a substantial amount of experience in the fixed income markets and prior experience managing a mortgage REIT, we depend on their experience and expertise to manage our day-to-day operations and our strategic business direction.  In addition, many of these individuals have strong industry reputations, which aid us in identifying and financing investment opportunities.  The loss of the services of these key personnel could diminish our relationships with lenders, and industry personnel and harm our business and our prospects.  We cannot assure you that these individuals can be replaced with equally skilled and experienced professionals.

6

The management agreement between us and our manager was not negotiated on an arms-length basis and the terms, including fees payable, may not be as favorable to us as if it was negotiated with an unaffiliated third party.

Because our executive officers and two of our directors are also officers and owners of our manager, the management agreement was not negotiated on an arms-length basis, and we did not have the benefit of arms-length negotiations of the type normally conducted with an unaffiliated third party.  As a result, the terms, including fees payable, may not be as favorable to us as an arms-length agreement.  Furthermore, because our executive officers and two of our directors are also officers and owners of our manager, we may choose not to enforce, or to enforce less vigorously, our rights under the management agreement because of our desire to maintain our ongoing relationship with our manager.

Termination by us of our management agreement with our manager without cause is difficult and costly.

The term of our management agreement expires on February 23, 2015.  The agreement is automatically renewed for a one-year term on each anniversary date thereafter unless terminated.  Our independent directors review our manager’s performance periodically and the management agreement may be terminated upon the affirmative vote of at least two-thirds of our independent directors, or by a vote of the holders of a majority of our outstanding common stock, based upon:  (1) unsatisfactory performance by our manager that is materially detrimental to us or (2) a determination that the management fees payable to our manager are not fair, subject to our manager’s right to prevent such a termination by accepting a reduction of management fees agreed to by at least two-thirds of our independent directors and our manager.

We must provide 180 days’ prior notice of any such termination.  Our manager will be paid a termination fee equal to four times the average annual management fee earned by our manager during the two years immediately preceding termination.  The termination fee may make it more difficult for us to terminate the management agreement.  These provisions increase the cost to us of terminating the management agreement, thereby adversely affecting our ability to terminate our manager without cause.

Our manager may allocate mortgage-related opportunities to ACM, and thus may divert attractive investment opportunities away from us.

Each of our executive officers and some of our directors also serve as officers and owners of our manager.  Our manager is also the external manager of ACM, a private mortgage REIT with investment objectives that are similar to ours.  Furthermore, two of our executive officers, Messrs. Michael and Benjamin Hough are also executive officers and directors of ACM.  Mr. Steele serves as our chief financial officer and also as chief financial officer of ACM.  Mr. Boos serves as our chief investment officer and also as chief investment officer of ACM.  Our executive officers, who as of December 31, 2013, collectively and beneficially owned approximately 0.6% of the outstanding common stock of ACM on a diluted basis, intend to continue in such capacities with ACM.  Most investment opportunities that are suitable for us are also suitable for ACM; therefore, these dual responsibilities create conflicts of interest for these officers in the event they are presented with opportunities that may benefit either us or ACM.  Our management agreement requires our manager to allocate investments between us and ACM by determining the entity for which they believe the investment opportunity is most suitable.  In making this determination, our manager considers the investment strategy and guidelines of each entity with respect to acquisition of assets, portfolio needs, market conditions, cash flow and other factors that they deem appropriate.  However, our manager generally has no obligation to make any specific investment opportunities available to us, and the above mentioned conflicts of interest may result in decisions or allocations of securities that may benefit one entity more than the other.  Thus, the executive officers of our manager could direct attractive investment opportunities to ACM instead of to us.  Such events could result in us investing in investments that provide less attractive returns, reducing the level of distributions we may be able to pay to our shareholders.

Furthermore, in the future our manager may sponsor or provide management services to other investment vehicles with investment objectives that overlap with ours.  Accordingly, we may further compete for access to the benefits that we expect our relationship with our manager to provide and for the time of its key employees.

Our manager and its key employees, who are our executive officers, face competing demands relating to their time and this may adversely affect our operations.

We rely on our manager and its employees, including Messrs. Michael and Benjamin Hough and Messrs. Steele and Boos, for the day-to-day operation of our business.  Our manager is also the manager of ACM and each of the key employees of our manager are executive officers of ACM.  As a result of their interests in ACM, Messrs. Michael and Benjamin Hough and Messrs. Steele and Boos face conflicts of interest in allocating their time among us and ACM.

Because our manager has duties to ACM as well as to our company, we do not have the undivided attention of the management team of our manager and our manager faces conflicts in allocating management time and resources between our company and ACM. Further, during turbulent market conditions or other times when we need focused support and assistance from our manager, ACM or other entities for which our manager also acts as an investment manager will likewise require greater focus and attention, placing

7

competing high levels of demand on our manager’s limited resources.  In such situations, we may not receive the necessary support and assistance we require or would otherwise receive if we were internally managed or if our manager did not act as a manager for other entities.

Our board of directors approved broad investment guidelines for our manager and do not approve each investment decision made by our manager; as a result, our manager may cause us to acquire assets that produce investment returns that are below expectations or that result in net operating losses.

Our manager is authorized to follow broad investment guidelines.  Our board of directors, including our independent directors, periodically reviews our investment guidelines and our investment policies.  However, our board does not review each proposed investment.  In addition, in conducting periodic reviews, the board of directors relies primarily on information provided to it by our manager.  Furthermore, transactions entered into by our manager may be difficult or impossible to unwind by the time they are reviewed by the board of directors.  Our manager has great latitude with the investment guidelines in determining the types of assets it may decide are proper investments for us.

Because our board of directors could change our investment policies without shareholder approval to permit us to invest in investments other than agency securities, we may invest in assets that bear greater credit, interest rate, prepayment or passive investment risks.

Our board of directors has adopted a policy that currently requires that the majority of our investments be agency securities.  Due to changes in market conditions, subject to our intent to qualify for an exemption from registration under the Investment Company Act and to maintain our qualification as a REIT, our board of directors, with the approval of a majority of our independent directors and without shareholder approval, may vary our investment strategy, our financing strategy or our hedging strategy at any time.  Our board of directors could change our investment policies to permit us to invest in investments other than agency securities, such as other investment-grade mortgage assets, other real estate-related investments (which may not be investment grade) that management determines are consistent with our asset allocation policy and with our tax status as a REIT, and the securities of other REITs. If we acquire investments of lower credit quality, our profitability may decline and we may incur losses if there are defaults on assets underlying those investments or if the rating agencies downgrade the credit quality of those investments.

Investing in other REITs involves obtaining interests in real estate-related investments indirectly, which carries several risks, including the following:

· returns on our investments are not directly linked to returns on the assets of the REITs in which we invest;

· we may have no ability to affect the management, investment decisions or operations of the REITs in which we invest;

· prices of publicly-traded securities are likely to be volatile; and

· the disposition value of investments is dependent upon general and specific market conditions.

Each of these risks could cause the performance of our investments in other REITs to be lower than anticipated, which would adversely impact the overall returns for our portfolio.

Our manager’s management fee is payable regardless of our performance.

Our manager is entitled to receive a management fee from us that is based on the amount of our equity (as defined in the management agreement), regardless of the performance of our portfolio.  For example, we would pay our manager a management fee for a specific period even if we experienced a net loss during the same period.  Our manager’s entitlement to substantial nonperformance-based compensation might reduce its incentive to devote its time and effort to seeking investments that provide attractive risk-adjusted returns for our portfolio.  This in turn could adversely affect our ability to make distributions to our shareholders and the market price of our stock.

8

Risks Related to Our Business

Volatile market conditions for mortgages and mortgage-related assets as well as the broader financial markets may adversely affect the value of the assets in which we invest.

Our results of operations are materially affected by conditions in the markets for mortgages and mortgage-related assets, including agency securities, as well as the broader financial markets and the economy generally.  Beginning in 2007, significant adverse changes in financial market conditions resulted in a deleveraging of the entire global financial system and the forced sale of large quantities of mortgage-related and other financial assets.  More recently, concerns over economic recession, inflation, geopolitical issues, unemployment, the availability and cost of financing, the mortgage market and a declining real estate market have contributed to increased volatility and diminished expectations for the economy and markets.  In particular, the residential mortgage market in the United States has experienced a variety of difficulties and changed economic conditions, including defaults, credit losses and liquidity concerns.  Certain commercial banks, investment banks and insurance companies have announced extensive losses from exposure to the residential mortgage market.  These factors have impacted investor perception of the risk associated with agency securities in which we invest.  As a result, values for agency securities in which we invest have experienced volatility.  Any decline in the value of our investments, or perceived market uncertainty about their value, would likely make it difficult for us to obtain financing on favorable terms or at all, or maintain our compliance with terms of any financing arrangements already in place.  Further increased volatility and deterioration in the broader residential mortgage and agency securities markets may adversely affect the performance and market value of our investments.

The federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between Fannie Mae and Freddie Mac and the federal government, may adversely affect our business.

The payments we expect to receive on the agency securities in which we invest depend upon a steady stream of payments on the mortgages underlying the securities and are guaranteed by Ginnie Mae, Fannie Mae and Freddie Mac.  Ginnie Mae is part of a U.S. Government agency and its guarantees are backed by the full faith and credit of the United States.  Fannie Mae and Freddie Mac are U.S. Government-sponsored enterprises, but their guarantees are not backed by the full faith and credit of the United States.

In response to the deteriorating financial condition of Fannie Mae and Freddie Mac and the credit market disruption, the U.S. Treasury undertook a series of actions to stabilize these government-sponsored enterprises and the financial markets, generally. On September 7, 2008, the Federal Housing Finance Agency (“FHFA”) placed Fannie Mae and Freddie Mac into federal conservatorship which is a statutory process pursuant to which the FHFA will operate Fannie Mae and Freddie Mac, support availability of mortgage financing and protect taxpayers.  The appointment of the FHFA as conservator of both Fannie Mae and Freddie Mac allows the FHFA to control the actions of the government-sponsored enterprises without forcing them to liquidate, which would be the case under receivership.  In addition, the U.S. Treasury has taken steps to capitalize and provide financing to Fannie Mae and Freddie Mac and agreed to purchase direct obligations and agency securities issued or guaranteed by Fannie Mae and Freddie Mac.

Shortly after Fannie Mae and Freddie Mac were placed in federal conservatorship, the Secretary of the U.S. Treasury noted that the guarantee payment structure of Fannie Mae and Freddie Mac required examination, and that changes in the structures of the entities were necessary.  The future roles of Fannie Mae and Freddie Mac could be significantly reduced and the nature of their guarantees could be eliminated or considerably limited relative to historical measurements.  Any changes to the nature of the guarantees provided by Fannie Mae and Freddie Mac could redefine what constitutes an agency security and could have broad adverse market implications as well as negatively impact us.

The problems faced by Fannie Mae and Freddie Mac resulting in their being placed into federal conservatorship have stirred debate among some federal policy makers regarding the continued role of the U.S. Government in providing liquidity for the residential mortgage market.  Following expiration of the current authorization, each of Fannie Mae and Freddie Mac could be dissolved and the U.S. Government could decide to stop providing liquidity support of any kind to the mortgage market. If Fannie Mae or Freddie Mac were eliminated, or their structures were to change radically, we would not be able to acquire agency securities from these companies, which would drastically reduce the amount and type of agency securities available for investment, which are our primary targeted investments.

Our income could be negatively affected in a number of ways depending on the manner in which related events unfold.  For example, the current credit support provided by the U.S. Treasury to Fannie Mae and Freddie Mac, and any additional credit support it may provide in the future, could have the effect of lowering the interest rate we expect to receive from agency securities, thereby tightening the spread between the interest we earn on our portfolio of targeted assets and our cost of financing that portfolio. A reduction in the supply of agency securities could also negatively affect the pricing of agency securities we seek to acquire by reducing the spread between the interest we earn on our portfolio of targeted assets and our cost of financing that portfolio.

As indicated above, government actions have changed the relationship between Fannie Mae and Freddie Mac and the U.S. Government and require Fannie Mae and Freddie Mac to reduce the amount of mortgage loans they own or for which they provide

9

guarantees on agency securities.  Future actions could further change the relationship between Fannie Mae and Freddie Mac and the federal government, and could also nationalize or eliminate such entities entirely.  Any law affecting these government-sponsored enterprises may create market uncertainty and have the effect of reducing the actual or perceived credit quality of securities issued or guaranteed by Fannie Mae or Freddie Mac.  As a result, such laws could increase the risk of loss on investments in Fannie Mae and/or Freddie Mac agency securities.  It also is possible that such laws could adversely impact the market for such securities and spreads at which they trade.  All of the foregoing could materially adversely affect our business, operations and financial condition.

Difficult conditions in the financial markets, and the economy generally, have caused many lenders, including some of our own lenders, to suffer substantial losses and may cause us losses related to our agency securities, and there is no assurance that these conditions will improve in the near future.  As a result, we may not be able to obtain cost-effective financing.

Dramatic declines in the housing market, with decreasing home prices and increasing foreclosures and unemployment, have resulted in significant asset write-downs by financial institutions, which have caused many financial institutions to seek additional capital, to merge with other institutions and, in some cases, to fail.  We rely on the availability of financing to acquire investments on a leveraged basis.  Institutions from which we seek to obtain financing may have owned or financed residential mortgage loans, real estate-related securities and real estate loans which have declined in value and caused losses as a result of downturns in the financial markets and the economy generally.  Many lenders and institutional investors have reduced and, in some cases, ceased to provide funding to borrowers, including other financial institutions.  If these conditions persist, these institutions may become insolvent or tighten their lending standards, which could make it more difficult for us to obtain financing on favorable terms or at all.  Our financial condition and results of operations may be adversely affected if we are unable to obtain cost-effective financing for our investments.

Any future downgrades of the U.S. government’s or certain European countries’ credit ratings may materially adversely affect our business, financial condition and results of operations.

On August 5, 2011, Standard & Poor’s downgraded the U.S. government’s credit rating for the first time in history. Because Fannie Mae and Freddie Mac are in conservatorship of the U.S. government, downgrades to the U.S. government’s credit rating could impact the credit risk associated with agency securities and, therefore, decrease the value of the agency securities in our portfolio. In addition, concerns over the U.S. debt ceiling and budget deficit, together with signs of deteriorating sovereign debt conditions in Europe, have increased the possibility of additional credit-rating downgrades and economic slowdowns, or a recession in the United States. A further downgrade of the U.S. government’s credit rating or a default by the U.S. government to satisfy its debt obligations likely would create broader financial turmoil and uncertainty, which would weigh heavily on the global banking system. Such circumstances could adversely affect our business in many ways, including but not limited to adversely impacting our ability to obtain attractive financing for our investments, increasing the cost of such financing if it is obtained, increasing the likelihood that our repurchase agreement lenders require that we post additional collateral as a result of margin calls causing us to sell assets at depressed prices in order to generate liquidity to satisfy these margin calls or to settle repurchase agreement obligations if we are unable to obtain new repurchase agreement borrowings when our current borrowings expire. As a result, these adverse economic and market conditions may also adversely affect our liquidity position, and could increase our risk of a counterparty defaulting on its obligations. If any of these events were to occur, it could materially adversely affect our business, financial condition and results of operations.

There is no certainty as to what effect “QE3” and other recently announced governmental actions might have in the future on the prices and liquidity of agency securities.

On September 13, 2012, the Board of Governors of the U.S. Federal Reserve System (the “U.S. Federal Reserve”) announced a third round of quantitative easing (“QE3”), which is an open-ended program designed to expand the U.S. Federal Reserve's holdings of long-term securities by purchasing an additional $40 billion of agency securities per month until key economic indicators, such as the unemployment rate, show signs of improvement. In December 2012, in an effort to keep long-term interest rates at low levels, the U.S. Federal Reserve announced an expansion of its asset buying program starting in January 2013, at which time it would commence outright purchases of longer-term U.S. Treasury securities at a pace of $45 billion per month. On December 18, 2013, the U.S. Federal Reserve announced that it would reduce its purchases of both agency securities and U.S. Treasury securities by $5 billion each for the month of January. On January 29, 2014, the U.S. Federal Reserve announced additional $5 billion reductions to its monthly purchase of both agency securities and U.S. Treasury securities to take effect in February 2014.

The immediate effect of the announcement of QE3 was an increase in the price of agency securities. Since the initial price spike, prices for all securities have receded below the price levels that existed before the announcement of QE3. It is unclear what effect, if any, the incremental reduction in the rate of the U.S. Federal Reserve’s monthly purchases will have on the value of the agency securities in which we invest. However, it is possible that the market for such securities, the price of such securities and, as a result, our net asset value and net interest margin could be negatively affected.

10

Mortgage loan modification programs and future legislative action may adversely affect the value of, and the returns on, the agency securities in which we invest.

During 2008 and 2009, the U.S. Government, through the Federal Housing Authority and the Federal Deposit Insurance Corporation, commenced implementation of programs designed to provide homeowners with assistance in avoiding residential mortgage loan foreclosures.  The programs 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.  In September 2011, the White House announced they are 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 enterprises. 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.

On January 4, 2012, the U.S. Federal Reserve issued a white paper outlining additional ideas with regard to refinancings and loan modifications. It is likely that loan modifications would result in increased prepayments on some agency securities.  These loan modification programs, as well as future legislative or regulatory actions, including amendments to the bankruptcy laws, that result in the modification of outstanding mortgage loans may adversely affect the value of, and the returns on, the agency securities in which we invest.

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 and Freddie Mac’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

If we are unable to find suitable investments, we may not be able to achieve our investment objectives or pay dividends.

The availability of mortgage-related assets meeting our criteria depends upon, among other things, the level of activity and quality of and demand for securities in the mortgage securitization and secondary markets.  The market for agency securities depends upon various factors including the level of activity in the residential real estate market, the level of and difference between short-term and long-term interest rates, incentives for issuers to securitize mortgage loans and demand for agency securities by institutional investors.  The size and level of activity in the residential real estate lending market depends on various factors, including the level of interest rates, regional and national economic conditions and real estate values.  To the extent we are unable to acquire a sufficient volume of mortgage-related assets meeting our criteria, our results of operations would be adversely affected.  Furthermore, we cannot assure you that we will be able to acquire sufficient mortgage-related assets at spreads above our costs of funds.

A disproportionate rise in short-term interest rates as compared to longer-term interest rates may adversely affect our income.

The relationship between short-term and longer-term interest rates is often referred to as the “yield curve.”  Ordinarily, short-term interest rates are lower than longer-term interest rates.  If short-term interest rates rise disproportionately relative to longer-term interest rates (a flattening of the yield curve), our borrowing costs may increase more rapidly than the interest income earned on our

11

assets.  Because we expect our investments, on average, generally will bear interest based on longer-term rates than our borrowings, a flattening of the yield curve would tend to decrease our net income and the market value of our net assets.  Additionally, to the extent cash flows from investments that return scheduled and unscheduled principal are reinvested, the spread between the yields on the new investments and available borrowing rates may decline, which would likely decrease our net income.  It is also possible that short-term interest rates may exceed longer-term interest rates (a yield curve inversion), in which event our borrowing costs may exceed our interest income and we could incur operating losses.

A flat or inverted yield curve may adversely affect agency securities prepayment rates and supply.

Our net interest margin varies primarily as a result of changes in interest rates as well as changes in the shape of the yield curve.  We believe that when the yield curve is relatively flat, borrowers have an incentive to refinance into mortgages with longer initial fixed rate periods and fixed rate mortgages, causing our adjustable-rate securities to experience faster prepayments.  In addition, a flatter yield curve generally leads to fixed-rate mortgage rates that are closer to the interest rates available on adjustable-rate mortgages, possibly decreasing the supply of adjustable-rate securities.  At times, short-term interest rates may increase and exceed long-term interest rates, causing an inverted yield curve.  When the yield curve is inverted, fixed-rate mortgage rates may approach or be lower than adjustable-rate mortgage rates, further exacerbating these conditions.  Increases in prepayments on our portfolio will cause our premium amortization to accelerate, lowering the yield on such assets.  If this happens, we could experience a decrease in net income or incur a net loss during these periods, which may negatively impact our distributions to shareholders.

Interest rate mismatches between our agency securities and our borrowings used to fund our purchases of these securities may reduce our income during periods of changing interest rates.

Historically, we have funded most of our investments with borrowings that have interest rates that adjust more frequently than the interest rate indices and repricing terms of our agency securities.  Accordingly, if short-term interest rates increase, our borrowing costs may increase faster than the interest rates on our securities adjust.  As a result, in a period of rising interest rates, we could experience a decrease in net income or a net loss.  Interest rates are highly sensitive to many factors, including governmental, monetary and tax policies, domestic and international economic and political considerations and other factors, all of which are beyond our control.

Interest rate caps on our adjustable-rate agency securities may reduce our income or cause us to suffer a loss during periods of rising interest rates.

The mortgage loans underlying our adjustable-rate securities typically will be subject to periodic and lifetime interest rate caps.  Additionally, we may invest in ARMs with an initial “teaser” rate that will provide us with a lower than market interest rate initially, which may accordingly have lower interest rate caps than ARMs without such teaser rates.  Periodic interest rate caps limit the amount an interest rate can increase during a given period.  Lifetime interest rate caps limit the amount an interest rate can increase through maturity of a mortgage loan.  If these interest rate caps apply to the mortgage loans underlying our adjustable-rate securities, the interest distributions made on the related securities will be similarly impacted.  Our borrowings may not be subject to similar interest rate caps.  Accordingly, in a period of rapidly increasing interest rates, the interest rates paid on our borrowings could increase without limitation while caps would limit the interest distributions on our adjustable-rate agency securities.  Further, some of the mortgage loans underlying our adjustable-rate agency securities may be subject to periodic payment caps that result in a portion of the interest on those loans being deferred and added to the principal outstanding.  As a result, we could receive less interest distributions on adjustable-rate agency securities, particularly those with an initial teaser rate, than we need to pay interest on our related borrowings.  These factors could lower our net interest margin, cause us to suffer a net loss or cause us to incur additional borrowings to fund interest payments during periods of rising interest rates or sell our investments at a loss.

Because we own securities with periods of fixed rates, an increase in interest rates may adversely affect our book value.

Increases in interest rates may negatively affect the market value of our agency securities.  If a security has a fixed rate, or is in a period where the rate is fixed, such as our hybrid ARMs, it generally will be more negatively affected by these increases than a security with a currently adjustable-rate.  In accordance with accounting rules, we are required to reduce our shareholders’ equity, or book value, by the amount of any decrease in the market value of our mortgage-related assets. Reductions in shareholders’ equity decrease the amounts we may borrow to purchase additional securities, which could restrict our ability to increase our net income.

Our delayed delivery transactions, including TBA contracts and dollar roll transactions, subject us to certain risks, including price risks and counterparty risks.

We purchase a substantial portion of our agency securities through delayed delivery transactions, including TBA contracts and dollar roll transactions. In a delayed delivery transaction, we enter into a forward purchase agreement with a counterparty to purchase either (1) identified agency securities, or (2) to-be-issued (or “to-be-announced”) agency securities with certain terms. As with any forward purchase contract, the value of the underlying agency securities may decrease between the contract date and the settlement

12

date. Furthermore, a transaction counterparty may fail to deliver the underlying agency securities at the settlement date. If any of the above risks were to occur, our financial condition and results of operations may be materially adversely affected.

Because we acquire agency securities that are backed by hybrid ARMs and fixed-rate securities, an increase in interest rates may adversely affect our profitability.

Most of our investments currently consist of agency securities that are backed by hybrid ARMs, which have a fixed rate for an initial period of time before becoming adjustable-rate securities, or fixed-rate mortgage securities.  As we typically hedge less than 100 percent of our funding cost exposure, during a period of rising interest rates the interest payments on our borrowings could increase, while the interest payments we earn on our hybrid mortgage securities and fixed-rate mortgage securities would not change.  As a result, our returns would be reduced.

We may experience a decline in the market value of our assets.

A decline in the market value of our agency securities or other assets may require us to recognize an “other-than-temporary” impairment against such assets under GAAP if we were to determine that, with respect to any assets in unrealized loss positions, we do not have the ability and intent to hold such assets to maturity or for a period of time sufficient to allow for recovery to the amortized cost of such assets.  If such a determination were to be made, we would recognize unrealized losses through earnings and write down the amortized cost of such assets to a new cost basis, based on the fair market value of such assets on the date they are considered to be other-than-temporarily impaired.  Such impairment charges reflect non-cash losses at the time of recognition; subsequent disposition or sale of such assets could further affect our future losses or gains, as they are based on the difference between the sale price received and adjusted amortized cost of such assets at the time of sale.  In this regard, we note that the fair market value of our agency securities is and has been affected by changes in interest rates and relative “credit spreads,” or the differences in value between agency securities and U.S. Treasuries with similar durations.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Market and Interest Rate Trends and the Effect on our Portfolio.”

Changes in prepayment rates on our agency securities may decrease our net interest margin.

Pools of mortgage loans underlie the agency securities that we acquire.  We receive principal distributions as payments are made on these underlying mortgage loans.  Prepayment rates are influenced by changes in current interest rates and a variety of economic, geographic and other factors, all of which are beyond our control.  Prepayment rates generally increase when interest rates fall and decrease when interest rates rise, but changes in prepayment rates are difficult to predict.  Prepayment rates also may be affected by conditions in the housing and financial markets, government actions, general economic conditions and the relative interest rates on fixed-rate and adjustable-rate mortgage loans.  Furthermore, specific government programs to support the housing market and U.S. economy, such as HARP and the three rounds of quantitative easing could cause variability in prepayment rates.  Variations in our expected prepayments could adversely affect our profitability, including in the following ways:

· We may purchase agency securities that have a higher interest rate than the market interest rate at the time of purchase.  In exchange for this higher interest rate, we would be required to pay a premium over the face amount of the security to acquire the security.  In accordance with accounting rules, we would amortize this premium over the term of the mortgage security.  If principal distributions are received faster than anticipated, we would be required to expense the premium faster.  

· We may not be able to reinvest the principal distributions received on agency securities in similar new agency securities and, to the extent that we can do so, the effective interest rates on the new agency securities will likely be lower than the yields on the mortgages that were prepaid.

· We also may acquire agency securities at a discount.  If the actual prepayment rates on a discount mortgage security are slower than anticipated at the time of purchase, we would be required to recognize the discount as income more slowly than anticipated.  This would adversely affect our profitability.  Slower than expected prepayments also may adversely affect the market value of a discount mortgage security.

Fannie Mae, Freddie Mac or Ginnie Mae guarantees of principal and interest related to agency securities do not protect us against prepayment risks.

Competition may prevent us from acquiring agency securities at favorable yields and that would negatively impact our profitability.

Our net income largely depends on our ability to acquire agency securities at favorable spreads over our borrowing costs.  In acquiring agency securities, we compete with other mortgage REITs, mortgage finance and specialty finance companies, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, other lenders and other entities that purchase mortgage-related assets.  Many of our competitors are substantially larger and have considerably greater financial, technical and marketing resources than we do.  Several other REITs have recently raised, or are

13

expected to raise, significant amounts of capital, and may have investment objectives that overlap with ours, which may create competition for investment opportunities.  As a result, we may not in the future be able to acquire sufficient agency securities at favorable spreads over our borrowing costs which would adversely affect our profitability.

Rapid changes in the values of our real estate-related investments may make it difficult for us to maintain our qualification as a REIT or exemption from the Investment Company Act.

We may acquire non-real estate related assets in the event our independent directors change our investment strategies.  If the market value or income potential of real estate-related investments declines as a result of increased interest rates, prepayment rates or other factors, we may need to increase our real estate investments and income and/or liquidate our non-qualifying assets in order to maintain our REIT qualification or exemption from the Investment Company Act.  If the decline in real estate asset values and/or income occurs quickly, this may be especially difficult to accomplish.  This difficulty may be exacerbated by the illiquid nature of any non-real estate assets that we may own.  We may have to make investment decisions that we otherwise would not make absent the REIT and Investment Company Act considerations.

Because assets we expect to acquire may experience periods of illiquidity, we may lose profits or be prevented from earning capital gains if we cannot sell mortgage-related assets at an opportune time.

We bear the risk of being unable to dispose of our mortgage-related assets at advantageous times or in a timely manner because mortgage-related assets generally experience periods of illiquidity, including the recent period of delinquencies and defaults with respect to residential mortgage loans.  The lack of liquidity may result from the absence of a willing buyer or an established market for these assets, as well as legal or contractual restrictions on resale or the unavailability of financing for these assets.  As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be relatively limited, which may cause us to incur losses.

Hedging against interest rate exposure may adversely affect our earnings.

Subject to complying with REIT requirements, we employ techniques that limit, or “hedge,” the adverse effects of rising interest rates on our short-term repurchase agreements and on the value of our assets.  Our hedging activity will vary in scope based on the level and volatility of interest rates and principal repayments, the type of securities held and other changing market conditions. These techniques may include entering into interest rate swap agreements or interest rate cap or floor agreements, purchasing or selling futures contracts, purchasing put and call options on securities or securities underlying futures contracts, or entering into forward rate agreements. We have implemented a policy to limit our use of hedging instruments to only those techniques described above and to only enter into hedging transactions with counterparties that have a high-quality credit rating.  However, there are no perfect hedging strategies, and interest rate hedging may fail to protect us from loss.  In addition, these hedging strategies may adversely affect us because hedging activities involve an expense that we will incur regardless of the effectiveness of the hedging activity. Hedging activities could result in losses if the event against which we hedge does not occur. Additionally, interest rate hedging could fail to protect us or 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.

Clearing facilities or exchanges upon which some of our hedging instruments are traded may increase margin requirements on our hedging instruments in the event of adverse economic developments.

In response to events having or expected to have adverse economic consequences or which create market uncertainty, clearing facilities or exchanges upon which some of our hedging instruments, such as interest rate swaps, are traded may require us to post additional collateral against our hedging instruments. In response to the U.S. approaching its debt ceiling without resolution and the government shutdown, the Chicago Mercantile Exchange announced on October 15, 2013 that it would increase margin requirements by 12% for all over-the-counter interest rate swap portfolios that its clearinghouse guaranteed. This increase was subsequently rolled back on October 17, 2013 upon the news that Congress passed legislation to temporarily suspend the debt ceiling and reopen the

14

government, which allowed time for broader negotiations concerning budgetary issues. In the event that future adverse economic developments or market uncertainty result in increased margin requirements for our hedging instruments, it could materially adversely affect our liquidity position, business, financial condition and results of operations.

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 Wall Street Reform and Consumer Act (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. However, the CFTC's Division of Swap Dealer and Intermediary Oversight recently issued a no-action letter saying, although it believes that mortgage REITs are properly considered commodity pools, it would not recommend that the CFTC take enforcement action against the operator of a mortgage REIT who does not register as a CPO if, among other things, the mortgage REIT limits the initial margin and premiums required to establish its swaps, futures and other commodity interest positions to not more than five percent of its total assets, the mortgage REIT limits the net income derived annually from those commodity interest positions that are not qualifying hedging transactions to less than five percent of its gross income and interests in the mortgage REIT are not marketed to the public as or in a commodity pool or otherwise as or in a vehicle for trading in the commodity futures, commodity options or swaps markets.

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 have submitted the required filing to claim the no-action relief afforded by the no-action letter described above. Consequently, we will be restricted to operating within the parameters discussed in the no-action letter and will not enter into hedging transactions covered by the no-action letter if they would cause us to exceed the limits set forth in the no-action letter.

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 that we fail to comply with statutory requirements relating to derivatives or with the CFTC's rules thereunder, including the no-action letter described above, 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.

It may be uneconomical to “roll” our TBA dollar roll transactions or we may be unable to meet margin calls on our TBA contracts, which could negatively affect our financial condition and results of operations.

We may utilize TBA dollar roll transactions as a means of investing in and financing agency securities. TBA contracts enable us to purchase or sell, for future delivery, agency securities with certain principal and interest terms and certain types of collateral, but the particular agency securities to be delivered are not identified until shortly before the TBA contract settlement date. Prior to settlement of the TBA contract we may choose to move the settlement of the securities out to a later date by entering into an offsetting position (referred to as a “pair off”), net settling the paired off positions for cash, and simultaneously purchasing a similar TBA contract for a later settlement date, collectively referred to as a “dollar roll.” The agency securities purchased for a forward settlement date under the TBA contract are typically priced at a discount to agency securities for settlement in the current month. This difference (or discount) is referred to as the “price drop.” The price drop is the economic equivalent of net interest carry income on the underlying agency securities over the roll period (interest income less implied financing cost) and is commonly referred to as “dollar roll income.” Consequently, dollar roll transactions and such forward purchases of agency securities represent off-balance sheet financing and increase our “at risk” leverage.

Under certain market conditions, TBA dollar roll transactions may result in negative carry income whereby the agency securities purchased for a forward settlement date under the TBA contract are priced at a premium to agency securities for settlement in the current month. Under such conditions, it would generally be uneconomical to roll our TBA contracts prior to the settlement date and we could have to take physical delivery of the underlying securities and settle our obligations for cash. We may not have sufficient funds or alternative financing sources available to settle such obligations. In addition, pursuant to the margin provisions established by the Mortgage-Backed Securities Division (“MBSD”) of the Fixed Income Clearing Corporation we are subject to margin calls on our

15

TBA contracts. Further, our prime brokerage agreements may require us to post additional margin above the levels established by the MBSD. Negative carry income on TBA dollar roll transactions or failure to procure adequate financing to settle our obligations or meet margin calls under our TBA contracts could result in defaults or force us to sell assets under adverse market conditions or through foreclosure and adversely affect our financial condition and results of operations.

We are highly dependent on information and communications systems.  Any systems failures could significantly disrupt our business, which may, in turn, negatively affect our operations and the market price of our stock and our ability to pay dividends to our shareholders.

Our business is highly dependent on communications and information systems.  Any failure or interruption of our manager’s systems or cyber-attacks or security breaches of our manager’s networks or systems could cause delays or other problems in our agency securities trading activities, which could have a material adverse effect on our operating results, the market price of our stock and our ability to pay dividends to our shareholders. In addition, we also face the risk of operational failure, termination or capacity constraints of any of the third parties with which we do business or that facilitate our business activities, including clearing agents or other financial intermediaries we use to facilitate our agency securities transactions.

Computer malware, viruses, and computer hacking and phishing attacks have become more prevalent in our industry and may occur on our systems in the future. We rely heavily on our manager’s financial, accounting and other data processing systems. It is difficult to determine what, if any, negative impact may directly result from any specific interruption or cyber-attacks or security breaches of our manager’s networks or systems or any failure to maintain performance, reliability and security of our technical infrastructure. As a result, any such computer malware, viruses, and computer hacking and phishing attacks may negatively affect our operations.

Risks Related to Debt Financing

We incur significant debt to finance our investments, which subjects us to increased risk of loss.

We generally borrow between six and 12 times the amount of our shareholders’ equity, although our borrowings may at times be above or below this amount.  As of December 31, 2013, our borrowings were approximately $16.5 billion (including on-balance sheet dollar roll liability), and our debt-to-shareholders’ equity ratio was approximately 7.0:1, while our effective leverage ratio, which includes the impact of off-balance sheet financing related to TBA dollar roll transactions, was 7.3:1.  To the extent we exceed a debt-to-shareholders’ equity ratio of 12:1, the adverse impact on our financial condition and results of operations from the types of risks described in this section would likely be more severe.  We incur leverage by borrowing against our agency securities.  Incurring debt subjects us to many risks, including the risks that:

· our cash flow from operations will be insufficient to make required payments of principal and interest, resulting in the loss of some or all of our securities due to foreclosure or sale in order to satisfy our debt obligations;

· our debt may increase our vulnerability to adverse economic and industry conditions;

· we may be required to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for distribution to shareholders, funding our operations, future business opportunities or other purposes;

· the terms of any refinancing will not be as favorable as the terms of the debt being refinanced;

· the use of leverage could adversely affect our ability to make distributions to our shareholders and could reduce the market price of our stock;

· a default under a loan could result in an involuntary liquidation of the securities pledged for such loan, including any cross-collateralized securities, which would result in a loss to us equal to the difference between the value of the securities upon liquidation and the carrying value of the securities; and

· to the extent we are compelled to liquidate assets to repay debts, such an event could jeopardize (1) our REIT status, or (2) our exemption from registration under the Investment Company Act, the loss of either of which could decrease our overall profitability and our ability to make distributions to our shareholders.

A decrease in the value of assets financed through repurchase agreements may lead our lenders to require us to pledge additional assets as collateral.  If our assets are insufficient to meet the collateral requirements, then we may be compelled to liquidate particular assets at an inopportune time.

A majority of our borrowings are and will be secured by our agency securities, generally under repurchase agreements.  The amount borrowed under a repurchase agreement is based on the market value of the agency securities pledged to secure the borrowings.  Our repurchase agreements allow our lenders to revise the market value of the agency securities pledged as collateral

16

from time to time to reflect then–current market conditions.  Possible market developments, including a sharp rise in interest rates, a change in prepayment rates or increasing market concern about the value or liquidity of one or more types of securities in which our portfolio is concentrated, may cause a decline in the market value of the agency securities used to secure these debt obligations, which could limit our ability to borrow or result in lenders requiring us to pledge additional collateral to secure our borrowings or repay a portion of the outstanding borrowings, on minimal notice.  In that situation, we could be required to sell agency securities under adverse market conditions in order to obtain the additional collateral required by the lender or to pay down our borrowings.  If these sales are made at prices lower than the carrying value of the agency securities, we would experience losses, thus adversely affecting our operating results and net profitability.  In recent months, a number of companies owning mortgage securities have been required by lenders to pledge additional collateral as the market value of their mortgage securities declined.  In the ordinary course of our business, we experience margin calls, which require us to pledge additional collateral or pay down our borrowings.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”

Further, financial institutions may require us to maintain a certain amount of cash that is not invested or to set aside non-leveraged assets sufficient to maintain a specified liquidity position which would allow us to satisfy our collateral obligations.  As a result, we may not be able to leverage our assets as fully as we would choose, which could reduce our return on equity.  In the event that we are unable to meet these collateral obligations, then, as described above, our financial condition could deteriorate rapidly.

Failure to procure adequate debt financing, or to renew or replace existing debt financing as it matures, would adversely affect our results and may, in turn, negatively affect the value of our stock and our ability to distribute dividends.

We use debt financing as a strategy to increase our return on investments.  However, we may not be able to achieve our desired debt-to-equity ratio for a number of reasons, including the following:

· our lenders do not make debt financing available to us at acceptable rates; or

· our lenders require that we pledge additional collateral to cover our borrowings, which we may be unable to do.

The dislocations in the residential mortgage market and credit markets have led lenders, including the financial institutions that provide financing for our investments, to heighten their credit review standards, and, in some cases, to reduce or eliminate loan amounts available to borrowers.  As a result, we cannot assure you that any, or sufficient, debt funding will be available to us in the future on terms that are acceptable to us.  In the event that we cannot obtain sufficient funding on acceptable terms, there may be a negative impact on the value of our stock and our ability to make distributions, and you may lose part or all of your investment.

Furthermore, because we rely primarily on short-term borrowings, our ability to achieve our investment objective depends not only on our ability to borrow money in sufficient amounts and on favorable terms, but also on our ability to renew or replace on a continuous basis our maturing short-term borrowings. As of December 31, 2013, a majority of our borrowings bore maturities of 30 days or less. If we are not able to renew or replace maturing borrowings, we will have to sell some or all of our assets, possibly under adverse market conditions.

Lenders may require us to enter into restrictive covenants relating to our operations.

When we obtain financing, lenders could impose restrictions on us that would affect our ability to incur additional debt, our capability to make distributions to shareholders and our flexibility to determine our operating policies.  Loan documents we execute may contain negative covenants that limit, among other things, our ability to repurchase stock, distribute more than a certain amount of our funds from operations, and employ leverage beyond certain amounts.

We may incur increased borrowing costs related to repurchase agreements and that would adversely affect our profitability.

Substantially all of our borrowings are expected to be collateralized borrowings in the form of repurchase agreements.  Our borrowing costs under our repurchase agreements generally correspond to short-term interest rates such as LIBOR or a short-term Treasury index, plus or minus a margin.  The margins on these borrowings over or under short-term interest rates may vary depending upon:

· the movement of interest rates;

· the availability of financing in the market; and

· the credit quality, value and liquidity of our agency securities.

As of December 31, 2013, the weighted average margin requirement under all our repurchase agreements was approximately 4.63% (weighted by borrowing amount).

17

If the interest rates on these repurchase agreements increase at a rate higher than the increase in rates payable on our investments, our profitability would be adversely affected.

If the counterparties to our repurchase transactions default on their obligations to resell the underlying security back to us at the end of the transaction term, or if the value of the underlying security has declined as of the end of that term or if we default on our obligations under the repurchase agreement, we will lose money on our repurchase transactions.

When we engage in a repurchase transaction, we generally sell securities to the transaction counterparty and receive cash from the counterparty.  The counterparty is obligated to resell the securities back to us at the end of the term of the transaction, which is typically from 30 days to less than one year, but which may have terms in excess of one year.  The cash we receive from the counterparty when we initially sell the securities to the counterparty is less than the value of those securities, which is referred to as the haircut.  If the counterparty defaults on its obligation to resell the securities back to us we would incur a loss on the transaction equal to the amount of the haircut (assuming there was no change in the value of the securities).  See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report for further discussion regarding risks related to exposure to European financial institution counterparties in light of recent market conditions. We would also lose money on a repurchase transaction if the value of the underlying securities has declined as of the end of the transaction term, as we would have to repurchase the securities for their initial value but would receive securities worth less than that amount.  Any losses we incur on our repurchase transactions could adversely affect our earnings, and thus our cash available for distribution to our shareholders.

If we default on one of our obligations under a repurchase transaction, the counterparty can terminate the transaction and cease entering into any other repurchase transactions with us.  In that case, we would likely need to establish a replacement repurchase facility with another repurchase dealer in order to continue to leverage our portfolio and carry out our investment strategy.  There is no assurance we would be able to establish a suitable replacement facility on acceptable terms or at all.

Our use of repurchase agreements to borrow funds may give our lenders greater rights in the event that either we or a lender file for bankruptcy.

Our borrowings under repurchase agreements may qualify for special treatment under the bankruptcy code, giving our lenders the ability to avoid the automatic stay provisions of the bankruptcy code and to take possession of and liquidate our collateral under the repurchase agreements without delay in the event that we file for bankruptcy.  Furthermore, the special treatment of repurchase agreements under the bankruptcy code may make it difficult for us to recover our pledged assets in the event that a lender files for bankruptcy.  Thus, our use of repurchase agreements will expose our pledged assets to risk in the event of a bankruptcy filing by either a lender or us.

Risks Related to Our Corporate Structure

Failure to maintain an exemption from the Investment Company Act would adversely affect our results of operations.

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. Under Section 3(c)(5)(C), the Investment Company Act exempts entities that are primarily engaged in the business of purchasing or otherwise acquiring “mortgages and other liens on and interests in real estate.” The staff of the SEC has provided guidance on the availability of this exemption. Specifically, the staff’s position generally requires us to maintain at least 55% of our assets directly in qualifying real estate interests and 80% in real estate-related investments (including our qualifying real estate interests). We refer to this exemption as the “Mortgage Exemption.” In order to constitute a qualifying real estate interest under the 55% requirement, a real estate interest must meet various criteria. Mortgage securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and, thus, may not qualify for purposes of the 55% requirement. Our ownership of these mortgage securities, therefore, is limited by the provisions of the Investment Company Act. Accordingly, we intend to maintain at least 55% of our assets in whole pools of mortgages issued by Ginnie Mae, Fannie Mae or Freddie Mac. However, competition for investments may prevent us from acquiring mortgage securities that meet the 55% requirement at favorable yields or from acquiring sufficient qualifying securities to comply with the Mortgage Exemption under the Investment Company Act.

In addition, 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 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 our stock and our ability to make distributions to our shareholders.

18

We are subject to financial reporting and other requirements for which our accounting, internal audit and other management systems and resources may not be adequately prepared.

We are subject to reporting and other obligations under the Exchange Act, including the requirements of Section 404 of the Sarbanes-Oxley Act.  Section 404 requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent registered public accounting firm addressing these assessments as of December 31, 2013.  These reporting and other obligations, such as our status as a large accelerated filer, place significant demands on our management, administrative, operational, internal audit and accounting resources and cause us to incur significant expenses.  We may need to upgrade our systems or create new systems; implement additional financial and management controls, reporting systems and procedures; expand or outsource our internal audit function; and hire additional accounting, internal audit and finance staff.  If we are unable to accomplish these objectives in a timely and effective fashion, our ability to comply with the financial reporting requirements and other rules that apply to reporting companies could be impaired.  Any failure to maintain effective internal controls could have a material adverse effect on our business, operating results and stock price.

Our policies are determined by our board of directors, and our shareholders have limited rights.

Our board of directors is responsible for our strategic business direction.  Our major policies, including our policies with respect to acquisitions, leasing, financing, growth, operations, debt limitation and distributions, are determined by our board of directors.  Our board of directors may amend or revise these and other policies from time to time without a vote of our shareholders.  Our board’s broad discretion in setting policies and shareholders’ inability to exert control over those policies increases the uncertainty and risks you face as a shareholder.

Our board of directors may approve the issuance of capital stock with terms that may discourage a third party from acquiring us and may increase or decrease our authorized capital stock without shareholder approval.

Subject to the rights of holders of our 7.625% Series A Cumulative Redeemable Preferred Stock (“Series A Preferred Stock”) to approve the classification or issuance of any class or series of stock ranking senior to our Series A Preferred Stock, our charter permits our board of directors to issue shares of preferred stock, issuable in one or more classes or series.  We may issue a class of preferred stock to individual investors in order to comply with the various REIT requirements.  Our charter further permits our board of directors to amend our charter to increase or decrease the aggregate number of shares of our authorized stock or the number of shares of stock of any class or series without shareholder approval.  Subject to the rights of holders of Series A Preferred Stock discussed above, our board of directors may also classify or reclassify any unissued shares of preferred or common stock and establish the preferences and rights (including the right to vote, participate in earnings and to convert into shares of our common stock) of any such shares of stock, which rights may be superior to those of shares of our common stock.  Thus, our board of directors could authorize the issuance of shares of preferred or common stock with terms and conditions that could have the effect of discouraging a takeover or other transaction in which holders of some or a majority of the outstanding shares of our common stock might receive a premium for their shares over the then current market price of our common stock.  Furthermore, to the extent we issue additional equity interests, your percentage ownership interest in us will be diluted.  In addition, depending on the terms and pricing of any additional offerings, you may also experience dilution in the book value and fair value of your shares.

Our ownership limitations may restrict business combination opportunities.

To qualify as a REIT under the Code, no more than 50% of the value of our outstanding shares of capital stock may be owned, directly or under applicable attribution rules, by five or fewer individuals (as defined by the Code to include certain entities) during the last half of each taxable year (other than our first REIT taxable year).  To preserve our REIT qualification, our charter generally prohibits direct or indirect ownership by any person of either (1) more than the aggregate stock ownership limit or (2) more than the common stock ownership limit.  In addition, the articles supplementary for our Series A Preferred Stock provide that generally no person may own, or be deemed to own by virtue of the attribution provisions of the Code, either more than 9.8% in value or in number of shares, whichever is more restrictive, of our outstanding Series A Preferred Stock. Generally, shares owned by affiliated owners will be aggregated for purposes of the ownership limits.  Any transfer of shares of our stock that would violate the ownership limits will result in the shares that would otherwise be held in violation of the ownership limits being designated as “shares-in-trust” and transferred automatically to a trust effective on the day before the purported transfer or other event giving rise to such excess ownership.  The intended transferee will acquire no rights in such shares.  The beneficiary of the trust will be one or more charitable organizations named by us.  The ownership limits could have the effect of delaying, deferring or preventing a change in control or other transaction in which holders of shares of common stock might receive a premium for their shares of common stock over the then current market price or that such holders might believe to be otherwise in their best interests.  The ownership limit provisions also may make our shares an unsuitable investment vehicle for any person seeking to obtain, either alone or with others as a group, ownership of either (1) more than 9.8% of the number or value of our outstanding shares of common stock or Series A Preferred Stock or (2) more than 9.8% of the number or value of our outstanding shares of all classes.

19

Provisions of Maryland law and other provisions of our organizational documents may limit the ability of a third party to acquire control of our company.

Certain provisions of the Maryland General Corporation Law (“MGCL”) may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium price for holders of our common stock or otherwise be in their best interests, including:

· “business combination” provisions that, subject to limitations, prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our shares or an affiliate thereof) for five years after the most recent date on which the shareholder becomes an interested stockholder, and thereafter impose special shareholder voting requirements on these combinations; and

· “control share” provisions that provide that “control shares” of our company (defined as shares which, when aggregated with other shares controlled by the acquiring shareholder, entitle the shareholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights except to the extent approved by our shareholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares.

Our bylaws provide that we are not subject to the “control share” provisions of the MGCL.  However, our board of directors may elect to make the “control share” statute applicable to us at any time, and may do so without shareholder approval.

Title 3, Subtitle 8 of the MGCL permits our board of directors, without shareholder approval and regardless of what is currently provided in our charter or bylaws, to elect on behalf of our company to be subject to statutory provisions that may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium price for holders of our common stock or otherwise be in their best interest.  Pursuant to Title 3, Subtitle 8 of the MGCL, our charter provides that our board of directors will have the exclusive power to fill vacancies on our board.  As a result, unless all of the directorships are vacant, our shareholders will not be able to fill vacancies with nominees of their own choosing.  Our board of directors may elect to opt in to additional provisions of Title 3, Subtitle 8 of the MGCL without shareholder approval at any time.

Additionally, our charter and bylaws contain other provisions that may delay or prevent a change of control of our company.  For example, our charter and bylaws provide that the number of directors constituting our full board may be fixed only by our directors, that our bylaws may only be amended by our directors and that a special meeting of shareholders may not be called by holders of our common stock holding less than a majority of our outstanding shares entitled to vote at such meeting.

Our rights and the rights of our shareholders to take action against our directors and officers are limited, which could limit your recourse in the event of actions not in shareholders’ best interests.

Our charter limits the liability of our directors and officers for money damages, except for liability resulting from actual receipt of an improper benefit or profit in money, property or services, or a final judgment based upon a finding of active and deliberate dishonesty by the director or officer that was material to the cause of action adjudicated.

Our charter also authorizes us to indemnify our directors and officers for actions taken by them in those capacities to the extent permitted by Maryland law, and our bylaws obligate us, to the maximum extent permitted by Maryland law, to indemnify any present or former director or officer of our company from and against any claim or liability to which he or she may become subject by reason of his or her service in that capacity.  In addition, we may be obligated to fund the defense costs incurred by our directors and officers.  Finally, we have entered into agreements with our directors and officers pursuant to which we have agreed to indemnify them to the maximum extent permitted by Maryland law.

Future offerings of debt securities, which would rank senior to our common stock upon liquidation, and future offerings of equity securities, which would dilute our existing shareholders and may be senior to our common stock for the purposes of dividend and liquidating distributions, may adversely affect the market price of our common stock.

Our common stock is ranked junior to our Series A Preferred Stock.  Our outstanding Series A Preferred Stock also has or will have a preference upon our dissolution, liquidation or winding up in respect of assets available for distribution to our shareholders. Holders of our common stock are not entitled to preemptive rights or other protections against dilution. In the future, we may attempt to increase our capital resources by making offerings of debt or additional offerings of equity securities, including commercial paper, senior or subordinated notes and series of preferred stock or common stock.  Upon liquidation, holders of our debt securities and shares of preferred stock, if any, and lenders with respect to other borrowings will receive a distribution of our available assets prior to the holders of our common stock.  Additional equity offerings may dilute the holdings of our existing shareholders or reduce the market price of our common stock, or both.  Preferred stock could have a preference on liquidating distributions or a preference on dividend payments or both that could limit our ability to make a dividend distribution to the holders of our common stock.  Because

20

our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings.  Thus, holders of our common stock bear the risk of our future offerings reducing the market price of our common stock and diluting their stock holdings in us.

We have not established a minimum dividend payment level and there are no assurances of our ability to pay dividends in the future.

We intend to pay quarterly dividends and to make distributions to our shareholders in amounts such that all or substantially all of our taxable income in each year, subject to certain adjustments, is distributed.  This, along with other factors, should enable us to qualify for the tax benefits accorded to a REIT under the Code.  However, we have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected by the risk factors described in this report.  All distributions will be made at the discretion of our board of directors and will depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our board of directors may deem relevant from time to time.  There are no assurances of our ability to pay dividends in the future.  In addition, some of our distributions may include a return of capital.

Broad market fluctuations could negatively impact the market price of our stock.

We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future.  Some of the factors that could affect our stock price or result in fluctuations in the price or trading volume of our common stock include:

· actual or anticipated variations in our quarterly operating results;

· changes in our operations or earnings estimates or publication of research reports about us or the industry;

· increases in market interest rates may lead purchasers of our stock to demand a higher yield;

· changes in market valuations of similar companies;

· adverse market reaction to any increased indebtedness we incur in the future;

· additions or departures of key management personnel;

· actions by institutional shareholders;

· speculation in the press or investment community; and

· general market and economic conditions.

In addition, the stock market has experienced price and volume fluctuations that have affected the market prices of many companies in industries similar or related to ours and may have been unrelated to operating performances of these companies.  These broad market fluctuations could reduce the market price of our common stock.

Future issuances or sales of shares could cause our share price to decline.

Sales of substantial numbers of shares of our common stock in the public market, or the perception that such sales might occur, could adversely affect the market price of our common stock.  In addition, the sale of these shares could impair our ability to raise capital through a sale of additional equity securities.

Other issuances of our common stock could have an adverse effect on the market price of our common stock.  In addition, future issuances of our common stock may be dilutive to existing shareholders.

21

Federal Income Tax Risks

If we do not qualify as a REIT, we will be subject to tax as a regular corporation and face substantial tax liability.

We expect to continue to operate so as to qualify as a REIT under the Code.  However, qualification as a REIT involves the application of highly technical and complex Code provisions for which only a limited number of judicial or administrative interpretations exist.  Even a technical or inadvertent mistake could jeopardize our REIT status.  Furthermore, new tax legislation, administrative guidance or court decisions, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to qualify as a REIT.  If we fail to qualify as a REIT in any tax year, then we would be taxed as a regular domestic corporation, which, among other things, means being unable to deduct distributions to shareholders in computing taxable income and being subject to federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates.  Any resulting tax liability could be substantial and would reduce the amount of cash available for distribution to shareholders, which could in turn have an adverse impact on the value of our stock.  Furthermore, unless we were entitled to relief under applicable statutory provisions, we would be disqualified from treatment as a REIT for the subsequent four taxable years following the year during which we lost our qualification, and thus, our cash available for distribution to shareholders would be reduced for each of the years during which we did not qualify as a REIT.

Even if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow.

Even if we remain qualified for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income and assets. Any of these taxes would decrease cash available for distribution to our shareholders.

Complying with REIT requirements may cause us to forego otherwise attractive opportunities.

In order to maintain our qualification as a REIT for federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our shareholders and the ownership of our stock.  We may be required to make distributions to shareholders at disadvantageous times or when we do not have funds readily available for distribution.  Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.

Complying with REIT requirements may limit our ability to hedge effectively.

The REIT provisions of the Code may limit our ability to hedge our assets and operations.  Under these provisions, any income that we generate from transactions intended to hedge our interest rate, inflation and/or currency risks will be excluded from gross income for purposes of the REIT 75% and 95% gross income tests if the instrument hedges (1) interest rate risk on liabilities incurred to carry or acquire real estate assets or (2) risk of currency fluctuations with respect to any item of income or gain that would be qualifying income under the REIT 75% or 95% gross income tests, and such instrument is properly identified under applicable regulations of the U.S. Treasury.  Income from hedging transactions entered into prior to July 31, 2008 that hedge interest rate risk on liabilities incurred to carry or acquire real estate assets will be excluded from gross income for purposes of the REIT 95% gross income test, but will not be qualifying income for purposes of the REIT 75% gross income test.  Income from hedging transactions that do not meet these requirements will generally constitute nonqualifying income for purposes of both the REIT 75% and 95% gross income tests.  As a result of these rules, we may have to limit our use of hedging techniques that might otherwise be advantageous, which could result in greater risks associated with interest rate or other changes than we would otherwise incur.

The failure of agency securities subject to a repurchase agreement to qualify as real estate assets would adversely affect our ability to qualify as a REIT.

We have entered and intend to continue to enter into repurchase agreements under which we will nominally sell certain of our agency securities to a counterparty and simultaneously enter into an agreement to repurchase the sold assets. We believe that for U.S. federal income tax purposes these transactions will be treated as secured debt and we will be treated as the owner of the agency securities that are the subject of any such agreement notwithstanding that such agreement may transfer record ownership of such assets to the counterparty during the term of the agreement. It is possible, however, that the Internal Revenue Service (“IRS”) could successfully assert that we do not own the agency securities during the term of the repurchase agreement, in which case we could fail to qualify as a REIT.

Complying with REIT requirements may force us to liquidate otherwise attractive investments.

In order to maintain our qualification as a REIT, we must also ensure that at the end of each calendar quarter at least 75% of the value of our assets consists of cash, cash items, government securities and qualified REIT real estate assets.  The remainder of our investment in securities (other than government securities and qualified real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer.  

22

In addition, in general, no more than 5% of the value of our assets (other than government securities and qualified real estate assets) can consist of the securities of any one issuer and no more than 25% of the value of our total securities can be represented by securities of one or more taxable REIT subsidiaries.  If we fail to comply with these requirements at the end of any calendar quarter, we must correct such failure within 30 days after the end of the calendar quarter in order to avoid losing our REIT status and suffering adverse tax consequences.  As a result, we may be required to liquidate otherwise attractive investments.

Complying with REIT requirements may force us to borrow to make distributions to shareholders or otherwise depend on external sources of capital to fund such distributions.

As a REIT, we must distribute at least 90% of our REIT taxable income (subject to certain adjustments) to our shareholders.  To the extent that we satisfy the distribution requirement, but distribute less than 100% of our taxable income, we will be subject to federal corporate income tax on our undistributed taxable income.  In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our shareholders in a calendar year is less than a minimum amount specified under federal tax laws.  While we generally intend to make distributions so that no income or excise taxes are due, we may from time to time, consistent with maintaining our REIT qualification, elect to pay taxes in lieu of making current distributions if we decide that strategy is more favorable to our shareholders.

From time to time, we may generate taxable income greater than our net income for financial reporting purposes due to, among other things, amortization of capitalized purchase premiums, or our taxable income may be greater than our cash flow available for distribution to shareholders.  If we do not have other funds available in these situations, we could be required to borrow funds, sell a portion of our agency securities at disadvantageous prices or find another alternative source of funds in order to make distributions sufficient to enable us to pay out enough of our taxable income to satisfy the distribution requirement and to avoid corporate income tax and the 4% excise tax in a particular year.  These alternatives could increase our costs or reduce our equity.

Because of the distribution requirement, it is unlikely that we will be able to fund all future capital needs, including capital needs in connection with investments, from cash retained from operations.  As a result, to fund future capital needs, we likely will have to rely on third-party sources of capital, including both debt and equity financing, which may or may not be available on favorable terms or at all.  Our access to third-party sources of capital will depend upon a number of factors, including the market’s perception of our growth potential and our current and potential future earnings and cash distributions and the market price of our stock.

Our ability to invest in and dispose of TBA contracts could be limited by our REIT status, and we could lose our REIT status as a result of these investments.

We purchase agency securities through TBA contracts. In certain instances, rather than take delivery of the agency securities subject to a TBA contract, we will dispose of the TBA contract through a dollar roll transaction in which we agree to purchase similar securities in the future at a predetermined price or otherwise, which may result in the recognition of income or gains. We account for dollar roll transactions as purchases and sales. The law is unclear regarding whether TBA contracts will be qualifying assets for the 75% asset test and whether income and gains from dispositions of TBA contracts will be qualifying income for the 75% gross income test.

Until such time as we seek and receive a favorable private letter ruling from the IRS, or we are advised by counsel that TBA contracts should be treated as qualifying assets for purposes of the 75% asset test, we will limit our investment in TBA contracts and any non-qualifying assets to no more than 25% of our assets at the end of any calendar quarter. Further, until such time as we seek and receive a favorable private letter ruling from the IRS or we are advised by counsel that income and gains from the disposition of TBA contracts should be treated as qualifying income for purposes of the 75% gross income test, we will limit our gains from dispositions of TBA contracts and any non-qualifying income to no more than 25% of our gross income for each calendar year. Accordingly, our ability to purchase agency securities through TBA contracts and to dispose of TBA contracts, through dollar roll transactions or otherwise, could be limited.

Moreover, even if we are advised by counsel that TBA contracts should be treated as qualifying assets or that income and gains from dispositions of TBA contracts should be treated as qualifying income, it is possible that the IRS could successfully take the position that such assets are not qualifying assets and such income is not qualifying income. In that event, we could be subject to a penalty tax or we could fail to qualify as a REIT if (i) the value of our TBA contracts, together with our non-qualifying assets for the 75% asset test, exceeded 25% of our gross assets at the end of any calendar quarter or (ii) our income and gains from the disposition of TBA contracts, together with our non-qualifying income for the 75% gross income test, exceeded 25% of our gross income for any taxable year.

Item 1B. Unresolved Staff Comments

None.

23

Item 2. Properties

We do not own any properties.  Our executive and administrative office is located at 110 Oakwood Drive, Suite 340, Winston-Salem, NC  27103.  As part of our management agreement, our manager is responsible for providing the office space required in rendering services to us, and accordingly, direct rent responsibilities belong to our manager.

Item 3. Legal Proceedings

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

Item 4. Mine Safety Disclosures

Not applicable.

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Information about our equity compensation plans and other related shareholder matters is incorporated by reference to our definitive Proxy Statement for our 2014 Annual Shareholders’ Meeting.

Market Information

Our common stock has been listed on the NYSE under the symbol “HTS” since April 30, 2008.  The following table presents the high and low sales prices for our common stock as reported by the NYSE for the periods indicated.

	High		Low
Quarter ended March 31, 2012		29.00		26.24
Quarter ended June 30, 2012		29.54		27.88
Quarter ended September 30, 2012		29.68		27.87
Quarter ended December 31, 2012		28.15		24.40
Quarter ended March 31, 2013		28.14		25.56
Quarter ended June 30, 2013		27.79		24.57
Quarter ended September 30, 2013		24.78		17.73
Quarter ended December 31, 2013		19.77		16.26

The per-share closing price for our common stock, as reported by the NYSE on February 18, 2014, was $19.56.

Holders of Our Common Stock

As of February 18, 2014, there were approximately 30 record holders of our common stock, including shares held in “street name” by nominees who are record holders.

Dividends

We intend to continue to pay quarterly dividends to holders of shares of common stock.  Future dividends will be at the discretion of our board of directors and will depend on our earnings and financial condition, maintenance of our REIT qualification, restrictions on making distributions under Maryland law and such other factors as our board of directors deems relevant.  For 2013, we paid $2.45 per share of common stock in dividends, all of which represented ordinary income for tax purposes.  For 2012, we paid $3.30 per share of common stock in dividends.  Of the $3.30, 97.0415% represented ordinary income, 2.9585% represented long-term capital gain, and 0.0% represented return of capital, for tax purposes.  The following table sets forth, for the periods indicated, the dividends declared per share of common stock.

	Common Dividends Declared Per Share
Quarter ended March 31, 2012	$	0.90
Quarter ended June 30, 2012	$	0.90
Quarter ended September 30, 2012	$	0.80
Quarter ended December 31, 2012	$	0.70
Quarter ended March 31, 2013	$	0.70
Quarter ended June 30, 2013	$	0.70
Quarter ended September 30, 2013	$	0.55
Quarter ended December 31, 2013	$	0.50

24

Performance Graph

The following graph provides a comparison of the cumulative total return on our common stock from December 31, 2008 to the NYSE closing price per share on December 31, 2013 with the cumulative total return on the Standard & Poor’s 500 Composite Stock Price Index (the “S&P 500”) and the FTSE National Association of Real Estate Investment Trusts Mortgage REIT Index (the “FTSE NAREIT MREIT Index”).  Total return values were calculated assuming a $100 investment on December 31, 2008 with reinvestment of all dividends in (i) the common stock, (ii) the S&P 500 and (iii) the FTSE NAREIT MREIT Index.

The actual returns shown on the graph above are as follows:

		Period Ending
Index	12/31/08	12/31/09	12/31/10	12/31/11	12/31/12	12/31/13
Hatteras Financial Corp.	100.00	123.42	156.00	156.43	165.68	122.05
S&P 500	100.00	126.46	145.51	148.59	172.37	228.19
NAREIT Mortgage REIT	100.00	124.63	152.79	149.10	178.75	175.25

25

Stock Repurchase Program

Period	Total Number of Shares Purchased(1)		Average Price Paid per Share(2)		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs(3)
October 1, 2013 – October 31, 2013		-	$	-		-		8,864,053
November 1, 2013 – November 30, 2013		700,000	$	17.19		700,000		8,164,053
December 1, 2013 – December 31, 2013		649,500	$	16.56		649,500		7,514,553
Total		1,349,500	$	17.64		1,349,500		7,514,553

⁽¹⁾ For the quarter ended December 31, 2013, we repurchased 1,349,500 shares of common stock under the Repurchase Program (as defined below) in at-the-market transactions at a total cost of $22,819,000.

⁽²⁾ Excludes commissions.

⁽³⁾ On June 18, 2013, our board of directors authorized a stock repurchase program (the “Repurchase Program”) to acquire up to 10,000,000 shares of our common stock. We may repurchase shares from time to time as liquidity and market conditions permit. The authorization does not include an expiration date.

26

Item 6. Selected Financial Data

The following table sets forth our selected historical operating and financial data.  The selected historical operating and financial data for the five years ended December 31, 2013 have been derived from our historical financial statements.

The information presented below is only a summary and does not provide all of the information contained in our historical financial statements, including the related notes.  You should read the information below in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our historical financial statements, including the related notes.  This table includes non-GAAP financial measures.  See the section on non-GAAP measures under “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” for important information about these non-GAAP measures and reconciliations to the most comparable GAAP measures.

(Dollars in thousands, except share-related amounts)
	Years Ended December 31
	2013			2012			2011			2010			2009
Statement of Income Data
Interest income on mortgage-backed securities	$	450,708		$	504,800		$	424,713		$	263,751		$	282,344
Interest income on short-term cash investments		1,560			1,508			1,407			1,265			771
Interest expense		(197,709	)		(197,064	)		(144,662	)		(95,923	)		(96,267	)
Net interest margin		254,559			309,244			281,458			169,093			186,848
Operating expenses		(27,866	)		(24,346	)		(17,661	)		(13,144	)		(12,448	)
Other income (loss):
Net realized gain (loss) on sale of mortgage-backed securities		(283,012	)		64,347			20,576			13,551			-
Impairment of mortgage-backed securities		(8,102	)		-			-			-			-
Loss on derivative instruments, net		(69,715	)		-			-			-			-
Total other income (loss)		(360,829	)		64,347			20,576			13,551			-
Net income (loss)		(134,136	)		349,245			284,373			169,500			174,400
Dividends on preferred stock		(21,922	)		(7,551	)		-			-			-
Net income (loss) available to common shareholders	$	(156,058	)	$	341,694		$	284,373		$	169,500		$	174,400
Earnings (loss) per share of common stock, basic and diluted	$	(1.59	)	$	3.67		$	3.97		$	4.30		$	4.82
Weighted average shares outstanding, basic and diluted		98,337,362			93,185,520			71,708,058			39,454,362			36,195,840
Distributions per common share	$	2.45		$	3.30		$	3.90		$	4.40		$	4.50
Selected Balance Sheet Data (at period end)
Mortgage-backed securities	$	17,642,532		$	23,919,251		$	17,741,873		$	9,587,216		$	6,992,771
Total assets	$	19,077,360		$	26,404,118		$	18,586,719		$	10,006,979		$	7,416,402
Repurchase agreements and dollar roll liability	$	16,481,509		$	22,866,429		$	16,162,375		$	8,681,060		$	6,046,518
Long-term repurchase agreements	$	-		$	-		$	-		$	-		$	300,000
Shareholders' equity	$	2,364,101		$	3,072,864		$	2,080,188		$	1,145,484		$	931,713
Key Statistics (1)
Average MBS	$	23,010,281		$	22,167,760		$	14,932,378		$	7,052,063		$	6,088,084
Average repurchase agreements and dollar roll liability	$	21,249,868		$	20,468,353		$	13,692,704		$	6,488,678		$	5,555,212
Average equity	$	2,731,439		$	2,732,423		$	1,899,211		$	1,019,200		$	875,914
Average portfolio yield  (2)		1.96	%		2.28	%		2.84	%		3.74	%		4.64	%
Average cost of funds  (3)		0.93	%		0.96	%		1.06	%		1.48	%		1.73	%
Interest rate spread  (4)		1.03	%		1.32	%		1.78	%		2.26	%		2.91	%
TBA dollar roll income	$	5,605		$	-		$	-		$	-		$	-
Average TBA dollar roll position	$	185,451		$	-		$	-		$	-		$	-
Average portfolio yield, including TBA dollar roll income  (5)		1.97	%		2.28	%		2.84	%		3.74	%		4.64	%

27

(Dollars in thousands, except share-related amounts)
	Years Ended December 31
	2013			2012			2011			2010			2009
Effective interest expense  (6)	$	204,366		$	197,064		$	144,662		$	95,923		$	96,267
Effective cost of funds  (6)		0.96	%		0.96	%		1.06	%		1.48	%		1.73	%
Effective net interest margin  (7)	$	253,507		$	309,244		$	281,458		$	169,093		$	186,848
Effective interest rate spread  (8)		1.01	%		1.32	%		1.78	%		2.26	%		2.91	%
Core earnings  (9)	$	203,719		$	277,347		$	263,797		$	155,949		$	174,400
Core earnings per share, basic and diluted  (9)	$	2.07		$	2.98		$	3.68		$	3.95		$	4.82
Average annual portfolio repayment rate  (10)		25.70	%		26.39	%		24.54	%		36.27	%		19.79	%
Debt to equity (at period end)  (11)	7.0:1			7.4:1			7.8:1			7.6:1			6.8:1
Debt to paid-in capital (at period end)  (12)	6.0:1			8.2:1			8.5:1			8.3:1			8.2:1
Effective debt to equity (at period end)  (13)	7.3:1			7.4:1			7.8:1			7.6:1			6.8:1

⁽¹⁾ The averages presented herein are computed from our books and records, using daily weighted values.  Percentages are annualized, as appropriate.

⁽²⁾ Average portfolio yield was calculated by dividing our interest income on MBS, net of amortization, by our average MBS.

⁽³⁾ Average cost of funds was calculated by dividing our total interest expense (including hedges) by the sum of our average balance outstanding under our repurchase agreements and our average dollar roll liability for the period.

⁽⁴⁾ Interest rate spread was calculated by subtracting our average cost of funds from our average portfolio yield.

⁽⁵⁾ Average portfolio yield, including TBA dollar roll income was calculated the same as average portfolio yield other than to include TBA dollar roll income in the numerator and our average TBA dollar roll position in the denominator.

⁽⁶⁾ Effective interest expense includes certain interest rate swap adjustments.  Effective cost of funds is effective interest expense for the period divided by average repurchase agreements and dollar roll liability for the period.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” for more information, including reconciliations for 2013 and 2012.  For 2009 through 2012, effective interest expense is identical to interest expense determined in accordance with GAAP.

⁽⁷⁾ Effective net interest margin includes certain interest rate swap adjustments and TBA dollar roll income. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” for more information including reconciliations for 2013 and 2012.  For 2009 through 2012, effective net interest margin is identical to net interest margin determined in accordance with GAAP.

⁽⁸⁾ Effective interest rate spread was calculated by subtracting our effective cost of funds from our average portfolio yield including TBA dollar roll income.

⁽⁹⁾ Core earnings was calculated by subtracting operating expenses and dividends on preferred stock from effective interest margin. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” for more information, including reconciliations for 2013 and 2012. For 2009 through 2011, core earnings consists of net interest margin determined in accordance with GAAP reduced by operating expenses.

⁽¹⁰⁾ Our average annual portfolio repayment rate was calculated by dividing our total principal payments received during the year (scheduled and unscheduled) by our average MBS.

⁽¹¹⁾ Our debt to equity ratio was calculated by dividing the amounts outstanding under our repurchase agreements and dollar roll liability at period end by our shareholders’ equity at period end.

⁽¹²⁾ Our debt to paid-in capital ratio was calculated by dividing the amounts outstanding under our repurchase agreements and dollar roll liability at period end by the sum of the carrying value of our preferred stock, the par value of our common stock and additional paid in capital at period end.

⁽¹³⁾ Our effective debt to equity ratio was calculated the same as our debt to equity ratio other than to include our off-balance sheet TBA dollar roll liability at period end in the numerator.  Our off-balance sheet TBA dollar roll liability was $684,484 as of December 31, 2013.  For 2009 through 2012, effective debt to equity is identical to our debt to equity ratio determined in accordance with GAAP.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and related notes included elsewhere in this report.

Dollar amounts other than share-related amounts are presented in thousands, unless otherwise noted.

Overview

We are an externally-managed mortgage REIT incorporated in Maryland in September 2007 to invest in single-family residential mortgage real estate assets. Currently, the majority of these assets consist of mortgage pass-through securities guaranteed or issued by a U.S. Government agency (such as Ginnie Mae), or by a U.S. Government-sponsored enterprise (such as Fannie Mae or Freddie

28

Mac). Our principal goal is to generate net income for distribution to our shareholders through regular quarterly dividends and protect and grow our shareholders’ equity (which we also refer to as our “book value”) through prudent interest rate risk management. Our net income is determined primarily by the difference between the interest income we earn on our agency securities net of premium or discount amortization and the cost of our borrowings and hedging activities, which we also refer to as our net interest spread or net interest margin. We utilize substantial borrowings in financing our investment portfolio, which can enhance potential returns but exacerbate losses. In general, our book value is most affected by our issuance of shares of our common stock, our retained earnings or losses, and changes in the value of our investment portfolio and our hedging instruments.

In order to grow our company, we may from time to time raise additional capital using various market based transactions. Accordingly, all of our financial results and data should be viewed with the knowledge that our equity raises have been significant for our company, and that some period to period comparisons may not be meaningful or may produce comparisons that may be misleading to future activity and results.

The following table represents key data regarding our company since the quarter ending March 31, 2011:

As of	Agency Securities  (1)		Repurchase Agreements		Equity		Shares Outstanding		Book Value Per Share		Quarterly Weighted Average Earnings Per Share
December 31, 2013	$	18,269,061	$	16,129,683	$	2,364,101		96,601,523	$	21.50	$	(0.16	)
September 30, 2013	$	20,840,488	$	18,829,771	$	2,373,641		97,908,523	$	21.31	$	(2.72	)
June 30, 2013	$	26,251,979	$	23,077,252	$	2,479,089		98,830,054	$	22.18	$	0.66
March 31, 2013	$	26,373,535	$	22,586,932	$	3,072,265		98,830,054	$	28.18	$	0.62
December 31, 2012	$	24,648,140	$	22,866,429	$	3,072,864		98,822,654	$	28.19	$	1.02
September 30, 2012	$	27,931,504	$	23,583,180	$	3,212,556		98,809,404	$	29.60	$	0.83
June 30, 2012	$	24,535,118	$	20,152,860	$	2,692,261		98,074,404	$	27.45	$	0.91
March 31, 2012	$	22,562,895	$	16,556,630	$	2,669,300		97,779,404	$	27.30	$	0.89
December 31, 2011	$	18,146,767	$	16,162,375	$	2,080,188		76,823,220	$	27.08	$	0.92
September 30, 2011	$	19,014,997	$	15,886,231	$	2,015,003		76,546,720	$	26.32	$	1.04
June 30, 2011	$	16,678,511	$	14,800,594	$	2,006,606		75,091,570	$	26.72	$	1.04
March 31, 2011	$	14,811,137	$	11,495,749	$	1,894,540		72,571,570	$	26.11	$	0.96

⁽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 margin, 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 margin varies primarily as a result of changes in interest rates, borrowing costs and prepayment speeds, the behavior of which involves various risks and uncertainties.  Prepayment rates, as reflected by the rate of principal paydown, and interest rates vary according to the type of investment, conditions in financial markets, government actions, competition and other factors, none of which can be predicted with any certainty.  In general, as prepayment rates on our agency securities purchased at a premium increase, related purchase premium amortization increases, thereby reducing the net yield on such assets.  Because changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our ability to manage interest rate risks and prepayment risks effectively while maintaining our status as a REIT.

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 margin.  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 margin 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 margin may suffer.  The current climate of government intervention in the mortgage market significantly increases the risk associated with prepayments.

29

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;

· our hedging activities;

· the market value of our investments; 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 Item 1A - “Risk Factors”.

Market and Interest Rate Trends and the Effect on our Portfolio

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.  

Since that time, there have been a number of proposals introduced, both from industry groups and by the U.S. Congressoutlining alternatives for reforming the U.S. housing system, specifically Fannie Mae and Freddie Mac, and transforming the government’s involvement in the housing market.  The most recent bill in Congress to receive serious consideration is the Housing Finance Reform and Taxpayer Protection Act of 2013, also known as the Corker-Warner bill.  This legislation, among other things, would eliminate Freddie Mac and Fannie Mae and replace them with a new agency which would provide a financial guarantee that would only be tapped after private institutions and investors stepped in. In addition, on July 11, 2013, members of the U.S. House of Representatives introduced the Protecting American Taxpayers and Homeowners Act (“PATH”), a broad financing reform bill that serves as a counterpart to the Corker-Warner Bill.  PATH would also revoke the charters of Fannie Mae and Freddie Mac and remove barriers to private investment. It remains unclear whether these or any other proposals will become law or, should a proposal become law, if or how the enacted law will differ from the current draft of the bill.  It is unclear how the proposals would impact housing finance, and what impact, if any, it would have on mortgage REITs.

U.S. Treasury and Agency Securities Market Intervention

One of the main factors impacting market prices of our investments has been the U.S. Federal Reserve’s programs to purchase U.S. Treasury and agency securities in the open market.  These programs, referred to as “quantitative easing” are aimed to improve the employment outlook and increase growth in the U.S. economy.  The third round of these purchases, commonly referred to as “QE3” was announced in September 2012.  One effect of these purchases has been an increase in the prices of agency securities, which has contributed to the decrease of our net interest margin. On December 18, 2013, the U.S. Federal Reserve announced that it would reduce its purchases of both agency securities and U.S. Treasury securities by $5 billion each for the month of January. On January 29, 2014, the U.S. Federal Reserve announced additional $5 billion reductions to its monthly purchase of both agency securities and U.S. Treasury securities to take effect in February 2014.  The announcements on the tapering of the U.S. Federal Reserve’s purchases drove interest rates higher on U.S. Treasury and agency securities and resulted in large negative price movements in our assets.  The unpredictability and size of these programs has also injected additional volatility into the pricing and availability of our assets.  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 additional price declines.

30

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.    A further downgrade 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 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 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.

The Dodd-Frank Act established the Office of Financial Research within the Treasury Department to improve the quality of financial data available to policymakers and to facilitate more robust and sophisticated analysis of the financial system. This analysis may also include the scrutiny of mortgage REITs for potential systematic risk.  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

31

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.

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 were subject to individual adoption by member nations, including the United States by January 1, 2013.  As of September 2013, the majority of participating countries had formally adopted most provisions of Basel III, with implementations generally beginning January 1, 2014.  It is unclear how the adoption of Basel III will affect our business at this time, however, as capital charges increase for banks we may see an increase in our borrowing costs.

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%-6% 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 December 31, 2013, we had entered into repurchase agreements and/or interest 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 8.2% of our equity at December 31, 2013.  At December 31, 2013, 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.

	Number of Counterparties		Exposure (1)		Exposure as a Percentage of Equity
England		1	$	29,120		1.2	%
France		1		32,282		1.4	%
Germany		2		24,921		1.0	%
Netherlands		1		41,904		1.8	%
Scotland		1		16,925		0.7	%
Switzerland		1		49,252		2.1	%
		7	$	194,404		8.2	%

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

If the European credit crisis continues to impact these major European banks, there is the possibility that it will also impact the operations of their U.S. banking subsidiaries. This could adversely affect our financing and operations as well as those of the entire mortgage sector in general. 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 value of swaps with our counterparties. We intend to make reverse margin calls on our counterparties to recover excess collateral as permitted by the

32

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 Effective 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			Fed Funds Effective Rate			Two Year Treasury			10 Year Treasury
December 31, 2013		0.17	%		0.07	%		0.38	%		3.04	%
September 30, 2013		0.18	%		0.06	%		0.33	%		2.64	%
June 30, 2013		0.19	%		0.07	%		0.36	%		2.49	%
March 31, 2013		0.20	%		0.09	%		0.24	%		1.85	%
December 31, 2012		0.21	%		0.09	%		0.25	%		1.78	%
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	%

Due to speculation regarding the decrease in U.S. Federal Reserve asset purchases, long-term rates hit the highest levels seen in over two years, with the 10-year Treasury briefly going over 3.0% intra-day in early September 2013 and then closing about that mark in late December 2013.  This sudden move in the long-term portion of the yield curve, and with uncertainty regarding the long-term trend, decreased the value of our assets. It also caused us to dispose of some assets due to the increased potential for unfavorable performance if this trend were to continue.

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.

33

The following table shows the weighted average principal repayment rate and the one-month constant prepayment rate (“CPR”) for the periods presented:

	Weighted Average Principal Repayment Rate  (1)		Weighted Average Principal Repayment Rate Annualized  (2)		One Month CPR  (3)
December 31, 2013		4.89%		19.55%		14.2
September 30, 2013		6.93%		27.72%		19.7
June 30, 2013		7.03%		28.10%		20.8
March 31, 2013		6.50%		26.01%		19.0
December 31, 2012		6.64%		26.55%		19.8
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

⁽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

We began operations following the closing of our initial private offering on November 5, 2007.  The following is a summary of our underwritten common stock transactions:

Date of Offering	Number of Shares of Common Stock Sold		Offering Price Per Share (2)		Net Proceeds (1)
March 30, 2012		20,125,000	$	26.81	$	539,327
March 18, 2011		16,675,000	$	28.50	$	468,765
January 5, 2011		11,500,000	$	28.75	$	325,707
September 21, 2010		7,475,000	$	28.75	$	205,642
December 15, 2008		9,409,090	$	22.00	$	196,463
April 30, 2008 (IPO)		11,500,000	$	24.00	$	255,440
February 5, 2008		6,900,000	$	24.00	$	158,743
November 5, 2007		8,203,937	$	20.00	$	157,054

⁽¹⁾ After deducting underwriting costs and other fees and costs associates with issuance.

⁽²⁾ Net price received by the company for shares of stock sold.

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.

We did not issue any common or preferred equity during 2013.  We 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 approximately $539.3 million.  During 2012, we also issued 1,713,900 shares of common stock under our at-the-market offering programs for net proceeds of approximately $48.3 million.

On August 27, 2012, we issued 11,500,000 shares of our Series A Preferred Stock for net proceeds of approximately $278.3 million.  This was our first preferred stock offering.

34

Book Value per Share

As of December 31, 2013, our book value per share of common stock (total shareholders’ equity plus the aggregate liquidation preference for Series A Preferred Stock divided by shares of common stock outstanding) was $21.50, a decrease of $6.69, from $28.19 at December 31, 2012.  The decrease in our book value was primarily a result of the sudden increase in interest rates during the middle of 2013 and the resulting adjustments we made to our portfolio.  The unrealized gain on our assets fell $4.05 per share, and our operating losses and distributions contributed $4.10 per share to the decline in book value.  The increase in the value of our interest rate hedges offset $1.31 per share of the overall decrease.  Although the primary purpose of our interest rate hedges is to synthetically fix future funding costs, we attempt to structure our interest rate hedge portfolio to also offset changes in our asset prices due to changes in interest rates.  The price movements of our interest rate hedges and MBS are not perfectly correlated when interest rates change, and depend on a variety of market forces as the hedges may be valued off of a different benchmark than our assets.  This mismatch in correlation, sometimes referred to as “basis risk” is not predictable and often occurs during times of illiquidity or other market disruptions. In the second quarter of 2013, for example, interest rates and prices changed more on agency securities than on U.S. Treasury securities or interest rate hedges with similar average lives.  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
December 31, 2013	$	25.30		(3.72	)		1.07			(1.15	)	$	21.50
September 30, 2013	$	25.19		(3.02	)		0.53			(1.39	)	$	21.31
June 30, 2013	$	25.16		0.26			(1.91	)		(1.33	)	$	22.18
March 31, 2013	$	25.15		0.30			4.94			(2.21	)	$	28.18
December 31, 2012	$	25.15		0.38			5.12			(2.46	)	$	28.19
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

Investments

We invest in both adjustable and fixed-rate agency securities. At December 31, 2013 and 2012, we owned $17.6 billion and $23.9 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 December 31, 2013 and 2012, our agency securities portfolio was purchased at a net premium to par, or face value, with a weighted-average amortized cost of 102.75 and 102.85, respectively, of face value.  As of December 31, 2013 and 2012, we had approximately $488.9 million and $648.2 million, respectively, of unamortized premium included in the cost basis of our agency securities.

During the year ended December 31, 2013, we purchased approximately $8.4 billion of agency securities with a weighted average coupon of 2.45%.  We also sold approximately $9.9 billion of agency securities with a weighted average coupon of 2.47%.  Together, these purchases and sales represented a sizable repositioning of our portfolio as well as a net reduction in overall size.  These actions were taken to better position the portfolio for current risk environment by reducing our leverage ratio and the duration of our assets.  During the year ended December 31, 2012, we purchased approximately $16.1 billion of agency securities with a weighted average coupon of 2.48%

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 (54 days) as compared to Freddie Mac (75 days).

35

Our investment portfolio consisted of the following types of Fannie Mae, Freddie Mac and Ginnie Mae securities at December 31, 2013:

	Agency
	Securities		Gross			Gross
	Amortized		Unrealized			Unrealized		Estimated
	Cost		Loss			Gain		Fair Value		% of Total
Agency Securities
Fannie Mae Certificates
ARMS	$	9,620,743	$	(44,871	)	$	167,848	$	9,743,720		55.2	%
Fixed Rate		806,312		(1,798	)		3,832		808,346		4.6	%
Total Fannie Mae		10,427,055		(46,669	)		171,680		10,552,066
Freddie Mac Certificates
ARMS		6,671,013		(70,752	)		57,808		6,658,069		37.8	%
Fixed Rate		338,738		(1,600	)		21		337,159		1.9	%
Total Freddie Mac		7,009,751		(72,352	)		57,829		6,995,228
Ginnie Mae Certificates
ARMS		-		-			-		-		0.0	%
Fixed Rate		96,236		(998	)		-		95,238		0.5	%
Total Ginnie Mae		96,236		(998	)		-		95,238
Total Agency Securities	$	17,533,042	$	(120,019	)	$	229,509	$	17,642,532

Our investment portfolio consisted of the following types of Fannie Mae and Freddie Mac securities at December 31, 2012:

	Agency Securities Amortized Cost		Gross Unrealized Loss			Gross Unrealized Gain		Estimated Fair Value		% of Total
Agency Securities Fannie Mae Certificates
ARMS	$	14,081,259	$	(100	)	$	329,780	$	14,410,939		60.3	%
Fixed Rate		743,299		-			9,296		752,595		3.1	%
Total Fannie Mae		14,824,558		(100	)		339,076		15,163,534
Freddie Mac Certificates
ARMS	$	7,850,630	$	(21	)	$	149,114	$	7,999,723		33.4	%
Fixed Rate		744,720		-			11,274		755,994		3.2	%
Total Freddie Mac		8,595,350		(21	)		160,388		8,755,717
Total Agency Securities	$	23,419,908		(121	)	$	499,464	$	23,919,251

36

Adjustable-rate securities

As of December 31, 2013 our investment portfolio consisted of ARM securities as follows:

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		7.5	%	$	1,165,714		3.15	%	$	101.77	$	1,186,380	$	106.10	$	1,236,878
13-24		9.8	%		1,526,598		3.49	%	$	102.30		1,561,668	$	105.73		1,614,081
25-36		14.2	%		2,212,306		2.99	%	$	102.45		2,266,557	$	104.96		2,321,985
37-48		15.4	%		2,430,716		2.73	%	$	102.77		2,498,130	$	103.88		2,524,939
49-60		15.1	%		2,394,168		2.94	%	$	102.58		2,455,924	$	103.72		2,483,318
61-72		29.0	%		4,664,901		2.46	%	$	103.31		4,819,437	$	101.83		4,750,098
73-84		9.0	%		1,461,452		2.44	%	$	102.89		1,503,660	$	100.62		1,470,490
Total ARMS		100.0	%	$	15,855,855		2.80	%	$	102.75	$	16,291,756	$	103.44	$	16,401,789

As of December 31, 2012, our investment portfolio consisted of ARM securities as follows:

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	%	$	856,698		4.03	%	$	101.24	$	867,348	$	106.79	$	914,832
13-24		4.3	%		911,412		3.88	%	$	102.28		932,202	$	106.08		966,854
25-36		10.2	%		2,155,206		3.60	%	$	102.27		2,204,154	$	105.55		2,274,763
37-48		14.3	%		3,059,130		3.06	%	$	102.38		3,132,043	$	104.84		3,207,245
49-60		16.1	%		3,450,959		2.76	%	$	102.82		3,548,369	$	104.81		3,616,891
61-72		13.5	%		2,868,337		3.26	%	$	102.55		2,941,356	$	105.54		3,027,295
73-84		33.9	%		7,276,854		2.44	%	$	103.37		7,522,264	$	104.54		7,607,359
85-96		0.6	%		126,924		3.08	%	$	103.47		131,327	$	105.17		133,487
97-108		-			-		-		$	-		-	$	-		-
109-120		2.9	%		610,509		2.81	%	$	103.53		632,087	$	105.00		641,013
121-140		0.1	%		19,995		2.69	%	$	103.72		20,739	$	104.65		20,923
Total ARMS		100.0	%	$	21,336,024		2.95	%	$	102.79	$	21,931,889	$	105.04	$	22,410,662

⁽¹⁾ The current face is the current monthly remaining dollar amount of principal of a mortgage security.  We compute current face 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.

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

As of December 31, 2013, excluding any fixed-rate securities, the ARMs underlying our adjustable rate agency securities had fixed interest rates for an average period of approximately 48 months after which time the interest rates reset and become adjustable annually.  At December 31, 2013, 96.4% of our agency ARMs were still in their initial fixed-rate period and 3.6% of our agency ARMs have already reached their initial reset period and will reset annually for the life of the security.  At December 31, 2013, an additional 3.9% of our agency ARMs will reach the end of their initial fixed-rate period in the next 12 months.

37

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 5%, and the average annual interest rate increase (or decrease) to the interest rates on our agency securities is 2% per year.  The average lifetime cap on increases (or decreases) to the interest rates on our agency securities is 5% 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 10-year and 15-year amortizing fixed rate securities.  At December 31, 2013, we owned $1.2 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 December 31, 2013.

Wtd Avg Months to Maturity	% 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)
133-144		6.1	%	$	72,252		3.50	%	$	105.40	$	76,154	$	104.76	$	75,693
145-156		38.5	%		456,585		3.50	%	$	104.82		478,592	$	104.59		477,544
157-168		7.7	%		93,198		3.00	%	$	103.26		96,237	$	102.19		95,238
169-180		47.7	%		566,299		3.50	%	$	104.24		590,303	$	104.59		592,268
Total Fixed Rate		100.0	%	$	1,188,334		3.46	%	$	104.46	$	1,241,286	$	104.41	$	1,240,743

The following table details our fixed rate portfolio at December 31, 2012.

Wtd Avg Months to Maturity	% 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)
155-167		6.8	%	$	95,979		3.00	%	$	103.36	$	99,201	$	106.44	$	102,158
168-180		93.2	%		1,339,726		2.60	%	$	103.66		1,388,818	$	104.98		1,406,431
Total Fixed Rate		100.0	%	$	1,435,705		2.62	%	$	103.64	$	1,488,019	$	105.08	$	1,508,589

⁽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.

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

Forward Purchases

While most of our purchases of agency securities are accounted for using trade date accounting, some forward purchases, such as certain TBA contracts, do not qualify for trade date accounting and are considered derivatives for financial statement purposes.  Pursuant to Accounting Standards Codification Topic 815, Derivatives and Hedging, 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.

38

The following table shows our TBA contracts at December 31, 2013.

	Face		Coupon		Cost		Fair Market Value		Net Liability
15-year TBA contracts	$	600,000		3.5%	$	632,270	$	627,187	$	5,083

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 December 31, 2013, we had established 30 borrowing relationships with various investment banking firms and other lenders.  We had an outstanding balance under our repurchase agreements at December 31, 2013 of $16.1 billion with 25 counterparties.  We had an outstanding balance of $22.9 billion at December 31, 2012 with 24 different counterparties.

Hedging Instruments

We generally intend to hedge, on an economic basis, 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, and in the case of derivatives not subject to hedge accounting, our earnings as well.

As of December 31, 2013, we had entered into 77 interest rate swap agreements with 14 counterparties to hedge (on an economic basis) a benchmark interest rate – LIBOR.  This portfolio of hedges is designed to lock in funding costs for specific 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 $10.5 billion of borrowings under our repurchase agreements.  We also purchase Eurodollar Futures Contracts (“Futures Contracts”), which are based on three month LIBOR, as part of our strategy to mitigate interest rate risk.  The effective notional amounts and rates of our interest rate swaps and Futures Contracts as of December 31, 2013 were as follows:

	Futures Contracts Notional		Futures Contracts Rate			Swap Notional		Swap Rate			Total		Weighted-Average Rate
Effective 2014	$	4,698,500		0.35	%	$	9,441,668		1.35	%	$	14,140,168		1.02	%
Effective 2015		5,105,000		0.79	%		6,341,665		1.12	%		11,446,665		0.97	%
Effective 2016		5,027,250		1.86	%		3,400,000		0.91	%		8,427,250		1.48	%
Effective 2017		4,781,000		2.98	%		1,083,335		0.90	%		5,864,335		2.60	%
Effective 2018		2,541,250		3.77	%		50,000		0.96	%		2,591,250		3.72	%
Effective 2019		35,000		4.24	%		-		-			35,000		4.24	%

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.

On September 30, 2013, we discontinued hedge accounting for our interest rate swap agreements by de-designating the swaps as cash flow hedges.  No swaps were terminated in conjunction with this action, and our risk management and hedging practices are unimpacted.  However, our accounting for these transactions will changed prospectively effective October 1, 2013.  All of our swaps

39

had previously been accounted for as cash flow hedges under ASC Topic 815, Derivatives and Hedging.  As a result of discontinuing hedge accounting, beginning October 1 changes in the fair value of our interest rate swap agreements have been recorded in “other income” in our consolidated statements of income, rather than in accumulated other comprehensive income (“AOCI”).  Also, net interest paid or received under the swaps, which up through September 30 was recognized in “interest expense,” has instead been recognized in “other income.”

Results of Operations

Use of GAAP and Non-GAAP Measures

In addition to our results presented in accordance with GAAP, the discussions of our results of operations and liquidity and capital resources include certain non-GAAP financial information, including presentations new this year.  We present these non-GAAP measures largely because of three developments during 2013: 1) our cessation of hedge accounting for our interest rates swaps effective September 30, 2013, as discussed elsewhere in this filing, 2) increased use of Futures Contracts as interest rate hedges, and 3) our use of dollar roll transactions, which generate non-traditional investment income and embody off-balance sheet financing.  These changes result in the recognition of material fair value adjustments in net income, as well as line item classifications that our management believes make it difficult to explain fully the economics of our results and strategies without supplemental disclosures.  The non-GAAP measures we employ are effective interest expense, effective net interest margin, core earnings and core earnings per share, and financial metrics derived from these non-GAAP measures, such as effective cost of funds and effective leverage.  We use these measures internally to assess our results and financial condition.  Therefore, we believe that providing these measures gives users of financial information additional clarity regarding our performance and financial condition and better enables them to see “through the eyes of management.”

We define effective interest expense as our interest expense determined in accordance with GAAP, adjusted to exclude reclassification of deferred swap losses included in interest expense subsequent to our termination of hedge accounting, to include interest rate swap monthly net settlements subsequent to our termination of hedge accounting, and to include swap equivalent gains and losses related to our Futures Contracts.

We similarly define effective net interest margin as our net interest margin determined in accordance with GAAP, adjusted to exclude reclassification of deferred swap losses included in interest expense subsequent to our termination of hedge accounting, to include interest rate swap monthly net settlements subsequent to our termination of hedge accounting, to include swap equivalent gains and losses related to our Futures Contracts, and to include TBA dollar roll income.  

We define core earnings as our effective net interest margin (as defined above) further adjusted to deduct operating expenses and dividends on preferred stock.

Our interest expense and net interest margin determined in accordance with GAAP reflect monthly cash settlement under our interest rate swap agreements until September 30, 2013, but not thereafter.  We believe that our presentation of effective interest expense, effective net interest margin and core earnings, all of which adjust for this difference after September 30, 2013, provide a better basis for comparison between 2012 and 2013.

We define our average cost of funds as our total net interest expense (including hedges) determined in accordance with GAAP divided by our average balance outstanding under our repurchase agreements and dollar roll liability computed from our books and records, using daily weighted values.  Similarly, we define effective cost of funds as our total effective interest expense divided by our average balance outstanding under our repurchase agreements and dollar roll liabilities computed from our books and records, using daily weighted values.

These measures involve differences from results computed in accordance with GAAP, and should be considered supplementary to, and not as a substitute for, our results computed in accordance with GAAP.  None of the non-GAAP measures we present represents cash provided by operating activities determined in accordance with GAAP, and none is a measure of liquidity or an indicator of our ability to pay cash dividends. Further, our definitions of these non-GAAP measures may not be comparable to similarly-titled measures of other companies.  Reconciliations of each non-GAAP measure to its nearest directly comparable measure calculated in accordance with GAAP are included below.

Please “Item 6.  Selected Financial Data” for definitions of other metrics we use below, including average portfolio yield and average portfolio repayment rate.

Overview

Our results for 2013 have been largely dominated by U.S. Federal Reserve actions, primarily the discussion around the timing of the end of its quantitative easing program.  The market speculation regarding the removal of government purchasing caused significant increases in interest rates, which caused a significant decrease in the value of our investment assets.  This trend, which

40

started in June 2013, carried on throughout the second half of the year.  This interest rate increase, and the resulting valuation decrease, significantly increased the risk profile of our investment portfolio.  To attempt to mitigate this risk, we undertook a portfolio rebalancing to decrease the duration of our assets and our leverage, which increased as our equity decreased.  The 2013 financial results reported below reflect the implementation of our portfolio adjustments our management deemed appropriate for the environment.

We raised $539 million in March 2012 through public offerings of our common stock and $278 million in August 2012 through a preferred stock offering.  In the first quarter of 2011, we raised $794 million through public offerings of our common stock.  The results discussed in this section should be read keeping in mind that the average portfolio size in 2013, which reflect the full year impact of these capital raises, was larger than in 2012.  Likewise, the average portfolio size in 2012 was higher than in 2011, due to the partial year benefits of the 2012 capital raises and the full year benefits of capital raises from early 2011.  This dynamic may cause some metrics regarding our results of operations to be less than perfect comparisons, and not necessarily clear indicators of normalized performance.

Our summarized results of operations for the three years December 31, 2013, along with related key metrics, were as follows:

Net Income

	Years Ended December 31									Change vs. Prior Year
	2013			2012			2011			2013		2012
Statement of Income Data
Total interest income	$	452,268		$	506,308		$	426,120			-11%		19%
Interest expense		(197,709	)		(197,064	)		(144,662	)		0%		36%
Net interest margin		254,559			309,244			281,458			-18%		10%
Operating expenses		(27,866	)		(24,346	)		(17,661	)		14%		38%
Other income (loss):
Net realized gain (loss) on sale of mortgage-backed securities		(283,012	)		64,347			20,576			-540%		213%
Impairment of mortgage-backed securities		(8,102	)		-			-			NM		NM
Loss on derivative instruments, net		(69,715	)		-			-			NM		NM
Total other income (loss)		(360,829	)		64,347			20,576			-661%		213%
Net income (loss)		(134,136	)		349,245			284,373			-138%		23%
Dividends on preferred stock		(21,922	)		(7,551	)		-			190%		NM
Net income (loss) available to common shareholders	$	(156,058	)	$	341,694		$	284,373			-146%		20%
Earnings (loss) per share of common stock, basic and diluted	$	(1.59	)	$	3.67		$	3.97			-143%		-8%
Core earnings	$	203,719		$	277,347		$	263,797			-27%		5%
Core earnings per share, basic and diluted	$	2.07		$	2.98		$	3.68			-30%		-19%
Weighted average shares outstanding		98,337,362			93,185,520			71,708,058			6%		30%

NM – Not meaningful

2013 vs. 2012

Net income swung to a loss due primarily to:

· Lower net interest margin, caused by the lower weighted average coupon of our portfolio stemming from investing cash flow into securities with rates that were lower than the average coupon of our existing portfolio

· Lower other income, primarily due to:

o Losses on mortgage-backed securities in the course of the portfolio rebalancing described in “Overview” above

o Realized and unrealized losses from Futures Contracts (we began using these in 2013 as an alternative means of hedging interest rate risk in the funding of our portfolio)

· Higher dividends on preferred stock—the preferred stock was only outstanding for a portion of 2012.

41

Core earnings decreased due primarily to:

· Lower net interest margin, caused by the lower weighted average coupon of our portfolio stemming from investing cash flow into securities with rates that were lower than the average coupon of our existing portfolio

· Higher dividends on preferred stock—the preferred stock was only outstanding for a portion of 2012.

2012 vs. 2011

Net income increased due primarily to the following:

· Higher net interest margin, driven by:

o The increased average size of our portfolio (enabled by capital raises in 2011 and 2012)

o Lower cost of funds

Partially offset by:

o A lower weighted average coupon on our portfolio driven by new money rates that were lower than the average coupon of our existing portfolio

· Higher gain on sale of mortgage-backed securities from opportunistic selling associated with managing risks in our portfolio.

These favorable changes were partially offset by:

· Increased operating expenses associated with the growth of the Company

· Dividends on preferred stock from the date of the offering forward.

Core earnings increased due to the same drivers of the increase in net income, excluding the increase in gain on sale of mortgage-backed securities.

Total Interest Income

	Years Ended December 31									Change vs. Prior Year
	2013			2012			2011			2013		2012
Coupon interest on MBS and short-term investments	$	618,192		$	669,152		$	519,455			-8%		29%
Net premium amortization		(165,924	)		(162,844	)		(93,335	)		-2%		-74%
Total interest income	$	452,268		$	506,308		$	426,120			-11%		19%
Average MBS	$	23,010,281		$	22,167,760		$	14,932,378			4%		48%
Weighted-average coupon on MBS		2.76	%		3.09	%		3.55	%		-11%		-13%
Average portfolio yield		1.96	%		2.28	%		2.84	%		-14%		-20%
Average annual portfolio repayment rate		25.70	%		26.39	%		24.54	%		-3%		8%

The major drivers of our interest income are the coupons on the securities we own, the size of our portfolio, and the rate of principal repayments.  The following are key components of the change between periods:

2013 vs. 2012

Total interest income decreased due primarily to:

· The decrease in our weighted-average coupon stemming from lower market rates available on new securities; and

· The increase in premium amortization from the larger average portfolio;

These declines were partially offset by:

· Growth in the average size of our portfolio.

2012 vs. 2011

Total interest income increased due primarily to:

· The substantial increase in the average size of our portfolio, driven by capital raises in 2011 and 2012;

42

This increase was partially offset by:

· The decrease in our weighted-average coupon, which was down 13% on a relative basis, stemming from lower market rates available on new securities;

· Higher premium amortization from the larger portfolio, exacerbated by the increase in our average repayment rate, which was due to elevated levels of refinancings associated with the low overall interest rate environment.

Interest Expense

	Years Ended December 31									Change vs. Prior Year
	2013			2012			2011			2013		2012
Repurchase agreements and dollar roll liability	$	81,856		$	79,833		$	39,561			3%		102%
Swaps settlements		91,525			117,231			105,101			-22%		12%
Reclassification of deferred hedge loss		24,328			-			-		NM		NM
Interest expense	$	197,709		$	197,064		$	144,662			0%		36%
Effective interest expense	$	204,366		$	197,064		$	144,662			4%		36%
Average repurchase agreements and dollar roll liability	$	21,249,868		$	20,468,353		$	13,692,704			4%		49%
Average rate on repurchase agreements and dollar roll liability		0.39	%		0.39	%		0.29	%		0%		34%
Average cost of funds		0.93	%		0.96	%		1.06	%		-3%		-9%
Effective cost of funds		0.96	%		0.96	%		1.06	%		0%		-9%

NM – Not meaningful

The costs of financing we incur are primarily affected by the amount of our borrowings, the interest rates on those borrowings and the degree to which we hedge those rates.  Note that our cessation of hedge accounting for our interest rate swaps caused changes in classification of swaps impacts, effective October 1, 2013.  The following are key components of the change between periods:

2013 vs. 2012

Interest expense was essentially flat due to several offsetting factors:

· Our average borrowings and related swap positions were higher, as a result of higher average leverage in support of the larger average investment portfolio;

· Offset by accounting impacts of our cessation of hedge accounting, which lowered GAAP interest expense by $6,657 and cost of funds by 3 basis points.

Effective interest expense increased due primarily to:

· Higher average borrowings and related swap positions, as a result of higher average leverage in support of the larger average investment portfolio.

2012 vs. 2011

Interest expense increased due primarily to:

· The substantial increase in the average size of borrowings (commensurate with the increase in the MBS portfolio), driven by capital raises in 2011 and 2012; and

· The increase in our average rate on repurchase agreements.

This increase was partially offset by:

· Lower average interest rates on our interest rate swaps due to substantially lower fixed rates on new swaps entered as a consequence of investing, and related hedging, the proceeds of our capital raises.

43

Net Interest Margin and Interest Rate Spread

	Years Ended December 31									Change vs. Prior Year
	2013			2012			2011			2013		2012
Net interest margin	$	254,559		$	309,244		$	281,458			-18%		10%
Effective net interest margin	$	253,507		$	309,244		$	281,458			-18%		10%
Average portfolio yield		1.96	%		2.28	%		2.84	%		-0.32%		-0.56%
Average cost of funds		0.93	%		0.96	%		1.06	%		-0.03%		-0.10%
Average interest rate spread		1.03	%		1.32	%		1.78	%		-0.29%		-0.46%
Average portfolio yield, including TBA dollar roll income		1.97	%		2.28	%		2.84	%		-0.31%		-0.56%
Effective cost of funds		0.96	%		0.96	%		1.06	%		0.00%		-0.10%
Effective interest rate spread		1.01	%		1.32	%		1.78	%		-0.31%		-0.46%

The most important metric of our earnings power is our net interest margin, or our “spread” when referred to in percentage form.  Our spread and our leverage largely indicate our ability to earn distributable income.  Our interest rate spread decreased during each of the periods presented versus the preceding periods.  See the discussions of Total Interest Income and Interest Expense above for the key drivers of these changes.

Other Income (Loss)

	Years Ended December 31							Change vs. Prior Year
	2013			2012		2011		2013	2012
Other income (loss):
Net realized gain (loss) on sale of mortgage-backed securities	$	(283,012	)	$	64,347	$	20,576	NM		213%
Impairment of mortgage-backed securities		(8,102	)		-		-	NM	NM
Loss on derivative instruments, net		(69,715	)		-		-	NM	NM
Total other income (loss)	$	(360,829	)	$	64,347	$	20,576	NM		213%

NM – Not meaningful

Our other income generally consists of realized gains and losses on our MBS investments and realized and unrealized gains and losses on derivative instruments.  Earnings related to these areas tend to be uneven, as can be seen in the table above.  Items particular to each period comparison are as follows:

2013 vs. 2012

Other income (loss) swung to a loss due primarily to:

· Losses on mortgage-backed securities.  As described in “Overview,” we undertook a portfolio rebalancing initiative over the second half of 2013.  We sold $9.9 billion face value of MBS in 2013 versus $5.8 billion of face value in 2012. We also impaired $158.2 million face value of securities prior to the end of the third quarter of 2013, resulting in a loss of $8,102.

· In 2013, we began using Eurodollar Futures as part of our hedging strategy.  Net realized and unrealized losses on these contracts were $58,883 for 2013 and are reflected in “Loss on derivative instruments, net.”  In 2012 and 2011, our hedging was done exclusively via interest rate swaps, with unrealized gains and losses recorded to “other comprehensive income,” in accordance with hedge accounting.

· Effective September 30, 2013, we discontinued the designation of our interest rate swaps as cash flow hedges for accounting purposes.  As a result, from October 1, 2013 forward, monthly swap settlements and the change in fair value of our swaps, which amounted to a net loss of $5,949, were recorded to “Loss on derivative instruments, net.”

· Our TBA dollar roll positions generated realized losses of $10,488 and TBA dollar income of $5,605 in 2013, both of which are reflected in “Loss on derivative instruments, net.”

44

2012 vs. 2011

· As our portfolio grew and the prices of our investments increased, the level of opportunistic selling and portfolio repositioning also increased.

Operating Expenses

	Years Ended December 31									Change vs. Prior Year
	2013			2012			2011			2013		2012
Management fee	$	18,180		$	17,420		$	13,787			4%		26%
Share based compensation		2,594			1,920			1,150			35%		67%
General and administrative		7,092			5,006			2,724			42%		84%
Total	$	27,866		$	24,346		$	17,661			14%		38%
Average equity	$	2,731,439		$	2,732,423		$	1,899,211			0%		44%
As a % of average equity		1.07	%		0.89	%		1.00	%		20%		-11%

We attempt to efficiently manage our operating expenses as they directly affect the return on investment.  Our total expenses grew over both compared periods as discussed below:

2013 vs. 2012 and 2012 vs. 2011

· Our management fee is defined as a percentage of our equity per the governing agreement, and increases as the amount of equity increases.

· Our share based compensation increased as we have more employees receiving grants

· Our general and administrative costs have increased along with our overall size, including expenses related to additional employees, increased technology (particularly software), insurance and professional fees.

Reconciliations of Non-GAAP Measures

The reconciliation of core earnings and effective net interest margin to their nearest comparable GAAP measure, net interest margin, is as follows for the three years ended December 31, 2013:

	2013			2012			2011
Net interest margin	$	254,559		$	309,244		$	281,458
Less: reclassification of deferred swap losses included in interest expense		24,328			-			-
Interest rate swaps – monthly net settlements (after hedge de-designation)		(30,985	)		-			-
Dollar roll income		5,605			-			-
Effective net interest margin		253,507			309,244			281,458
Total operating expenses		(27,866	)		(24,346	)		(17,661	)
Dividends on preferred stock		(21,922	)		(7,551	)		-
Core earnings	$	203,719		$	277,347		$	263,797

The reconciliation of effective interest expense to its nearest comparable GAAP measure, interest expense, along with their respective cost of funds measures, is as follows for the three years ended December 31, 2013:

	2013						2012					2011
	Amount			% (1)			Amount		% (1)			Amount		% (1)
Interest expense and cost of funds	$	197,709			0.93	%	$	197,064		0.96	%	$	144,662		1.06	%
Less: reclassification of deferred swap losses included in interest expense (after hedge de-designation)		(24,328	)		-0.12	%		-		0.00	%		-		0.00	%
Interest rate swaps – monthly net settlements (after hedge de-designation)		30,985			0.15	%		-		0.00	%		-		0.00	%
Effective interest expense and effective cost of funds	$	204,366			0.96	%	$	197,064		0.96	%	$	144,662		1.06	%
(1) Dollar amount as a percentage of our average repurchase agreements and dollar roll liability

45

Contractual Obligations and Commitments

We had the following contractual obligations under repurchase agreements as of December 31, 2013 (dollar amounts in thousands):

	December 31, 2013
	Balance		Weighted Average Contractual Rate			Contractual Interest Payments		Total Contractual Obligation
Within 30 days	$	13,170,898		0.37	%	$	2,311	$	13,173,209
30 days to 3 months		2,958,785		0.40	%		1,845		2,960,630
	$	16,129,683		0.37	%	$	4,156	$	16,133,839

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 December 31, 2013.

Face	Cost		Fair Market Value		Due to Brokers
$984,629	$	1,036,044	$	1,030,780	$	1,037,879

In addition, we had contractual commitments under interest rate swap agreements as of December 31, 2013.  These agreements were for a total notional amount of $10.5 billion, had an average rate of 1.37% and a weighted average term of 24 months.

Liquidity and Capital Resources

Our primary sources of funds are borrowings under repurchase arrangements and dollar roll transactions, 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 December 31, 2013, 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.

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 dollar roll transactions and on derivative instruments when their value declines.  This typically occurs when prevailing market rates decrease, with the severity of the decrease also dependent on the term of the derivatives involved.  The amount of any margin call will generally be dollar for dollar, on a daily basis.  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

46

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.

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 three 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.

	Average Daily Repurchase Agreements		Repurchase Agreements at Period End		Highest Daily Repurchase Balance During Quarter		Lowest Daily Repurchase Balance During Quarter
December 31, 2013	$	17,464,981	$	16,129,683	$	18,832,650	$	16,119,555
September 30, 2013		21,989,907		18,829,771		23,495,767		18,829,771
June 30, 2013		22,701,463		23,077,252		23,429,222		22,383,758
March 31, 2013		22,342,818		22,586,932		23,017,196		21,337,947
December 31, 2012		23,692,240		22,866,429		24,396,444		22,824,383
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

As of December 31, 2013 and 2012, 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 approximately 4.6%  and 4.3%, respectively (weighted by borrowing amount).  This rate has remained fairly 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 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 December 31, 2013 and 2012, we had approximately $1.6 billion and $1.8 billion,

47

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.

One risk to our liquidity is the collateral, or haircut, held by our lenders.  In the event of insolvency by a repurchase agreement lender, our claim to our haircut becomes that of a general unsecured creditor.  For example, in October of 2011, MF Global, Inc., one of our lending counterparties, filed for relief under Chapter 11 of the U.S. Bankruptcy Code.  We were unable to recover approximately $0.8 million that was due us at that time under our repurchase agreement with MF Global, Inc.  Due to the complexity of this estate, it will likely be several years before we receive any clarity as to any recovery, and therefore, we recorded a loss allowance for the total amount due at that time.

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.

Liquidity Sources—Dollar Roll Transactions

We may also enter into dollar roll transactions as a source of financing for our investments.  Dollar roll transactions represent a form of financing that may be on or off balance sheet, depending on whether the security rolled is a specified pool or a TBA contract.  TBA contracts that are financed using dollar rolls transactions are accounted for as derivatives and shown on our balance sheet at net fair market value. Under certain market conditions it may be uneconomical for us to roll our TBA contracts and we may need to settle our obligations and take delivery of the underlying securities.  If we were required to take physical delivery to settle a TBA contract, we would have to fund our total purchase commitment with cash or other financing sources and our liquidity position could be negatively impacted.  Our TBA dollar roll transactions are also subject to margin requirements governed by our prime brokerage agreements.  In the event of a margin call, we must generally provide additional collateral on the same business day. The table below sets forth information regarding the volume of dollar roll transactions (both specified pools and TBA contracts) during the quarter ended December 31, 2013, which was the first quarter in which we engaged in dollar roll transactions.

	Average Daily Dollar Roll Liability		Gross Dollar Roll Liability at Period End		Highest Daily Dollar Roll Balance During Quarter		Lowest Daily Dollar Balance During Quarter
December 31, 2013	$	1,275,595	$	1,037,879	$	2,134,370	$	-

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 2012, we received funds from sales of our common stock under an “at-the-market” offering program and from fully underwritten offerings we completed in March and August.  

48

At The Market Offerings

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, including sales made directly on the NYSE or to or through a market maker other than on an exchange.

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.

No shares of common stock were issued under the 2012 Program during 2013.  For the year ended December 31, 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 year ended December 31, 2012.

Underwritten Offerings

On March 30, 2012, we completed an underwritten 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 $539.3 million after the payment of underwriting discounts and expenses.

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

On January 5, 2011, we completed an underwritten public offering of 11,500,000 shares of common stock, including 1,500,000 shares pursuant to the underwriters’ overallotment option, at a price to the public of $28.75 per share, and received net proceeds of approximately $325.7 million after the payment of underwriting discounts and expenses.

On March 18, 2011, we completed an underwritten public offering of 14,500,000 shares of common stock at a price to the public of $28.50 per share, and received net proceeds of approximately $407.6 million after the payment of underwriting discounts and expenses.  As part of this transaction, we issued an additional 2,175,000 shares of common stock pursuant to the underwriters’ overallotment option for net proceeds to us of approximately $61.2 million.

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

Liquidity Uses—Share Buybacks

On June 18, 2013, our board of directors authorized the Repurchase Program to acquire up to 10,000,000 shares of our common stock.  Over the remainder of 2013, we repurchased 2,485,447 shares of common stock under the Repurchase Program in at-the-market transactions at a total cost of $43.9 million.  We may repurchase additional shares from time to time as liquidity and market conditions permit.

During periods when our board of directors has authorized us to repurchase shares under the Repurchase Program, we will not be authorized to issue shares of common stock under the 2012 Program described above.  Similarly, during periods when our board of directors has authorized us to issue shares of common stock under the 2012 Program, we will not be authorized to repurchase shares under the Repurchase Program.

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

49

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 six and 12 times the amount of our shareholders’ equity.  At December 31, 2013 and December 31, 2012, our total on-balance sheet borrowings were approximately $16.5 billion and $22.9 billion (excluding accrued interest), respectively, which represented a leverage ratio of approximately 7.0:1 and 7.4:1, respectively. Our effective leverage ratio (defined as our debt-to-shareholders equity ratio, including the effects of off-balance sheet dollar roll liabilities) was approximately 7.3:1 as of December 31, 2013.

Critical Accounting Policies

Our financial statements are prepared in conformity with GAAP.  In preparing the financial statements, management is required to make various judgments, estimates and assumptions that affect the reported amounts.  Changes in these estimates and assumptions could have a material effect on our financial statements.  The following is a summary of our policies most affected by management’s judgments, estimates and assumptions.

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.

Market Valuation of Investment Securities:  We invest in agency securities representing interests in or obligations backed by pools of single-family adjustable-rate mortgage loans.  Guidance under the Financial Accounting Standards Board (“FASB”) ASC Topic on Investments requires us to classify our investments as either trading, available-for-sale or held-to-maturity securities. Management determines the appropriate classifications of the securities at the time they are acquired and evaluates the appropriateness of such classifications at each balance sheet date. We currently classify all of our agency securities as available-for-sale. 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 MBS are determined by management by obtaining valuations for our MBS 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 determined using the specific identification method.  Firm purchase commitments to acquire “when issued” or TBA securities are recorded at fair value in accordance with ASC Topic 815, Derivatives andHedging.  The fair value of these purchase commitments is included in other assets or liabilities in the accompanying balance sheets.

Impairment of Assets:  We assess our 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, we use a two-step evaluation process.  First, we determine whether we have made any decision to sell a security that is in an unrealized loss position, or, if not is it more likely than not that we will be required to sell the security prior to recovering its amortized cost basis.  If we determine that the answer to either of these questions is “yes” then the security is considered other-than-temporarily impaired.  We recorded $8,102 of impairment as of September 30, 2013, on securities that were sold at a loss in early October.  There were no other impairment losses recognized during any of the other periods presented.

Derivative Instruments:  We account for derivative instruments in accordance with the guidance included in the ASC Topic 815, Derivatives and Hedging.  This guidance establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities.  The guidance requires that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value, and that changes in the derivative’s fair value be recognized currently in earnings unless specific hedge accounting criteria are met.  Special accounting for qualifying hedges allows a derivative’s gains and losses to either offset related results on the hedged item in the statement of income or be accumulated in other comprehensive income, and requires that a company formally document, designate, and assess the effectiveness of transactions that receive hedge accounting.  We use derivative instruments to manage our exposure to changing interest rates generally with interest rate swap agreements.

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.

50

Off-Balance Sheet Arrangements

As of December 31, 2013 and 2012, we did not maintain any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, or special purpose or variable interest entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.  Further, as of December 31, 2013 and 2012, we had not guaranteed any obligations of any unconsolidated entities or entered into any commitment or intent to provide funding to any such entities.

As of December 31, 2013, we had TBA dollar roll transactions outstanding of $632 million.  Forward purchase commitments and TBA dollar roll transactions represent off-balance sheet financing. Pursuant to ASC 815, we account for these positions as derivative transactions and, consequently, they are not reflected in our on-balance sheet debt and leverage ratios.

Item 7A. 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 Margin

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 and Futures Contracts.  These instruments are intended to serve as a hedge against future interest rate increases on our variable rate borrowings.  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 margin or cause a net loss during periods of rising interest rates, which would harm our financial condition, cash flows and results of operations.

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

51

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, even or ten 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.

We may structure our interest rate hedges 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 is sometimes referred to as “tail risk”.  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 market value interest rate risk by estimating the effective duration of our assets relative to the effective duration 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 annual interest income, at

52

December 31, 2013 and 2012, assuming a static portfolio.  When evaluating the impact of changes in interest rates on net income, 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.

December 31, 2013

Change in Interest rates	Percentage Change in Projected Net Interest Income	Percentage Change in Projected Portfolio Value
+ 1.00%	0.66%	(0.96%)
+ 0.50%	1.27%	(0.47%)
- 0.50%	6.34%	0.19%
- 1.00%	(2.28%)	0.61%

December 31, 2012

Change in Interest rates	Percentage Change in Projected Net Interest Income	Percentage Change in Projected Portfolio Value
+ 1.00%	(5.02%)	(0.90%)
+ 0.50%	(0.37%)	(0.44%)
- 0.50%	3.86%	0.18%
- 1.00%	(7.09%)	0.33%

While the charts 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 margin 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 margin 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 margin and portfolio value, which includes the value of swaps, should interest rates immediately change.  Given the low level of interest rates at December 31, 2013 and 2012, 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 margin 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 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, such as 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 8. Financial Statements and Supplementary Data

The required response under this Item is submitted in a separate section of this report.  See Index to the Financial Statements on page F-1.

53

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A. 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 December 31, 2013, 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.

Management’s Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in 13a-15(f) and 15d-15(f) of the Exchange Act.  Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Based on our evaluation under the framework in Internal Control—Integrated Framework (1992), our management concluded that our internal control over financial reporting was effective as of December 31, 2013.

Ernst & Young LLP, a registered independent accounting firm, has audited our financial statements included in this annual report on Form 10-K and, as part of its audit, has issued a report on the effectiveness of our internal control over financial reporting as of December 31, 2013.  This report appears on page F-27 of this Annual Report on Form 10-K.

Changes in Internal Control over Financial Reporting

There was no change to our internal control over financial reporting during the fourth quarter ended December 31, 2013 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Item 9B. Other Information.

For the quarter ended December 31, 2013, all items required to be disclosed under Form 8-K were reported under Form 8-K.

Additional Material U.S. Federal Income Tax Considerations

The following is a summary of additional material U.S. federal income tax considerations with respect to the ownership of our stock. This summary supplements and should be read together with the discussion under “Material U.S. Federal Income Tax Considerations” in the prospectus dated February 29, 2012 and filed as part of a Registration Statement on Form S-3 (No. 333-179805).

Tax Rates

Legislation enacted in 2012 made the following adjustments, which were effective as of January 1, 2013, to the federal income tax rates: (1) the maximum tax rate on "qualified dividend income" received by U.S. shareholders taxed at individual rates is 20%, (2) the maximum tax rate on long-term capital gain applicable to U.S. shareholders taxed at individual rates is 20%, and (3) the highest marginal individual income tax rate is 39.6%. Pursuant to such legislation, the backup withholding rate remains at 28%. We urge you to consult your tax advisors regarding the impact of this legislation on the purchase, ownership and sale of our stock.

Taxation of Taxable U.S. Shareholders

For payments after June 30, 2014, a U.S. withholding tax at a 30% rate will be imposed on dividends paid on our stock received by U.S. shareholders who own their stock through foreign accounts or foreign intermediaries if certain disclosure requirements related to U.S. accounts or ownership are not satisfied. In addition, if those disclosure requirements are not satisfied, a U.S. withholding tax at a 30% rate will be imposed on proceeds from the sale of our stock received after December 31, 2016 by U.S. shareholders who own their stock through foreign accounts or foreign intermediaries. We will not pay any additional amounts in respect of any amounts withheld.

54

Taxation of Non-U.S. Shareholders

For payments after June 30, 2014, a U.S. withholding tax at a 30% rate will be imposed on dividends paid on our stock received by certain non-U.S. shareholders if they held our stock through foreign entities that fail to meet certain disclosure requirements related to U.S. persons that either have accounts with such entities or own equity interests in such entities. In addition, if those disclosure requirements are not satisfied, a U.S. withholding tax at a 30% rate will be imposed on proceeds from the sale of our stock received after December 31, 2016 by certain non-U.S. shareholders. If payment of withholding taxes is required, non-U.S. shareholders that are otherwise eligible for an exemption from, or reduction of, U.S. withholding taxes with respect of such dividends and proceeds will be required to seek a refund from the Internal Revenue Service to obtain the benefit or such exemption or reduction. We will not pay any additional amounts in respect of any amounts withheld.

PART III

Item 10. Directors, Executive Officers and Corporate Governance

The information required by Item 10 is incorporated by reference to our definitive Proxy Statement for our 2014 Annual Shareholders’ meeting.

Item 11. Executive Compensation

The information required by Item 11 is incorporated by reference to our definitive Proxy Statement for our 2014 Annual Shareholders’ meeting.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required by Item 12 is incorporated by reference to our definitive Proxy Statement for our 2014 Annual Shareholders’ meeting.

Item 13. Certain Relationships and Related Transactions, and Director Independence

The information required by Item 13 is incorporated by reference to our definitive Proxy Statement for our 2014 Annual Shareholders’ meeting.

Item 14. Principal Accountant Fees and Services

The information required by Item 14 is incorporated by reference to our definitive Proxy Statement for our 2014 Annual Shareholders’ meeting.

PART IV

Item 15. Exhibits and Financial Statement Schedules

1. Financial Statements

Included herein at pages F-1 through F-27.

2. Financial Statement Schedules

All schedules for which provision is made in Regulation S-X are either not required to be included herein under the related instructions or are inapplicable or the related information is included in the footnotes to the applicable financial statement and, therefore, have been omitted.

55

3. Exhibits

The following exhibits are filed as part of this Annual Report on Form 10-K:

Exhibit Number	Description of Exhibit
3.1	Articles of Incorporation (including all articles of amendment and articles supplementary) (4)
3.2	Bylaws (1)
4.1	Form of Common Stock Certificate (2)
4.2	Form of 7.625% Series A Cumulative Redeemable Preferred Stock Certificate (5)
10.1	Management Agreement, by and among Hatteras Financial Corp. and Atlantic Capital Advisors, LLC dated February 23, 2012(6)
10.2	2007 Equity Incentive Plan* (1)
10.3	2010 Equity Incentive Plan*(3)
10.4	Form of Amended and Restated Restricted Stock Award Agreement for executive officers * (1)
10.5	Form of Restricted Stock Award Agreement for independent directors * (1)
10.6	Form of Indemnification Agreement * (1)
10.7	First Addendum and Amendment to Restricted Stock Agreements between William H. Gibbs, Jr. and Hatteras Financial Corp. effective June 26, 2013 * (7)
10.8	Consulting Agreement between William H. Gibbs, Jr. and Hatteras Financial Corp. effective June 26, 2013 * (7)
12.1	Statement of computation of ratios of earnings to combined fixed charges and preferred stock dividends
21.1	List of subsidiaries
23.1	Consent of Ernst & Young LLP
24.1	Power of Attorney (included on the signature page of this Annual Report on Form 10-K)
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. 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002
101	Submitted electronically herewith as Exhibit 101 to this report are the following documents formatted in XBRL (Extensible Business Reporting Language): (i) Consolidated Balance Sheets at December 31, 2013 and 2012; (ii) Consolidated Statements of Income for the years ended December 31, 2013, 2012 and 2011; (iii) Consolidated Statements of Comprehensive Income for the years ended December 31, 2013, 2012 and 2011, (iv) Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2013, 2012 and 2011; (v) Consolidated Statements of Cash Flows for the years ended December 31, 2013, 2012 and 2011; and (vi) Notes to Consolidated Financial Statements for the year ended December 31, 2013.

* Represents management contract or compensatory plan or agreement.

⁽¹⁾ Previously filed as an exhibit to the Registrant’s Registration Statement on Form S-11 (No. 333-149314) filed with the SEC on February 20, 2008 and incorporated herein by reference.

⁽²⁾ Previously filed as an exhibit to Amendment No. 3 to the Registrant’s Registration Statement on Form S-11 (No. 333-149314) filed with the SEC on April 22, 2008 and incorporated herein by reference.

⁽³⁾ Previously filed as an exhibit to the Registrant’s Current Report on Form 8-K filed with the SEC on May 6, 2010 and incorporated herein by reference.

⁽⁴⁾ Previously filed as an exhibit to the Registrant’s Quarterly Report on Form 10-Q filed with the SEC on October 30, 2012 and incorporated herein by reference.

⁽⁵⁾ Previously filed as an exhibit to the Registrant’s Registration Statement on Form 8-A filed with the SEC on August 23, 2012 and incorporated herein by reference.

⁽⁶⁾ Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-K filed with the SEC on February 23, 2012 and incorporated herein by reference.

⁽⁷⁾ Previously filed as an exhibit to the Registrant’s Quarterly Report on Form 10-Q filed with the SEC on July 30, 2013 and incorporated herein by reference.

56

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	HATTERAS FINANCIAL CORP.
Dated: February 21, 2014	By:	/s/ Michael R. Hough
			Michael R. Hough
			Chief Executive Officer and Chairman of the Board of Directors

KNOW ALL MEN BY THESE PRESENTS, that we, the undersigned officers and directors of Hatteras Financial Corp., hereby severally constitute Michael R. Hough, Benjamin M. Hough and Kenneth A. Steele, and each of them singly, our true and lawful attorneys with full power to them, and each of them singly, to sign for us and in our names in the capacities indicated below, the Form 10-K filed herewith and any and all amendments to said Form 10-K, and generally to do all such things in our names and in our capacities as officers and directors to enable Hatteras Financial Corp. to comply with the provisions of the Securities Exchange Act of 1934, as amended and all requirements of the Securities and Exchange Commission, hereby ratifying and confirming our signatures as they may be signed by our said attorneys, or any of them, to said Form 10-K and any and all amendments thereto.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and dates indicated.

Date	Signature
February 21, 2014	/s/ Michael R. Hough	Chief Executive Officer (Principal Executive Officer) and Chairman of the Board of Directors
	Michael R. Hough
February 21, 2014	/s/ Benjamin M. Hough	Director
	Benjamin M. Hough
February 21, 2014	/s/ David W. Berson	Director
	David W. Berson
February 21, 2014	/s/ Ira G. Kawaller	Director
	Ira G. Kawaller
February 21, 2014	/a/ Jeffrey D. Miller	Director
	Jeffrey D. Miller
February 21, 2014	/s/ Thomas D. Wren	Director
	Thomas D. Wren
February 21, 2014	/s/ Kenneth A. Steele	Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)
	Kenneth A. Steele

57

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders of Hatteras Financial Corp.

We have audited the accompanying consolidated balance sheets of Hatteras Financial Corp. as of December 31, 2013 and 2012, and the related consolidated statements of income, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2013. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the  financial position of Hatteras Financial Corp. at December 31, 2013 and 2012, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2013, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Hatteras Financial Corp.’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) and our report dated February 21, 2014 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Raleigh, North Carolina

February 21, 2014

F-1

Hatteras Financial Corp.

Consolidated Balance Sheets

(Dollars in thousands, except share related amounts)
	December 31, 2013			December 31, 2012
Assets
Mortgage-backed securities, at fair value
(including pledged assets of $17,049,670 and $22,591,973 at December 31, 2013	$	17,642,532		$	23,919,251
and December 31, 2012, respectively)
Cash and cash equivalents		763,326			168,424
Restricted cash		225,379			281,021
Unsettled purchased mortgage-backed securities, at fair value		-			138,338
Receivable for securities sold		231,214			1,587,535
Accrued interest receivable		55,156			77,113
Principal payments receivable		95,021			190,832
Debt security, held to maturity, at cost		15,000			15,000
Interest rate swap asset		15,841			-
Other assets		33,891			26,604
Total assets	$	19,077,360		$	26,404,118
Liabilities and shareholders’ equity
Repurchase agreements	$	16,129,683		$	22,866,429
Dollar roll liability		351,826			-
Payable for unsettled securities		-			137,121
Accrued interest payable		8,279			7,592
Interest rate swap liability		125,133			243,945
Futures contract liability		36,733			-
Dividend payable		52,929			73,804
Accounts payable and other liabilities		8,676			2,363
Total  liabilities		16,713,259			23,331,254
Shareholders’ equity:
7.625% Series A Cumulative Redeemable Preferred stock, $.001 par value, 25,000,000
shares authorized, 11,500,000 shares issued and outstanding at December 31, 2013
and December 31, 2012, respectively ($287,500 aggregate liquidation preference)		278,252			278,252
Common stock, $.001 par value, 200,000,000 shares authorized,
96,601,523 and 98,822,654 shares issued and outstanding at
December 31, 2013 and December 31, 2012, respectively		97			99
Additional paid-in capital		2,453,018			2,494,303
Retained earnings (accumulated deficit)		(359,214	)		37,356
Accumulated other comprehensive (loss) income		(8,052	)		262,854
Total shareholders’ equity		2,364,101			3,072,864
Total liabilities and shareholders’ equity	$	19,077,360		$	26,404,118

See accompanying notes.

F-2

Hatteras Financial Corp.

Consolidated Statements of Income

For the years ended December 31, 2013, 2012, and 2011

(Dollars in thousands, except share related amounts)
	2013			2012		2011
Interest income:
Interest income on mortgage-backed securities	$	450,708		$	504,800	$	424,713
Interest income on short-term cash investments		1,560			1,508		1,407
Total interest income		452,268			506,308		426,120
Interest expense		197,709			197,064		144,662
Net interest margin		254,559			309,244		281,458
Operating expenses:
Management fee		18,180			17,420		13,787
Share based compensation		2,594			1,920		1,150
General and administrative		7,092			5,006		2,724
Total operating expenses		27,866			24,346		17,661
Other income (loss):
Net realized gain (loss) on sale of mortgage-backed securities		(283,012	)		64,347		20,576
Impairment of mortgage-backed securities		(8,102	)		-		-
Loss on derivative instruments, net		(69,715	)		-		-
Total other income (loss)		(360,829	)		64,347		20,576
Net income (loss)		(134,136	)		349,245		284,373
Dividends on preferred stock		21,922			7,551		-
Net income (loss) available to common shareholders	$	(156,058	)	$	341,694	$	284,373
Earnings (loss) per share - common stock, basic	$	(1.59	)	$	3.67	$	3.97
Earnings (loss) per share - common stock, diluted	$	(1.59	)	$	3.67	$	3.97
Weighted average common shares outstanding, basic		98,337,362			93,185,520		71,708,058
Weighted average common shares outstanding, diluted		98,337,362			93,185,520		71,708,058

See accompanying notes.

F-3

Hatteras Financial Corp

Consolidated Statements of Comprehensive Income

(Dollars in thousands)
	2013			2012			2011
Net income (loss)	$	(134,136	)	$	349,245		$	284,373
Other comprehensive income (loss):
Net unrealized gains (losses) on securities available for sale		(391,590	)		115,008			223,333
Net unrealized gains (losses) on interest rate hedges		120,684			(25,476	)		(155,902	)
Other comprehensive income (loss)		(270,906	)		89,532			67,431
Comprehensive income (loss)	$	(405,042	)	$	438,777		$	351,804

See accompanying notes.

F-4

Hatteras Financial Corp.

Consolidated Statements of Changes in Shareholders’ Equity

For the years ended December 31, 2013, 2012, and 2011

	7.625% Series A
	Cumulative
	Redeemable								Retained			Accumulated
	Preferred		Common			Additional			Earnings			Other
(Dollars in thousands)	Stock		Stock			Paid-in			(Accumulated			Comprehensive
	Amount		Amount			Capital			Deficit)			Income (Loss)			Total
Balance at December 31, 2010	$	-	$	46		$	1,043,027		$	(3,480	)	$	105,891		$	1,145,484
Issuance of common stock		-		31			860,571									860,602
Share based compensation expense		-		-			1,150			-			-			1,150
Dividends declared on common stock		-		-			-			(278,852	)		-			(278,852	)
Net income		-		-			-			284,373			-			284,373
Other comprehensive income													67,431			67,431
Balance at December 31, 2011		-		77			1,904,748			2,041			173,322			2,080,188
Issuance of preferred stock		278,252		-			-			-			-			278,252
Issuance of common stock		-		22			587,635			-			-			587,657
Share based compensation expense		-		-			1,920			-			-			1,920
Dividends declared on preferred stock		-		-			-			(7,551	)		-			(7,551	)
Dividends declared on common stock		-		-			-			(306,379	)		-			(306,379	)
Net income		-		-			-			349,245			-			349,245
Other comprehensive income		-		-			-			-			89,532			89,532
Balance at December 31, 2012		278,252		99			2,494,303			37,356			262,854			3,072,864
Repurchase of common stock		-		(2	)		(43,879	)		-			-			(43,881	)
Share based compensation expense		-		-			2,594			-			-			2,594
Dividends declared on preferred stock		-		-			-			(21,922	)		-			(21,922	)
Dividends declared on common stock		-		-			-			(240,512	)		-			(240,512	)
Net loss		-		-			-			(134,136	)		-			(134,136	)
Other comprehensive loss		-		-			-			-			(270,906	)		(270,906	)
Balance at December 31, 2013	$	278,252	$	97		$	2,453,018		$	(359,214	)	$	(8,052	)	$	2,364,101

See accompanying notes.

F-5

Hatteras Financial Corp.

Consolidated Statements of Cash Flows

For the years ended December 31, 2013, 2012, and 2011

(Dollars in thousands)
	2013			2012			2011
Operating activities
Net income (loss)	$	(134,136	)	$	349,245		$	284,373
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
Net amortization of premium related to mortgage-backed securities		165,924			162,844			93,335
Reclassification of deferred swap loss		25,816			-			-
Amortization related to interest rate swap agreements		311			361			346
Share based compensation expense		2,594			1,920			1,150
Hedge ineffectiveness		(205	)		178			655
Net (gain) loss on sale of mortgage-backed securities		283,012			(64,347	)		(20,576	)
Impairment loss on mortgage-backed securities		8,102			-			-
Net loss on derivative instruments		68,205			-			-
Changes in operating assets and liabilities:
(Increase) decrease in accrued interest receivable		21,957			(14,088	)		(25,052	)
Increase in other assets		(2,432	)		(191	)		(1,881	)
Increase in accrued interest payable		687			2,996			1,419
Increase in accounts payable and other liabilities		572			110			1,111
Net cash provided by operating activities		440,407			439,028			334,880
Investing activities
Purchases of mortgage-backed securities		(10,180,894	)		(17,988,431	)		(13,351,128	)
Principal repayments of mortgage-backed securities		5,782,709			5,635,988			3,559,612
Sale of mortgage-backed securities		11,280,146			4,518,105			1,766,557
Net payments on derivative instruments		(67,656	)		-			-
Net cash provided by (used in) investing activities		6,814,305			(7,834,338	)		(8,024,959	)
Financing activities
Issuance of preferred stock		-			278,252			-
(Repurchase) issuance of common stock		(43,881	)		587,657			860,602
Cash dividends paid		(283,309	)		(309,267	)		(255,827	)
Proceeds from repurchase agreements		226,824,755			231,718,347			163,847,236
Principal repayments on repurchase agreements		(233,561,501	)		(225,014,293	)		(156,365,921	)
Proceeds from dollar roll liability		1,784,998			-			-
Repayments on dollar roll liability		(1,433,172	)		-			-
Increase (decrease) in restricted cash margin on derivatives		55,642			(44,007	)		(161,592	)
Payment on termination interest rate swap		(3,342	)		-			-
Net cash provided by (used in) financing activities		(6,659,810	)		7,216,689			7,924,498
Net increase (decrease) in cash and cash equivalents		594,902			(178,621	)		234,419
Cash and cash equivalents, beginning of period		168,424			347,045			112,626
Cash and cash equivalents, end of period	$	763,326		$	168,424		$	347,045
Supplemental disclosure of cash flow information
Cash paid during the period for interest	$	197,022		$	194,068		$	143,243
Supplemental schedule of non-cash investing activities
Obligation to brokers for purchase of unsettled mortgage-backed securities	$	-		$	722,221		$	397,936

F-6

(Dollars in thousands)
	2013		2012		2011
Receivable for securities sold	$	231,214	$	1,587,535	$	-
Supplemental schedule of non-cash financing activities
Dividends declared on preferred stock, not yet paid	$	4,628	$	4,628	$	-
Dividends declared on common stock, not yet paid	$	48,301	$	69,176	$	69,141

See accompanying notes.

F-7

Hatteras Financial Corp.

Notes to Consolidated Financial Statements

December 31, 2013

(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. The Company invests primarily in single-family residential mortgage assets, such as mortgage-backed securities (“MBS”), issued or guaranteed by the U.S. Government   - Ginnie Mae - or by the U.S. Government sponsored enterprises - Fannie Mae and 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.  However, certain activities that the Company may perform may cause it to earn income which will not be qualifying income for REIT purposes.  The Company has designated certain of its subsidiaries as taxable REIT subsidiaries (“TRSs”) as defined in the Internal Revenue Code of 1986, as amended (the “Code”), to engage in such activities, and the Company may in the future form additional TRSs.

2. Summary of Significant Accounting Policies

Basis of Presentation and Use of Estimates

The accompanying consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). 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.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and all of its subsidiaries. The Company also considers the provisions of Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) Topic 810 on Consolidation in determining whether consolidation is appropriate for any interests held in variable interest entities. All significant intercompany balances and transactions have been eliminated.  

Cash and Cash Equivalents

The Company considers all highly liquid investments with original maturities of three months or less, and which are not restricted as to use, to be cash equivalents. The carrying amounts of cash equivalents approximate their fair value.

Restricted Cash

Restricted cash is cash held in margin accounts at various counterparties as collateral related to interest rate swaps, Eurodollar futures contracts and forward commitments to purchase TBA securities.

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, receivable for securities sold, accrued interest receivable, principal payment receivable, payable for unsettled securities, derivative instruments, repurchase agreements, dollar roll liabilities and accrued interest payable to meet the definition of financial instruments.  The carrying amount of cash and cash equivalents, restricted cash, receivable for securities sold, accrued interest receivable, dollar roll liabilities 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 repurchase agreements is deemed to approximate fair value given their short-term duration 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 derivative instruments.

F-8

The Company limits its exposure to credit losses on its portfolio of securities by purchasing agency securities.  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 expected prepayment characteristics.  See Note 4 for additional information on MBS.

The Company is engaged in various trading and brokerage activities including repurchase agreements, dollar rolls, interest rate swap agreements and futures contracts 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 6 for additional information on repurchase agreements and Note 7 for additional information on dollar rolls, interest rate swap agreements and futures contracts.

Mortgage-Backed Securities

The Company invests in agency securities representing interests in or obligations backed by pools of single-family residential mortgage loans.  Guidance under the FASB 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 (loss).  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 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 (“ASC 815”).  The fair value of these purchase commitments is included in other assets or liabilities in the accompanying consolidated 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 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.  See Note 4 for discussion of any impairment losses recognized during the periods presented.

Derivative Instruments

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 objectives of the Company’s risk management strategy are 1) to attempt to mitigate the risk of the cost of its variable rate liabilities increasing during a period of rising interest rates, and 2) to reduce fluctuations in net book value over a range of interest rate scenarios.  The principal instruments that the Company uses to achieve these objectives are interest rate swaps.  The Company also purchases or sells Eurodollar Futures Contracts (“Futures Contracts”) to replicate the economic hedging results achieved with interest rate swaps.  The Company does not enter into any of these transactions for speculative purposes.

The Company accounts for derivative instruments in accordance with ASC 815, which requires an entity to recognize all derivatives as either assets or liabilities and to measure those instruments at fair value.  The accounting for changes in the fair value of derivative instruments depends on whether the instruments are designated and qualify as part of a hedging relationship pursuant to ASC 815.  Changes in fair value related to derivatives not in hedge designated relationships are recorded in “Gain (loss) on derivative instruments, net” in the Company’s consolidated statements of income, whereas changes in fair value related to derivatives in hedge designated relationships are initially recorded in other comprehensive income (loss) and later reclassified to income at the time that the hedged transactions affect earnings.  Any portion of the changes in fair value due to hedge ineffectiveness is immediately recognized in the income statement.

Derivative instruments in a gain position are reported as derivative assets at fair value and derivative instruments in a loss position are reported as derivative liabilities at fair value in the Company’s consolidated balance sheets.  In the Company’s consolidated statements of cash flows, cash receipts and payments related to derivative instruments are classified according to the underlying nature or purpose of the derivative transaction, generally in the operating section if the derivatives are designated as accounting hedges and in the investing section otherwise.  The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that the counterparties to these instruments fail to perform their obligations under the contracts.  The Company attempts to minimize this risk by limiting its counterparties to major financial institutions with acceptable credit ratings, monitoring positions with individual counterparties and adjusting posted collateral as required.

F-9

All of the Company’s swaps have historically been accounted for as cash flow hedges under ASC 815.  However, on September 30, 2013, the Company discontinued hedge accounting for its interest rate swap agreements by de-designating the swaps as cash flow hedges.  No swaps were terminated in conjunction with this action, and the Company’s risk management and hedging practices were not impacted.  As a result of discontinuing hedge accounting, beginning October 1, 2013 changes in the fair value of the Company's interest rate swap agreements are recorded in “Loss on derivative instruments, net” in the Company's consolidated statements of income, rather than in accumulated other comprehensive income (loss) (AOCI).  Also, net interest paid or received under the swaps, which up through September 30 was recognized in “interest expense,” is instead recognized in “Loss on derivative instruments, net.”  These swaps continue to be reported as assets or liabilities on the Company's consolidated balance sheets at their fair value.

As long as the forecasted transactions that were being hedged (i.e. rollovers of the Company’s repurchase agreement borrowings) are still expected to occur, the balance in AOCI from swap activity up through September 30, 2013 will remain in AOCI and be recognized in the Company's consolidated statements of income as "interest expense" over the remaining term of the swaps.  See Note 7 for further information.

At times, the Company may also enter into TBA contracts as a means of investing in and financing agency securities via “dollar roll” transactions.  TBA dollar roll transactions involve moving the settlement of a TBA contract out to a later date by entering into an offsetting short position (referred to as a "pair off"), net settling the paired off positions for cash, and simultaneously purchasing a similar TBA contract for a later settlement date.  The agency securities purchased at the forward settlement date are typically priced at a discount to securities for settlement in the current month.  This difference is referred to as the “price drop.”  The price drop represents compensation to the Company for foregoing net interest margin (interest income less repurchase agreement financing cost) and is referred to as “dollar roll income,” which the Company classifies in “Loss on derivative instruments, net.”  Realized gains and losses related to TBA contracts are also recognized in “Loss on derivative instruments, net.”  TBA dollar roll transactions represent off-balance sheet financing.  

Repurchase Agreements

The Company finances the acquisition of its agency securities through the use of repurchase agreements. Under these repurchase agreements, the Company sells securities to a lender and agrees to repurchase the same securities in the future for a price that is higher than the original sales price. The difference between the sale price that the Company receives and the repurchase price that the Company pays represents interest paid to the lender.  Although structured as a sale and repurchase obligation, a repurchase agreement operates as a financing under which the Company pledges its securities as collateral to secure a loan which is equal in value to a specified percentage of the estimated fair value of the pledged collateral.  The Company retains beneficial ownership of the pledged collateral.  At the maturity of a repurchase agreement, the Company is required to repay the loan and concurrently receives back its pledged collateral from the lender or, with the consent of the lender, the Company may renew such agreement at the then prevailing financing rate.  These repurchase agreements may require the Company to pledge additional assets to the lender in the event the estimated fair value of the existing pledged collateral declines.

Dollar Roll Liability

In addition to the TBA dollar roll transactions described above, the Company may from time to time execute dollar roll transaction on agency securities (“CUSIP dollar rolls”).  These transactions represent on-balance sheet financing, presented as “Dollar roll liability” in the Company’s consolidated balance sheets.  During the period of a CUSIP dollar roll, the financed security remains on the Company’s balance sheet, and the components of the net interest margin earned from the price drop are classified in “interest income on mortgage-backed securities” and “interest expense,” respectively.

Offsetting of Assets and Liabilities

The Company’s derivative agreements and repurchase agreements generally contain provisions that allow for netting or the offsetting of receivables and payables with each counterparty.  The Company reports amounts in its consolidated balance sheets on a gross basis without regard for such rights of offset or master netting arrangements.

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

F-10

tests.  The Company and two of its subsidiaries have made an election to treat these subsidiaries as TRSs.  As such, these TRSs are taxable as domestic C corporations and are subject to federal, state and local income taxes based upon their taxable income.

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 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 $2,594, $1,920, and $1,150 for the years ended December 31, 2013, 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.  Participating securities are unvested share-based awards that contain rights to receive nonforfeitable dividends, such as those awarded under the Company’s equity incentive plan.  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.

Other Comprehensive Income

Other comprehensive income refers to revenue, expenses, gains, and losses that are recorded directly as an adjustment to shareholders’ equity.  Other comprehensive income for the Company generally arises from unrealized gains or losses generated from changes in market values of the securities held as available-for-sale and derivative instruments that have been designated as accounting hedges.

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, which may have resulted in a material modification to the presentation of the Company’s consolidated financial statements.  In June 2013, the FASB released ASU 2013-08 Financial Services—Investment Companies (Topic 946): Amendments to the Scope, Measurement, and Disclosure Requirements that set forth new guidance on determining whether a company is subject to investment company accounting.  These final rules maintained the scope exemption for real estate investment trusts.

In December 2011, the FASB released Accounting Standards Update 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities (“ASU 2011-11”).  Under this update, the Company is required to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and transactions subject to an agreement similar to a master netting arrangement. The scope includes derivatives, sale and repurchase agreements and securities borrowing and securities lending arrangements. This disclosure is intended to enable financial statement users to understand the effect of such arrangements on the Company’s financial position. The objective of this update is to support further convergence between U.S. GAAP and International Financial Reporting Standards (“IFRS”). In January 2013, the FASB released ASU 2013-01 Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities.  Under this update, the FASB limited the scope of ASU 2011-11 to items identified in the implementation guidance which include derivatives, sale and repurchase agreements and securities borrowing and securities lending arrangements that are either offset on the balance sheet or subject to an enforceable master netting agreement. This disclosure was adopted effective January 1, 2013 and did not have a material effect on the Company’s consolidated financial statements.

In February 2013, the FASB issued ASU 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified out of Accumulated Other Comprehensive Income. Under this update, enhanced disclosures are required for items reclassified out of accumulated other comprehensive income.  This disclosure was adopted effective January 1, 2013 and did not have a material effect on the Company’s consolidated financial statements.

F-11

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.

Other than the Futures Contracts, all of the Company’s agency securities and other derivatives were valued using Level 2 inputs at December 31, 2013 and 2012.    The Futures Contracts were valued using Level 1 inputs at December 31, 2013.  See Notes 4 and 7, respectively for a discussion on how agency securities and other derivatives were valued.  

The carrying values and fair values of all financial instruments as of December 31, 2013 and 2012 were as follows:

	December 31, 2013				December 31, 2012
	Carrying		Fair		Carrying		Fair
	Value		Value		Value		Value
Assets
Mortgage-backed securities	$	17,642,532	$	17,642,532	$	23,919,251	$	23,919,251
Unsettled purchased mortgage backed securities		-		-		138,338		138,338
Cash and cash equivalents		763,326		763,326		168,424		168,424
Restricted cash		225,379		225,379		281,021		281,021
Accrued interest receivable		55,156		55,156		77,113		77,113
Receivable for securities sold		231,214		231,214		1,587,535		1,587,535
Principal payments receivable		95,021		95,021		190,832		190,832
Debt security, held to maturity		15,000		14,307		15,000		13,981
Interest rate swap asset		15,841		15,841		-		-
Futures Contracts*		11,148		11,148		-		-
Short term investment*		19,910		19,910		20,187		20,187
Forward purchase commitments*		-		-		5,452		5,452
Liabilities
Repurchase agreements	$	16,129,683		16,129,683	$	22,866,429	$	22,866,429
Dollar roll liabilities		351,826		351,826		-		-
Payable for unsettled securities		-		-		137,121		137,121
Accrued interest payable		8,279		8,279		7,592		7,592
Interest rate swap liability		125,133		125,133		243,945		243,945
Futures contract liability		36,733		36,733		-		-
Forward purchase commitments**		5,741		5,741		-		-
*These lines are included in other assets on the consolidated balance sheets
**This line included in accounts payable and other liabilities on the consolidated 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.

F-12

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 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 December 31, 2013, all of the Company’s agency securities values were based on third-party sources.

The Company’s investment portfolio consists solely of agency securities, which are backed by a U.S. Government agency or a U.S. Government sponsored enterprise.  The following table presents certain information about the Company’s agency securities at December 31, 2013.

	Agency
	Securities		Gross			Gross
	Amortized		Unrealized			Unrealized		Estimated
	Cost		Loss			Gain		Fair Value
Agency Securities
Fannie Mae Certificates
ARMS	$	9,620,743	$	(44,871	)	$	167,848	$	9,743,720
Fixed Rate		806,312		(1,798	)		3,832		808,346
Total Fannie Mae		10,427,055		(46,669	)		171,680		10,552,066
Freddie Mac Certificates
ARMS		6,671,013		(70,752	)		57,808		6,658,069
Fixed Rate		338,738		(1,600	)		21		337,159
Total Freddie Mac		7,009,751		(72,352	)		57,829		6,995,228
Ginnie Mae Certificates
ARMS		-		-			-		-
Fixed Rate		96,236		(998	)		-		95,238
Total Ginnie Mae		96,236		(998	)		-		95,238
Total Agency Securities	$	17,533,042	$	(120,019	)	$	229,509	$	17,642,532

F-13

The following table presents certain information about the Company’s agency securities at December 31, 2012.

	Amortized Cost		Gross Unrealized Loss			Gross Unrealized Gain		Estimated Fair Value
Agency Securities
Fannie Mae Certificates
ARMS	$	14,081,259	$	(100	)	$	329,780	$	14,410,939
Fixed Rate		743,299					9,296		752,595
Total Fannie Mae		14,824,558		(100	)		339,076		15,163,534
Freddie Mac Certificates
ARMS		7,850,630		(21	)		149,114		7,999,723
Fixed Rate		744,720		-			11,274		755,994
Total Freddie Mac		8,595,350		(21	)		160,388	$	8,755,717
Total Agency Securities	$	23,419,908	$	(121	)	$	499,464	$	23,919,251

The components of the carrying value of available-for-sale agency securities at December 31, 2013 and 2012 are presented below.

	As of December 31
	2013			2012
Principal balance	$	17,044,190		$	22,771,731
Unamortized premium		488,854			648,181
Unamortized discount		(2	)		(4	)
Gross unrealized gains		229,509			499,464
Gross unrealized losses		(120,019	)		(121	)
Carrying value/estimated fair value	$	17,642,532		$	23,919,251

The following table presents components of interest income on the Company’s agency securities portfolio for the three years ended December 31, 2013:

	Years Ended December 31
	2013			2012			2011
Coupon interest on MBS	$	616,632		$	667,644		$	518,048
Net premium amortization		(165,924	)		(162,844	)		(93,335	)
Interest income on MBS, net	$	450,708		$	504,800		$	424,713

During the second half of 2013, the Company repositioned a significant portion of its portfolio, resulting in an elevated level of sales of securities.  Gross gains and losses from sales of securities for the three years ended December 31, 2013 were as follows:

	Years Ended December 31
	2013			2012			2011
Gross gains on MBS	$	18,717		$	66,084		$	22,135
Gross losses on MBS		(301,729	)		(1,737	)		(1,559	)
Net gain (loss) on MBS	$	(283,012	)	$	64,347		$	20,576

F-14

The Company monitors the performance and market value of its agency securities portfolio on an ongoing basis, and on a quarterly basis reviews its agency securities for impairment.  At December 31, 2013 and 2012, the Company had the following securities in a loss position presented below:

	Less than 12 months					Less than 12 months
	as of December 31, 2013					as of December 31, 2012
	Fair Market		Unrealized			Fair Market		Unrealized
	Value		Loss			Value		Loss
Fannie Mae Certificates
ARMS	$	3,233,274	$	(44,871	)	$	149,954	$	(100	)
Fixed Rate		281,760		(1,798	)		-		-
Freddie Mac Certificates
ARMS		4,046,473		(70,752	)		41,625		(21	)
Fixed Rate		316,835		(1,600	)		-		-
Ginnie Mae Certificates
ARMS		-		-			-		-
Fixed Rate		95,238		(998	)		-		-
Total temporarily impaired securities	$	7,973,580	$	(120,019	)	$	191,580	$	(121	)
Number of securities in an unrealized loss position				279					4

The Company did not make the decision to sell the above securities as of December 31, 2013 and 2012, nor was it deemed more likely than not the Company would be required to sell these securities before recovery of their amortized cost basis.  The Company recognized an other-than-temporary impairment of $8,102 as of September 30, 2013 on three securities the Company had decided to sell, the sale of which would occur prior to the recovery of their amortized cost.  These securities were disposed of in early October 2013.  There were no other impairment losses recognized during the three year period presented herein.

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.  The following table presents certain information about the Company’s adjustable rate agency securities that will reprice or amortize based on contractual terms, which do not consider prepayment assumptions, at December 31, 2013 and 2012.

	December 31, 2013								December 31, 2012
						Weighted								Weighted
						Average								Average
	Fair Value		% of Total			Coupon			Fair Value		% of Total			Coupon
Months to Coupon Reset
0 - 12	$	1,236,878		7.5	%		3.15	%	$	914,832		4.1	%		4.03	%
13 - 24		1,614,081		9.8	%		3.49	%		966,854		4.3	%		3.88	%
25 - 36		2,321,985		14.2	%		2.99	%		2,274,763		10.2	%		3.60	%
37 - 48		2,524,939		15.4	%		2.73	%		3,207,245		14.3	%		3.06	%
49 - 60		2,483,318		15.1	%		2.94	%		3,616,891		16.1	%		2.76	%
61 - 72		4,750,098		29.0	%		2.46	%		3,027,295		13.5	%		3.26	%
73 - 84		1,470,490		9.0	%		2.44	%		7,607,359		33.9	%		2.44	%
85 - 96		-		-			-			133,487		0.6	%		3.08	%
97 - 108		-		-			-			-		-			-
109 - 120		-		-			-			641,013		2.9	%		2.81	%
121 - 140		-		-			-			20,923		0.1	%		2.69	%
Total ARMS	$	16,401,789		100.0	%		2.80	%	$	22,410,662		100.0	%		2.95	%

F-15

The following table presents certain information about the Company’s fixed rate agency securities that will reprice or amortize based on contractual terms, which do not consider prepayment assumptions, at December 31, 2013 and 2012.

	December 31, 2013								December 31, 2012
						Weighted								Weighted
						Average								Average
Wtd Average Months to Maturity	Fair Value		% of Total			Coupon			Fair Value		% of Total			Coupon
133-144	$	75,693		6.1	%		3.50	%	$	-		-			-
145-156		477,544		38.5	%		3.50	%		102,158		6.8	%		3.00	%
157-168		95,238		7.7	%		3.00	%		-		-			-
169-180		592,268		47.7	%		3.50	%		1,406,431		93.2	%		2.60	%
Total Fixed Rate Securities	$	1,240,743		100.0	%		3.46	%	$	1,508,589		100.0	%		2.62	%

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 $14,307 and $13,981 at December 31, 2013 and 2012, respectively, which was determined by calculating the present value of the projected future cash flows using a discount rate from a similar issuer.

6. Repurchase Agreements

At December 31, 2013 and 2012, the Company had repurchase agreements in place in the amount of $16,129,683 and $22,866,429, respectively, to finance MBS purchases. As of December 31, 2013 and 2012, the weighted average interest rate on these borrowings was 0.37% and 0.47%, 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 December 31, 2013 and 2012, the Company had repurchase agreements outstanding with 25 and 24 counterparties, respectively, with a weighted average contractual maturity of 0.8 months. The following table presents the contractual repricing information regarding the Company’s repurchase agreements:

	December 31, 2013					December 31, 2012
			Weighted Average					Weighted Average
	Balance		Contractual Rate			Balance		Contractual Rate
Within 30 days	$	13,170,898		0.37	%	$	20,500,568		0.47	%
30 days to 3 months		2,958,785		0.40	%		2,365,861		0.48	%
	$	16,129,683		0.37	%	$	22,866,429		0.47	%

The fair value of securities, cash, and accrued interest the Company had pledged under repurchase agreements at December 31, 2013 and 2012 was $17,088,392 and $24,268,949 respectively.

See Note 2 for a discussion of TBA dollar roll transactions, which represent off-balance sheet financing.

7. Derivatives and Other Hedging Instruments

In connection with the Company’s risk management strategy, the Company hedges a portion of its interest rate risk by entering into derivative contracts.  The Company may enter into agreements for interest rate swaps, interest rate swaptions, interest rate cap or floor contracts and futures or forward contracts.  The Company’s risk management strategy attempts to manage the overall risk of the portfolio, reduce fluctuations in book value and generate additional income distributable to shareholders.  For additional information regarding the Company’s derivative instruments and its overall risk management strategy, please refer to the discussion of derivative instruments in Note 2.

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 fair value of Futures Contracts is based on quoted prices from the exchange on which they trade.  The table below presents the fair value of the Company’s derivative instruments as well as their classification on the consolidated balance sheets as of December 31, 2013 and 2012, respectively.

F-16

Derivative Instruments	Balance Sheet Location	December 31, 2013		December 31, 2012
Interest rate swaps	Interest rate swap asset	$	15,841	$	-
Forward purchase commitments	Other assets		-		5,452
Futures contracts	Other assets		11,148
Interest rate swaps	Interest rate swap liability	$	125,133	$	243,945
Futures contracts	Futures contract liability		36,733		-
Forward purchase commitments including TBA dollar roll transactions	Other liabilities		5,741		-

Interest Rate Swaps

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.  Interest rate swaps 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 lockup interest rates on a portion of the Company’s repurchase agreements 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 swaps are benchmark interest rate swaps 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.

Until September 30, 2013, the Company elected cash flow hedge accounting for its interest rate swaps.  Under cash flow hedge accounting, effective hedge gains or losses are initially recorded in AOCI and subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings.  Ineffective hedge gains and losses are recorded on a current basis 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.  See “Financial Statement Presentation” below for quantification of gains and losses for the three years ended December 31, 2013.

On September 30, 2013, the Company de-designated its interest rate swaps as cash flow hedges, thus terminating cash flow hedge accounting.  As long as the forecasted rollovers of the related repurchase agreements are still expected to occur, amounts reported in AOCI related to the cash flow hedges through September 30, 2013 will remain in AOCI and will continue to be reclassified to interest expense as interest is accrued and paid on the related repurchase agreements.  During the next 12 months, the Company estimates that an additional $82,182 will be reclassified out of AOCI as an increase to interest expense.

The Company will continue to hedge its exposure to variability in future funding costs via interest rate swaps.  As a result of discontinuing hedge accounting, beginning October 1, 2013, changes in the fair value of the Company’s interest rate swaps were recorded in “loss on derivative instruments, net” in the consolidated statements of income, consistent with the Company’s historical accounting for Futures Contracts described below.  Monthly net cash settlements under the swaps were also recorded in “loss on derivative instruments, net” beginning October 1, 2013.

The volume of activity for the Company’s interest rate swap instruments is shown in the table below.  

	Interest Rate
	Swaps
Notional amount as of December 31, 2012	$	10,700,000
Additions		800,000
Settlements, terminations, or expirations		(1,000,000	)
Notional amount as of December 31, 2013	$	10,500,000

F-17

As of December 31, 2013, the weighted-average remaining term of the Company’s swaps is 24 months.  The table below shows the remaining term of the Company’s interest rate swaps as of December 31, 2013.

			Remaining		Weighted Average
	Notional		Term		Fixed Interest
Maturity	Amount		in Months		Rate in Contract
12 months or less	$	2,200,000		8		1.71%
Over 12 months to 24 months		3,700,000		18		1.73%
Over 24 months to 36 months		2,400,000		30		0.92%
Over 36 months to 48 months		1,800,000		41		0.89%
Over 48 months to 60 months		400,000		50		0.96%
Total	$	10,500,000		24		1.37%

Eurodollar Futures Contracts

The Company uses Futures Contracts to 1) synthetically replicate an interest rate swap, or 2) offset the changes in value of its forward purchases of certain agency securities.  As of December 31, 2013, the fair value of all Futures Contracts was a liability of $(25,585).  The Company did not own Futures Contracts prior to 2013.

	Fair Value
	Futures Contracts
Futures Contracts designed to replicate swaps	$	(27,881	)
Futures Contracts designed to hedge value changes in forward purchases		2,296
Total fair market value of Futures Contracts	$	(25,585	)

The volume of activity for the Company’s Futures Contracts is shown in the table below.

	Number of
	Contracts
As of December 31, 2012		-
Purchases		125,860
Settlements		(28,164	)
Maturities		(2,369	)
As of December 31, 2013		95,327

Each Futures Contract embodies $1 million of notional value and is effective for a term of approximately three months.

The Company has not designated its Futures Contracts as hedges for accounting purposes.  As a result, realized and unrealized changes in fair value thereon are recognized in earnings in the period in which the changes occur.  During the year ended December 31, 2013 the Company recognized realized and unrealized losses on Futures Contracts of $33,298 and $25,585, respectively, in the consolidated statements of income in “Loss on derivative instruments, net.”  The Company did not own Futures Contracts prior to 2013.

To Be Announced Securities Purchases

The Company purchases certain of its investment securities in the forward market.  The Company purchases ARM TBA contracts and 15-year TBA contracts from dealers.  ARM TBA contracts are not a frequently-traded security and are generally used to acquire mortgage backed securities for the portfolio.  15-year TBA contracts are a highly liquid security, and may be physically settled, net settled or traded as an investment.  The Company also has commitments with various mortgage origination companies to purchase their production as it becomes securitized.  Forward purchases do not qualify for trade date accounting and are considered derivatives for financial statement purposes.  Pursuant to ASC 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.  

F-18

The following table shows the ARM securities forward purchase commitments shown as a net asset in other assets on the balance sheets as of December 31, 2013 and 2012.

	Face		Cost		Fair Market Value		Net Asset
December 31, 2013	$	-	$	-	$	-	$	-
December 31, 2012	$	565,000	$	585,100	$	587,247	$	2,147

At times, the Company also uses TBA contracts to purchase its 15-year fixed-rate securities.  These TBA contracts may be physically settled or financed in the dollar roll market.  Income from dollar roll transactions and realized gains and losses on TBA contracts are recognized in the consolidated statements of income in “Loss on derivative instruments, net.”

At December 31, 2013, the Company had the following 15-year TBA dollar roll securities:

	Face		Cost		Fair Market Value		Net Liability
December 31, 2013	$	600,000	$	632,270	$	627,187	$	5,083

At December 31, 2013 and 2012, the Company also had estimated purchase commitments with mortgage originators with a net fair value in the amount of ($658) and $3,305, respectively.

Financial Statement Presentation

The Company does not use either offsetting or netting to present any of its derivative assets or liabilities.  The following table shows the gross amounts associated with the Company’s derivative financial instruments and the impact if netting were used as of December 31, 2013.

	Assets/(Liabilities)			Cash Collateral Posted		Net Asset/(Liability)
Interest rate swaps	$	15,841		$	-	$	15,841
Futures contracts		11,148			-		11,148
Interest rate swaps	$	(125,133	)	$	133,661	$	8,528
Futures contracts		(36,733	)		77,713		40,980
Forward purchase commitments including TBA dollar roll transactions		(5,741	)		14,005		8,264

The following table shows the gross amounts associated with the Company’s derivative financial instruments and the impact if netting were used as of December 31, 2012.

	Assets/(Liabilities)			Cash Collateral Posted		Net Asset/(Liability)
Forward purchase commitments	$	5,452		$	-	$	5,452
Interest rate swaps	$	(243,945	)	$	281,021	$	37,076

F-19

The components of “Loss on derivative instruments, net” for the three years ended December 31, 2013, 2012 and 2011 were as follows.  Impacts from the Company’s interest rate swaps subsequent to the September 30, 2013 hedge de-designation are included herein.

	Years Ended December 31
	2013			2012		2011
Interest rate swaps – fair value adjustments	$	25,036		$	-	$	-
Interest rate swaps – monthly net settlements		(30,985	)		-		-
Futures Contracts – fair value adjustments		(25,585	)		-		-
Futures Contracts – realized losses		(33,298	)		-		-
TBA dollar roll income		5,605			-		-
Net realized loss on TBA contracts		(10,488	)		-		-
Loss on derivative instruments, net	$	(69,715	)	$	-	$	-

See Note 2 for a discussion of dollar roll transactions and dollar roll income.

As discussed above, effective September 30, 2013, the Company discontinued cash flow hedge accounting for its interest rate swaps.  The table below presents the effect of the cash flow hedges on the Company’s comprehensive income for the years ended December 31, 2013, 2012 and 2011.

	Years Ended December 31
	2013			2012			2011
Amount of gain (loss) recognized in OCI (effective portion)	$	15,030		$	(141,392	)	$	(273,389	)
Amount of loss reclassified from OCI into net income as interest expense (effective portion)		(116,847	)		(116,792	)		(102,614	)
Amount of loss recognized in net income as interest expense (ineffective portion)		(205	)		(178	)		(654	)

The following table presents the impact of the Company’s interest rate swap agreements on the Company’s AOCI for the years ended December 31, 2013 and 2012, respectively.

	Years Ended December 31
	2013			2012
Beginning balance	$	(243,051	)	$	(218,451	)
Unrealized gain (loss) on interest rate swaps		15,030			(141,392	)
Reclassification of net losses included in income statement		116,847			116,792
Ending balance	$	(111,174	)	$	(243,051	)

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 December 31, 2013, the Company was in compliance with these requirements.

As of December 31, 2013, the fair value of derivatives in a net liability position related to these agreements was $125,133.  The Company has collateral posting requirements with each of its counterparties and all interest rate swap agreements were fully collateralized as of December 31, 2013.

F-20

8. Capital Stock

Issuance of Preferred Stock

The Company amended its charter on August 16, 2012 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.

The board of directors has the authority to increase the authorized amounts, or to classify any unissued shares by setting or changing in any one or more respects the preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends, qualifications or terms or conditions of redemption of such shares.

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 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 December 31, 2013, the Company has declared and paid all required quarterly dividends on the Series A Preferred Stock.

Issuance of Common Stock

On March 30, 2012, the Company completed a secondary public offering of 20,125,000 shares of its common stock, including 2,625,000 shares pursuant to the underwriters’ overallotment option, at a price to the Company of $26.81 per share, and received net proceeds of $539,327 after the payment of underwriting discounts and expenses.

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 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 year ended December 31, 2013 and 2012, the Company issued 0 and 1,713,900 shares of common stock, respectively in at-the-market transactions, raising net proceeds to the Company, after sales commissions and fees, of $0 and $48,330, respectively.  The total commissions and fees charged to additional paid in capital in connection with the issuance of these shares was $0 and $298 for the year ended December 31, 2013 and 2012, respectively.

Stock Repurchase Program

On June 18, 2013, the Company’s board of directors authorized a stock repurchase program (the “Repurchase Program”) to acquire up to 10,000,000 shares of the Company’s common stock.  Over the remainder of 2013, the Company repurchased 2,485,447 shares of common stock under the Repurchase Program in at-the-market transactions at a total cost of $43,881.

During periods when the Company’s board of directors has authorized the Company to repurchase shares under the Repurchase Program, the Company will not be authorized to issue shares of common stock under the 2012 Program described above.  Similarly, during periods when the Company’s board of directors has authorized the Company to issue shares of common stock under the 2012 Program, the Company will not be authorized to repurchase shares under the Repurchase Program.

F-21

9. Earnings per Share

The following table details the Company’s calculation of earnings per share for the three years ended December 31, 2013, 2012 and 2011:

	2013			2012			2011
Basic earnings per share:
Net income (loss)	$	(134,136	)	$	349,245		$	284,373
Less preferred stock dividends		(21,922	)		(7,551	)		-
Net income (loss) available to common shareholders	$	(156,058	)	$	341,694		$	284,373
Weighted average shares		98,337,362			93,185,520			71,708,058
Basic earnings (loss) per share	$	(1.59	)	$	3.67		$	3.97
Diluted earnings per share:
Net income (loss)	$	(134,136	)	$	349,245		$	284,373
Less preferred stock dividends		(21,922	)		(7,551	)		-
Net income (loss) available to common shareholders	$	(156,058	)	$	341,694		$	284,373
Weighted average shares		98,337,362			93,185,520			71,708,058
Potential dilutive shares from		-			-			-
exercise of stock options
Diluted weighted average shares		98,337,362			93,185,520			71,708,058
Diluted earnings (loss) per share	$	(1.59	)	$	3.67		$	3.97

There were no potentially dilutive shares for the three years ended December 31, 2013.

10. Equity Incentive Plans

The Company’s equity incentive plans provide for the grant of awards to the Company’s employees, the Company’s manager and its employees, the Company’s independent directors, and other significant service providers.  Awards may consist of nonqualified stock options, incentive stock options, restricted and unrestricted shares of stock, stock appreciation rights, phantom stock awards or other stock-based awards, and typically vest over periods of three to five years from grant date.  The equity incentive plans are administered by the compensation and governance committee or by any other committee appointed by the board of directors or, in the absence of such a committee, by the board of directors.  At December 31, 2013, 528,227 awards relating to shares of common stock remained available for grant.  Unless previously terminated by the board of directors, awards may be granted under the equity incentive plans until the tenth anniversary of the date that the Company’s shareholders approved such plan.

Stock Option Awards

Each stock option awarded is exercisable after the period or periods specified in the award agreement, which will generally not exceed ten years from the date of grant. Stock options will be exercisable at such times and subject to such terms as determined by the compensation and governance or other administrative committee.

At December 31, 2013, the Company did not have any stock options outstanding.  No options have been granted since 2007 and there has not been any related compensation expense since 2010.

F-22

Restricted Stock Awards

For the year ended December 31, 2013, the Company issued 264,316 shares of restricted common stock and recognized an expense of $178 related to the vesting of these shares. The shares vest over a three or five year period.  The fair market value of the shares granted was determined by the closing stock market price on the date of grant.  The Company also recognized $2,416 of compensation expense in the current year related to restricted shares issued in prior years.  At December 31, 2013, the Company had unrecorded compensation expense of $10,135 related to the unvested shares of restricted common stock granted.  This expense is expected to be recognized over a weighted average remaining period of 3.8 years as of December 31, 2013.  The following table presents information about the Company’s restricted stock awards for the periods presented:

	2013					2012
				Weighted					Weighted
	Shares of			Average		Shares of			Average
	Restricted			Price on		Restricted			Price on
	Stock			Grant Date		Stock			Grant Date
Shares non-vested at beginning of year		351,192		$	27.75		253,436		$	27.01
Granted		264,316			18.76		160,534			28.47
Cancelled/forfeited		-			-		-			-
Vested		(91,260	)		20.92		(62,778	)		29.37
Shares non-vested at end of year		524,248		$	23.22		351,192		$	27.75

The total fair value of restricted stock awards vested during the year ended December 31, 2013, 2012 and 2011 were $1,871, $1,807 and $829, respectively, based upon the fair market value of the Company’s common stock on the vesting date.

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.

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.

	Years Ended December 31
	2013		2012		2011
Management Fee	$	18,180	$	17,420	$	13,787
Reimbursable Expenses		3,200		1,779		-
Total	$	21,380	$	19,199	$	13,787

None of the reimbursement payments were specifically attributable to the compensation of the Company’s executive officers.  At December 31, 2013 and 2012, the Company owed ACA $2,752 and $2,120, respectively, for the management fee and reimbursable expenses, which is included in accounts payable and other liabilities.

F-23

In addition, the Company recognized share based compensation expense related to common share options and restricted common shares granted to management of $2,594, $1,920, and $1,150, respectively, for the years ended December 31, 2013, 2012 and 2011, respectively.

12. Accumulated Other Comprehensive Income

The Company records unrealized gains and losses on its agency securities and its TBA securities as described in Note 4.  As discussed in Note 7, the Company ceased hedge accounting for its interest rate swaps effective September 30, 2013.  Beginning October 1, 2013, changes in the fair value of interest rate swaps are recorded directly to net income.  The cumulative unrealized loss on interest rate swaps in AOCI as of September 30, 2013 is being amortized to net income as the hedged forecasted transactions occur.  The following table rolls forward the components of AOCI, including reclassification adjustments, for the year ended December 31, 2013.

	Unrealized gain/(loss) on available for sale agency securities			Unrealized gain/(loss) on unsettled agency securities			Unrealized gain/(loss) on other investments			Unrealized gain/(loss) on derivative instruments			Total
Beginning balance, accumulated other comprehensive income (loss) at January 1, 2013	$	499,343		$	1,217		$	(107	)	$	(237,599	)	$	262,854
Other comprehensive income (loss) before reclassifications		(680,967	)		642			(520	)		(21,054	)		(701,899	)
Balance Sheet Reclassification:
Amount reclassified to mortgage-backed securities available for sale		-			(1,859	)		-			24,891			23,032
Income Statement Reclassifications:
Amounts reclassified to net loss on the sale of mortgage-backed securities		283,012			-			-			-			283,012
Amounts reclassified for impairment loss on mortgage-backed securities		8,102			-			-			-			8,102
Amounts reclassified to interest expense		-			-			-			116,847			116,847
Net current period other comprehensive income (loss)		(389,853	)		(1,217	)		(520	)		120,684			(270,906	)
Ending balance, accumulated other comprehensive income (loss) at December 31, 2013	$	109,490		$	-		$	(627	)	$	(116,915	)	$	(8,052	)

F-24

13. Summarized Quarterly Financial Results

The following is a presentation of the quarterly results of operations for the years ended December 31, 2013 and 2012.

Hatteras Financial Corp.

Consolidated Statements of Income

(Dollars in thousands, except share related amounts)	Three months ended December 31, 2013 (Unaudited)			Three months ended September 30, 2013 (Unaudited)			Three months ended June 30, 2013 (Unaudited)		Three months ended March 31, 2013 (Unaudited)
Interest income:
Interest income on mortgage-backed securities	$	104,312		$	107,040		$	115,115	$	124,241
Interest income on short-term cash investments		456			303			359		442
Total interest income		104,768			107,343			115,474		124,683
Interest expense		40,754			51,599			52,079		53,277
Net interest margin		64,014			55,744			63,395		71,406
Operating expenses:
Management fee		4,224			4,522			4,714		4,720
Share based compensation		701			637			627		629
General and administrative		2,583			1,538			1,602		1,369
Total operating expenses		7,508			6,697			6,943		6,718
Other income (loss):
Net realized gain (loss) on sale of mortgage-backed securities		(68,679	)		(225,635	)		8,802		2,500
Impairment of mortgage-backed securities		-			(8,102	)		-		-
Gain (loss) on derivative instruments, net		2,205			(77,456	)		5,485		51
Total other income (loss)		(66,474	)		(311,193	)		14,287		2,551
Net income (loss)		(9,968	)		(262,146	)		70,739		67,239
Dividends on preferred stock		5,481			5,481			5,480		5,480
Net income (loss) available to common shareholders	$	(15,449	)	$	(267,627	)	$	65,259	$	61,759
Earnings (loss) per share - common stock, basic	$	(0.16	)	$	(2.72	)	$	0.66	$	0.62
Earnings (loss) per share - common stock, diluted	$	(0.16	)	$	(2.72	)	$	0.66	$	0.62
Dividends per share	$	0.50		$	0.55		$	0.70	$	0.70
Weighted average shares outstanding		97,389,614			98,318,205			98,830,054		98,827,587

F-25

Hatteras Financial Corp.

Consolidated Statements of Income

(In thousands, except per share amounts)	Three months Ended December 31, 2012 (Unaudited)		Three months Ended September 30, 2012 (Unaudited)		Three months Ended June 30, 2012 (Unaudited)		Three months Ended March 31, 2012 (Unaudited)
Interest income:
Interest income on mortgage-backed securities	$	131,381	$	131,940	$	128,720	$	112,759
Interest income on short-term cash investments		347		387		441		333
Interest income		131,728		132,327		129,161		113,092
Interest expense		57,019		52,767		46,169		41,109
Net interest margin		74,709		79,560		82,992		71,983
Operating expenses:
Management fee		4,709		4,557		4,312		3,842
Share based compensation		619		447		425		429
General and administrative		1,737		1,040		1,316		913
Total operating expenses		7,065		6,044		6,053		5,184
Other income:
Gain on sale of mortgage-backed securities		39,103		10,534		12,205		2,505
Net income		106,747		84,050		89,144		69,304
Dividends on preferred stock		5,481		2,070		0		0
Net income available to common shareholders	$	101,266	$	81,980	$	89,144	$	69,304
Earnings per share - common stock, basic	$	1.02	$	0.83	$	0.91	$	0.89
Earnings per share - common stock, diluted	$	1.02	$	0.83	$	0.91	$	0.89
Dividends per share	$	0.70	$	0.80	$	0.90	$	0.90
Weighted average shares outstanding		98,811,996		98,233,589		97,969,074		77,610,117

F-26

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders of Hatteras Financial Corp.

We have audited Hatteras Financial Corp.’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework)(the COSO criteria). Hatteras Financial Corp.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Hatteras Financial Corp. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based onthe COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheets of Hatteras Financial Corp.  as of December 31, 2013 and 2012, and the related statements of income, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2013 of Hatteras Financial Corp. and our report dated February 21, 2014 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Raleigh, North Carolina

February 21, 2014

F-27