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Arlington Asset Investment Corp. - Quarter Report: 2010 September (Form 10-Q)

Form 10-Q
Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

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

For the quarterly period ended September 30, 2010

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: 000-50230

 

 

ARLINGTON ASSET INVESTMENT CORP.

(Exact name of Registrant as specified in its charter)

 

 

 

Virginia   54-1873198

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

1001 Nineteenth Street North

Arlington, VA

  22209
(Address of Principal Executive Offices)   (Zip Code)

(703) 373-0200

(Registrant’s Telephone Number, Including Area Code)

 

 

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

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

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

 

Large accelerated filer  ¨

   Accelerated filer  x    Non-accelerated filer  ¨    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

Number of shares outstanding of each of the registrant’s classes of common stock, as of October 31, 2010:

 

Title

 

Outstanding

Class A Common Stock

  7,127,299 shares

Class B Common Stock

  566,112 shares

 

 

 


Table of Contents

 

ARLINGTON ASSET INVESTMENT CORP.

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2010

INDEX

 

          Page  

PART I—FINANCIAL INFORMATION

  

Item 1.

  

Consolidated Financial Statements and Notes—(unaudited)

     3   
  

Consolidated Balance Sheets—September 30, 2010 and December 31, 2009

     3   
  

Consolidated Statements of Operations—Three and Nine Months Ended September 30, 2010 and 2009

     4   
  

Consolidated Statements of Changes in Equity—Nine Months Ended September 30, 2010 and Year  Ended December 31, 2009

     5   
  

Consolidated Statements of Cash Flows—Nine Months Ended September 30, 2010 and 2009

     6   
  

Notes to Consolidated Financial Statements

     7   

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     21   

Item 3.

  

Quantitative and Qualitative Disclosures about Market Risk

     33   

Item 4.

  

Controls and Procedures

     36   

PART II—OTHER INFORMATION

  

Item 1.

  

Legal Proceedings

     39   

Item 1A.

  

Risk Factors

     39   

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

     40   

Item 6.

  

Exhibits

     41   
  

Signatures

     42   

 

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PART I

FINANCIAL INFORMATION

 

Item 1. Consolidated Financial Statements and Notes—(unaudited)

ARLINGTON ASSET INVESTMENT CORP.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

(Unaudited)

 

     September 30,
2010
    December 31,
2009
 

ASSETS

    

Cash and cash equivalents

   $ 8,231      $ 10,123   

Receivables

    

Interest

     2,368        2,011   

Sold securities receivable

     58,686        —     

Other

     424        20   

Mortgage-backed securities, at fair value

    

Available-for-sale

     220,403        295,600   

Trading

     163,151        —     

Other investments

     5,857        2,580   

Deposits

     5,929        2,589   

Prepaid expenses and other assets

     572        726   
                

Total assets

   $ 465,621      $ 313,649   
                

LIABILITIES AND EQUITY

    

Liabilities:

    

Repurchase agreements

   $ 164,584      $ 126,830   

Purchased securities payable

     64,277        —     

Interest payable

     160        124   

Dividend payable

     4,672        —     

Derivative liability

     4,597        —     

Accounts payable, accrued expenses and other liabilities

     14,544        13,904   

Accrued compensation and benefits

     5,715        5,921   

Long-term debt

     15,948        16,857   
                

Total liabilities

     274,497        163,636   
                

Commitments and contingencies (Note 7)

    

Equity:

    

Preferred stock, $0.01 par value, 25,000,000 shares authorized, none issued and outstanding

     —          —     

Class A common stock, $0.01 par value, 450,000,000 shares authorized, 7,127,299 and 7,352,774 shares issued and outstanding, respectively

     71        74   

Class B common stock, $0.01 par value, 100,000,000 shares authorized, 566,112 shares issued and outstanding

     6        6   

Additional paid-in capital

     1,505,823        1,507,394   

Accumulated other comprehensive income, net of taxes

     41,399        7,015   

Accumulated deficit

     (1,356,175     (1,364,476
                

Total equity

     191,124        150,013   
                

Total liabilities and equity

   $ 465,621      $ 313,649   
                

See notes to consolidated financial statements.

 

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ARLINGTON ASSET INVESTMENT CORP.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except per share data)

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
       2010             2009             2010             2009      

Interest income

        

Interest on investment securities

   $ 10,150      $ 3,717      $ 29,400      $ 7,578   

Dividends and other interest income

     —          2        1        130   
                                

Total interest income

     10,150        3,719        29,401        7,708   

Interest expense

        

Interest on short-term debt

     178        114        405        418   

Interest on long-term debt

     146        196        423        2,986   
                                

Total interest expense

     324        310        828        3,404   
                                

Net interest income

     9,826        3,409        28,573        4,304   

Other income, net

        

Investment (loss) gain

     (2,089     1,588        642        1,632   

Gain on extinguishment of long-term debt

     —          27,982        —          160,435   

Other loss

     (3     (4     (10     (147
                                

Total other (loss) income, net

     (2,092     29,566        632        161,920   
                                

Income from continuing operations before other expenses

     7,734        32,975        29,205        166,224   

Other expenses

        

Compensation and benefits

     2,365        2,736        7,664        13,238   

Professional services

     233        878        993        5,997   

Business development

     19        17        58        7,900   

Occupancy and equipment

     90        94        294        416   

Communications

     44        99        156        247   

Other operating expenses

     387        1,163        1,684        3,859   
                                

Total other expenses

     3,138        4,987        10,849        31,657   
                                

Income from continuing operations before income taxes

     4,596        27,988        18,356        134,567   

Income tax (benefit) provision

     (560     3,584        (199     12,029   
                                

Income from continuing operations, net of taxes

     5,156        24,404        18,555        122,538   

Income (loss) from discontinued operations, net of taxes

     —          18,033        —          (22,153
                                

Net income

     5,156        42,437        18,555        100,385   

Net loss attributable to noncontrolling interests

     —          —          —          (11,459
                                

Net income attributable to Arlington Asset Investment Corp. shareholders

   $ 5,156      $ 42,437      $ 18,555      $ 111,844   
                                

Amounts attributable to Arlington Asset Investment Corp. shareholders

        

Income from continuing operations, net of taxes

   $ 5,156      $ 24,404      $ 18,555      $ 122,538   

Income (loss) from discontinued operations, net of taxes

     —          18,033        —          (10,694
                                

Net income

   $ 5,156      $ 42,437      $ 18,555      $ 111,844   
                                

Earnings per share—basic:

        

Income from continuing operations attributable to Arlington Asset Investment Corp. shareholders

   $ 0.66      $ 3.17      $ 2.39      $ 15.97   

Income (loss) from discontinued operations attributable to Arlington Asset Investment Corp. shareholders

     —          2.34        —          (1.39
                                

Net income attributable to Arlington Asset Investment Corp. shareholders

   $ 0.66      $ 5.51      $ 2.39      $ 14.58   
                                

Earnings per share—diluted:

        

Income from continuing operations attributable to Arlington Asset Investment Corp. shareholders

   $ 0.65      $ 3.09      $ 2.35      $ 15.65   

Income (loss) from discontinued operations attributable to Arlington Asset Investment Corp. shareholders

     —          2.29        —          (1.37
                                

Net income attributable to Arlington Asset Investment Corp. shareholders

   $ 0.65      $ 5.38      $ 2.35      $ 14.28   
                                

Dividends declared per share

   $ 0.60      $ —        $ 1.30      $ —     
                                

Weighted average shares outstanding (in thousands)

        

Basic

     7,755        7,705        7,768        7,673   
                                

Diluted

     7,887        7,895        7,904        7,830   
                                

See notes to consolidated financial statements.

 

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ARLINGTON ASSET INVESTMENT CORP.

CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

(Dollars in thousands)

(Unaudited)

 

    Class A
Common
Stock
(#)
    Class A
Amount
($)
    Class B
Common
Stock
(#)
    Class B
Amount
($)
    Additional
Paid-In
Capital
    Accumulated
Other
Comprehensive
Income
(Loss)
    Accumulated
Deficit
    Noncontrolling
Interest
    Total     Comprehensive
Income
 

Balances, December 31, 2008

    7,382,265      $ 74        578,584      $ 6      $ 1,494,642      $ (118   $ (1,481,021   $ 129,673      $ 143,256     
                                                                         

Net income (loss)

    —          —          —          —          —          —          116,545        (11,459     105,086      $ 105,086   

Conversion of Class B shares to Class A shares

    12,469        —          (12,469     —          —          —          —          —          —          —     

Issuance of Class A common stock

    1,816        —          —          —          364        —          —          —          364        —     

Retirement of Class A common stock

    (27,500     —          —          —          (275     —          —          —          (275     —     

Forfeitures of Class A common stock

    (16,276     —          (3     —          (213     —          —          —          (213     —     

Stock compensation expense for stock options

    —          —          —          —          23        —          —          —          23        —     

Amortization of Class A common shares issued as stock-based awards

    —          —          —          —          7,795        —          —          —          7,795        —     

Equity in issuance of subsidiary common shares to employees

    —          —          —          —          5,058        —          —          —          5,058        —     

Elimination of noncontrolling interest resulting from sale of subsidiary

    —          —          —          —          —          —          —          (118,269     (118,269     —     

Other comprehensive income:

                   

Net change in unrealized gain on available-for-sale investment securities, (net of taxes of $-0-)

    —          —          —          —          —          7,133        —          55        7,188        7,188   
                         

Comprehensive income

                    $ 112,274   
                                                                               

Balances, December 31, 2009

    7,352,774        74        566,112        6        1,507,394        7,015        (1,364,476     —          150,013     

Net income

    —          —          —          —          —          —          18,555        —          18,555      $ 18,555   

Issuance of Class A common stock

    4,353        —          —          —          447        —          —          —          447        —     

Repurchase of Class A common stock

    (222,846     (2     —          —          (4,398     —          —          —          (4,400     —     

Forfeitures of Class A common stock

    (6,982     (1     —          —          (122     —          —          —          (123     —     

Amortization of Class A common shares issued as stock-based awards

    —          —          —          —          2,502        —          —          —          2,502        —     

Other comprehensive income:

                   

Net change in unrealized gain on available-for-sale investment securities, (net of taxes of $-0-)

    —          —          —          —          —          34,384        —          —          34,384        34,384   
                         

Comprehensive income

                    $ 52,939   
                         

Dividends declared

    —          —          —          —          —          —          (10,254     —          (10,254  
                                                                         

Balances, September 30, 2010

    7,127,299      $ 71        566,112      $ 6      $ 1,505,823      $ 41,399      $ (1,356,175   $ —        $ 191,124     
                                                                         

See notes to consolidated financial statements.

 

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ARLINGTON ASSET INVESTMENT CORP.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 

     Nine Months Ended
September 30,
 
   2010     2009  

Cash flows from operating activities:

    

Net income

   $ 18,555      $ 100,385   

Adjustments to reconcile net income to net cash provided by (used in) operating activities

    

Net income from investments, mortgage-backed securities, and other fees

     (5,142     (14,749

Net (discount)/premium accretion/amortization on mortgage-backed securities

     (9,045     (602

Depreciation and amortization

     30        4,718   

Gain on extinguishment of long-term debt

     —          (160,435

Other

     2,504        24,394   

Changes in operating assets

    

Receivables

    

Interest receivable

     (485     (51

Sold securities receivable

     (58,686     —     

Other

     (404     (898

Prepaid expenses and other assets

     (3,190     6,313   

Due from clearing broker

     —          (7,132

Trading securities

     —          (26,517

Changes in operating liabilities

    

Accounts payable and accrued expenses

     (100     2,988   

Purchased securities payable

     64,277        —     

Accrued compensation and benefits

     (206     (15,165

Trading account securities sold but not yet purchased

     —          12,339   
                

Net cash provided by (used in) operating activities

     8,108        (74,412
                

Cash flows from investing activities:

    

Purchases of available-for-sale mortgage-backed securities

     (133,141     (397,767

Purchases of trading mortgage-backed securities

     (280,602     —     

Proceeds from sales of available-for-sale mortgage-backed securities

     237,801        806,408   

Proceeds from sales of trading mortgage-backed securities

     111,764        —     

Receipt of principal payments on available-for-sale mortgage-backed securities

     21,251        15,105   

Receipt of principal payments on trading mortgage-backed securities

     7,440        —     

Purchases of other investments

     (3,777     —     

Receipt of principal payments on other investments

     26        —     

Proceeds from sales of and distributions from investments

     1,160        14,166   

Proceeds from U.S. Treasury bond maturities

     —          550,000   

Deconsolidation of FBR Capital Markets cash balance

     —          (122,752

Other

     (14     (937
                

Net cash (used in) provided by investing activities

     (38,092     864,223   
                

Cash flows from financing activities:

    

Proceeds from (repayments of) repurchase agreements, net

     37,754        (963,040

Repurchase of common stock and subsidiary stock

     (4,076     (73,300

Dividends paid

     (5,586     —     

Proceeds from subsidiary stock transactions

     —          80,944   

Repayments of long-term debt

     —          (75,769
                

Net cash provided by (used in) financing activities

     28,092        (1,031,165
                

Net decrease in cash and cash equivalents

     (1,892     (241,354

Cash and cash equivalents, beginning of period

     10,123        254,653   

Less: Cash and cash equivalents held by discontinued operations, beginning of period

     —          207,801   
                

Cash and cash equivalents held by continuing operations, beginning of period

     10,123        46,852   
                

Cash and cash equivalents, end of period

     8,231        13,299   

Less: Cash and cash equivalents held by discontinued operations, end of period

     —          —     
                

Cash and cash equivalents held by continuing operations, end of period

   $ 8,231      $ 13,299   
                

Supplemental cash flow information

    

Cash payments for interest

   $ 722      $ 3,592   

Cash payments for taxes

   $ 700      $ 1,623   

See notes to consolidated financial statements.

 

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

1. Basis of Presentation:

The consolidated financial statements of Arlington Asset Investment Corp. (Arlington Asset), formerly known as Friedman, Billings, Ramsey Group, Inc., and its subsidiaries (unless the context otherwise provides, collectively, the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to Form 10-Q. Therefore, they do not include all information required by GAAP for complete financial statements. The interim financial statements reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair statement of the results for the periods presented. All significant intercompany accounts and transactions have been eliminated in consolidation. The results of operations for the three and nine months ended September 30, 2010 are not necessarily indicative of the operating results for the entire year or any other subsequent interim period. The Company’s unaudited condensed consolidated financial statements and notes thereto should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

Prior to May 20, 2009, the Company consolidated the results of operations of FBR Capital Markets Corporation (FBR Capital Markets), its former majority-owned subsidiary and its subsidiaries because the Company owned 56% of the outstanding shares of FBR Capital Markets’ common stock. During 2009, the Company liquidated all of its interest in FBR Capital Markets, resulting in no remaining holdings in FBR Capital Markets, as of October 28, 2009. As a result, effective October 28, 2009, the Company reported the results of operations of FBR Capital Markets and its subsidiaries as discontinued operations in accordance with the accounting guidance provided for the impairment or disposal of long-lived assets.

The preparation of the Company’s financial statements in conformity with GAAP requires the Company to make estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Although the Company based the estimates and assumptions on historical experience, when available, market information, and on various other factors that the Company believes to be reasonable under the circumstances, management exercises significant judgment in the final determination of the estimates. Actual results may differ from these estimates.

Certain amounts in the consolidated financial statements and notes for prior periods have been reclassified to conform to the current period presentation. These reclassifications had no effect on the results of operations of the Company.

 

2. Financial Instruments:

Fair Value of Financial Instruments

The Company adopted amended accounting principles related to fair value measurements as of January 1, 2008. This amendment defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, not adjusted for transaction costs. This amendment also establishes a fair value hierarchy that prioritizes the inputs to valuation

 

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techniques used to measure fair value into three broad levels giving the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3) as described below:

 

Level 1 Inputs

     Unadjusted quoted prices in active markets for identical assets or liabilities that are accessible by the Company;

Level 2 Inputs

     Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly; and

Level 3 Inputs

     Unobservable inputs for the asset or liability, including significant assumptions of the Company and other market participants.

The Company determines fair values for the following assets and liabilities:

Mortgage-backed securities (MBS), at fair value—The Company’s agency-backed MBS, which are generally guaranteed by Fannie Mae or Freddie Mac, and other AAA-rated non-agency or private-label MBS are generally classified within Level 2 of the fair value hierarchy as they are valued after considering quoted market prices provided by a broker or dealer, or alternative pricing sources with reasonable levels of price transparency. The Company reviews broker or pricing service quotes to determine whether the quotes are relevant, for example, whether an active market exists to provide price transparency or whether the quote is an indicative price or a binding offer. The independent brokers and dealers providing market prices are those who make markets in these financial instruments.

The Company classifies certain other non-agency MBS within Level 3 of the fair value hierarchy because they trade infrequently and, therefore, have little or no price transparency. These MBS include private-label MBS. The Company utilizes present value techniques based on estimated cash flows of the instrument taking into consideration various assumptions derived by management and other assumptions used by other market participants. These assumptions are corroborated by evidence such as historical data, risk characteristics, transactions in similar instruments, and completed or pending transactions, when available.

Establishing fair value is inherently subjective given the volatile and sometimes illiquid markets for some of the Company’s MBS and requires management to make a number of assumptions, including assumptions about the future of interest rates, prepayment rates, discount rates, credit loss rates, and the timing of credit losses. The assumptions the Company applies are specific to each MBS. Although the Company relies on the internal calculations to compute the fair value of these MBS, the Company requests and considers indications of value (mark) from third-party dealers to assist in the valuation process.

Other investments—The Company’s other investments consists of investment in equity securities, investment funds, interest-only MBS and other MBS related securities. The Company’s equity securities are classified within Level 1 of the fair value hierarchy if they are valued using quoted market prices. Interest-only MBS and residual interest in securitization are classified within Level 3 of the fair value hierarchy as discussed above.

Derivative instruments—In the normal course of the Company’s operations, the Company is a party to various financial instruments that are accounted for as derivatives in accordance with the amended accounting principles related to accounting for derivative instruments and hedging activities. These derivatives are generally classified within Level 2 of the fair value hierarchy because they are valued using broker or dealer quotations which are model based calculations based on market-based inputs, including, but not limited to, contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs.

Other—Cash and cash equivalents, interest receivable, repurchase agreements, accounts payable, accrued expenses and other liabilities are reflected in the consolidated balance sheets at their amortized cost, which approximates fair value because of the short term nature of these instruments.

 

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The estimated fair values of the Company’s financial instruments are as follows:

 

     September 30, 2010      December 31, 2009  
   Carrying
Amount
     Estimated
Fair Value
     Carrying
Amount
     Estimated
Fair Value
 

Financial assets

           

Cash and cash equivalents

   $ 8,231       $ 8,231       $ 10,123       $ 10,123   

Interest receivables

     2,368         2,368         2,011         2,011   

Non-interest bearing receivables

     424         424         20         20   

MBS

           

Agency-backed MBS

     163,344         163,344         136,912         136,912   

Private-label MBS

           

Senior securities

     57,071         57,071         94,380         94,380   

Re-REMIC securities

     163,139         163,139         64,308         64,308   

Other investments

     5,857         5,857         2,580         2,580   

Financial liabilities

           

Repurchase agreements

     164,584         164,584         126,830         126,830   

Interest payable

     160         160         124         124   

Long-term debt

     15,948         15,948         16,857         16,857   

Eurodollar futures

     4,597         4,597         —           —     

Fair Value Hierarchy

The following tables set forth by level within the fair value hierarchy financial instruments accounted for under accounting principles related to fair value measurements as of September 30, 2010 and December 31, 2009. As required by these accounting principles, assets and liabilities that are measured at fair value are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Financial Instruments Measured at Fair Value on a Recurring Basis

 

     September 30, 2010  
     Total     Level 1      Level 2     Level 3  

MBS, at fair value

         

Trading

         

Agency-backed MBS

   $ 163,151      $ —         $ 163,151      $ —     
                                 

Available-for-sale

         

Agency-backed MBS

     193        —           193        —     

Private-label MBS

         

Senior securities

     57,071        —           —          57,071   

Re-REMIC securities

     163,139        —           —          163,139   
                                 

Total available-for-sale

     220,403        —           193        220,210   
                                 

Total MBS

     383,554        —           163,344        220,210   

Eurodollar futures, at fair value

     (4,597     —           (4,597     —     

Interest-only MBS, at fair value

     3,752        —           —          3,752   
                                 

Total

   $ 382,709      $ —         $ 158,747      $ 223,962   
                                 
     December 31, 2009  
     Total     Level 1      Level 2     Level 3  

MBS, at fair value

         

Available-for-sale

         

Agency-backed MBS

   $ 136,912      $ —         $ 136,912      $ —     

Private-label MBS

         

Senior securities

     94,380        —           —          94,380   

Re-REMIC securities

     64,308        —           —          64,308   
                                 

Total MBS

   $ 295,600      $ —         $ 136,912      $ 158,688   
                                 

 

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The total financial assets measured and reported at fair value on a recurring basis and classified within Level 3 were $223,962, or 48.10%, and $158,688, or 50.59%, of the Company’s total assets as of September 30, 2010 and December 31, 2009, respectively.

Level 3 Financial Assets and Liabilities

Financial Instruments Measured at Fair Value on a Recurring Basis

As of September 30, 2010, the fair value of the Company’s Level 3, private-label MBS, available-for-sale was $220,210. These securities are primarily senior and re-REMIC tranches in securitization trusts issued between 2005 and 2010. The senior securities represent interests in securitizations that have the first right to cash flows and absorb losses last. The re-REMIC securities category represents interests in re-securitizations of senior residential mortgage-backed securities (RMBS) and pro-rata mezzanine securities. For re-REMIC securities, the cash flows from, and any credit losses absorbed by, the underlying RMBS are allocated among the re-REMIC securities issued in the re-securitization transactions based on the re-REMIC structure. For example, prime and non-prime residential senior securities have been resecuritized to create a two-tranche structure with a re-REMIC senior security and a re-REMIC subordinated security. In these re-REMIC securities, all principal payments from the underlying securities are directed to the re-REMIC senior security until the face value is fully paid off. Thereafter, all principal payments are directed to the re-REMIC subordinated security. For pro-rata mezzanine securities, principal payments from the underlying RMBS are typically allocated concurrently and proportionally to the mezzanine securities along with senior securities. The re-REMIC subordinated and mezzanine securities absorb credit losses first, if any, however, these credit losses occur only when credit losses exceed the credit protection provided to the underlying securities. Senior, re-REMIC and mezzanine securities receive interest while any face value is outstanding.

As of September 30, 2010, the Company’s senior securities and re-REMIC securities are collateralized by residential Prime and Alt-A mortgage loans and have an original loan-to-value of 71%, original FICO score of 727, three month prepayment rate of 15% and recent three-month loss severities of 40%. These underlying collateral loans have a weighted-average coupon rate of 5.90%. These securities are currently rated below investment grade. The significant inputs for the valuation model include the following weighted averages:

 

     September 30, 2010     December 31, 2009  
     Senior
Securities
    Re-REMIC
Securities
    Senior
Securities
    Re-REMIC
Securities
 

Discount rate

     8.48     15.69     13.20     14.83

Default rate

     9.34     5.57     8.25     8.22

Loss severity rate

     46.04     42.77     57.08     53.08

Prepayment rate

     15.73     14.64     14.90     14.16

 

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The tables below set forth a summary of changes in the fair value and gains and losses of the Company’s Level 3 financial assets and liabilities that are measured at fair value on a recurring basis for the three and nine months ended September 30, 2010 and 2009.

 

     Three Months Ended September 30, 2010  
     Senior
Securities
    Re-REMIC
Securities
    Total  

Beginning balance, July 1, 2010

   $ 61,642      $ 151,106      $ 212,748   

Total net gains (losses) (realized/unrealized)

      

Included in earnings

     1,470        472        1,942   

Included in other comprehensive income

     931        11,143        12,074   

Purchases

     14,117        7,620        21,737   

Sales

     (19,509     (6,445     (25,954

Principal payoffs

     (2,736     (2,652     (5,388

Net accretion of discount

     1,156        1,895        3,051   
                        

Ending balance, September 30, 2010

   $ 57,071      $ 163,139      $ 220,210   
                        

The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date

   $ —        $ —        $ —     
                        
     Three Months Ended September 30, 2009  
     Senior
Securities
    Re-REMIC
Securities
    Total  

Beginning balance, July 1, 2009

   $ 25,710      $ 4,234      $ 29,944   

Total net gains (losses) (realized/unrealized)

      

Included in earnings

     2,907        244        3,151   

Included in other comprehensive income

     137        548        685   

Purchases

     17,917        15,507        33,424   

Sales

     (10,161     —          (10,161

Principal payoffs

     (1,478     (564     (2,042

Net accretion of discount

     632        113        745   
                        

Ending balance, September 30, 2009

   $ 35,664      $ 20,082      $ 55,746   
                        

The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date

   $ —        $ 244      $ 244   
                        
     Nine Months Ended September 30, 2010  
     Senior
Securities
    Re-REMIC
Securities
    Total  

Beginning balance, January 1, 2010

   $ 94,380      $ 64,308      $ 158,688   

Total net gains (losses) (realized/unrealized)

      

Included in earnings

     4,478        3,596        8,074   

Included in other comprehensive income

     3,943        29,503        33,446   

Purchases

     29,577        103,562        133,139   

Sales

     (68,321     (34,212     (102,533

Principal payoffs

     (11,056     (8,657     (19,713

Net accretion of discount

     4,070        5,039        9,109   
                        

Ending balance, September 30, 2010

   $ 57,071      $ 163,139      $ 220,210   
                        

The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date

   $ —        $ —        $ —     
                        

 

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     Nine Months Ended September 30, 2009  
     Senior
Securities
    Re-REMIC
Securities
    Total  

Beginning balance, January 1, 2009

   $ 61,466      $ 4,420      $ 65,886   

Total net gains (losses) (realized/unrealized)

      

Included in earnings

     4,420        561        4,981   

Included in other comprehensive income

     179        548        727   

Purchases

     37,634        15,507        53,141   

Sales

     (64,103     —          (64,103

Principal payoffs

     (4,564     (1,067     (5,631

Net accretion of discount

     632        113        745   
                        

Ending balance, September 30, 2009

   $ 35,664      $ 20,082      $ 55,746   
                        

The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date

   $ —        $ 561      $ 561   
                        

There were no transfers in or out of Level 3 during the three and nine months ended September 30, 2010 and 2009.

Gains and losses included in earnings for the three and nine months ended September 30, 2010 and 2009 are reported in the following statement of operations line descriptions:

 

    Other Income, Net Investment Gain  
    Three Months Ended September 30,     Nine Months Ended September 30,  
      2010             2009             2010             2009      

Total gains included in earnings for the period

  $ 1,942      $ 3,151      $ 8,074      $ 4,981   
                               

Change in unrealized gains relating to assets still held at reporting date

  $ —        $ 244      $ —        $ 561   
                               

Financial Instruments Measured at Fair Value on a Non-Recurring Basis

In addition, the Company also measures non-public equity securities and investment funds at fair value on a non-recurring basis. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets. Due to the nature of these financial assets, enterprise values are primarily used to value these financial assets. In determining the enterprise value, the Company analyzes various financial, performance and market factors to estimate fair value, including where applicable, market trading activity. As a result, these financial assets are classified within Level 3 of the fair value hierarchy. For the three and nine months ended September 30, 2010, there were no changes to the carrying value of these financial assets. For the three and nine months ended September 30, 2009, the Company recognized $86 and $1,086, respectively, in losses reducing the carrying value of those assets measured at fair value on a non-recurring basis.

 

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MBS, at Fair Value

MBS, at fair value(1) (2), consisted of the following as of the dates indicated:

 

    September 30, 2010     December 31, 2009  
    Balance     Net
Unamortized
Premium
(Discount)
    Percent     Weighted
Average
Life
    Weighted
Average
Rating(3)
    Balance     Net
Unamortized
Premium
(Discount)
    Percent     Weighted
Average
Life
    Weighted
Average
Rating(3)
 

Trading

                   

Fannie Mae

  $ 163,151      $ 6,736        42.54     3.0        AAA      $ —        $ —          —          —          —     

Available-for-sale

                   

Agency-backed

                   

Fannie Mae

    193        —          0.05     2.7        AAA        11,021        311        3.73     4.12        AAA   

Freddie Mac

    —          —          —          —          —          125,891        5,224        42.59     4.14        AAA   

Private-label

                   

Senior securities

    57,071        (26,034     14.88     5.0        CC        94,380        (53,554     31.92     6.79        CCC   

Re-REMIC securities

    163,139        (161,383     42.53     8.1        NR        64,308        (96,507     21.76     7.25        NR   
                                                       
  $ 383,554      $ (180,681     100.00       $ 295,600      $ (144,526     100.00    
                                                       

 

(1)

The Company’s MBS portfolio is primarily comprised of adjustable-rate MBS. The weighted-average coupon of the MBS portfolio at September 30, 2010 and December 31, 2009 was 5.35% and 5.49%, respectively.

(2)

As of September 30, 2010 and December 31, 2009, $189,425 and $133,590, respectively, each representing fair value of the Company’s MBS investments were pledged as collateral for repurchase agreements.

(3)

The securities issued by Fannie Mae and Freddie Mac are not rated by any rating agency; however, they are commonly thought of as having an implied rating of “AAA.” There is no assurance, however, that these securities would receive such a rating if they were ever rated by a rating agency.

The Company has generally purchased private-label MBS at a discount. The Company estimates the future expected cash flows based on the Company’s observation of current information and events and applying a number of assumptions related to prepayment rates, interest rates, default rates, and the timing and amount of credit losses. These assumptions are difficult to predict as they are subject to uncertainties and contingencies related to future events that may impact the Company’s estimates and its interest income.

Based on the Company’s estimates of the expected cash flows associated with its discounted private-label MBS, to the extent that a security has a probability of incurring credit loss, a portion of the purchase discount that the Company is entitled to earn, which the Company considers to be a credit reserve against future potential credit losses, may not be accreted into interest income. The amount designated as credit reserve may be adjusted over time, based on the actual performance of the security, its underlying collateral, actual and projected cash flow from such collateral, economic conditions and other factors. If the performance of a security with a credit reserve is more favorable than forecasted, a portion of the amount designated as credit reserve may be accreted into interest income over time. Conversely, if the performance of a security with a credit reserve is less favorable than forecasted, additional amounts of the purchase discount may be designated as a credit reserve, or impairment charges and write-downs of such securities to a new cost basis could result.

 

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The following tables present the changes of the unamortized discount and designated credit reserves on available-for-sale, private-label MBS for the three and nine months ended September 30, 2010 and 2009.

 

     For Three Months Ended September 30, 2010  
     Senior Securities     Re-REMIC Securities  
     Unamortized
Discount
    Credit
Reserve
    Unamortized
Discount
    Credit
Reserve
 

Beginning balance, July 1, 2010

   $ 33,378      $ 545      $ 156,896      $ 4,938   

Accretion of discount

     (1,156     —          (1,895     —     

Reclassifications, net

     433        (433     136        (136

Acquisitions

     5,857        —          7,034        —     

Sales

     (12,590     —          (5,530     (60
                                

Ending balance, September 30, 2010

   $ 25,922      $ 112      $ 156,641      $ 4,742   
                                
     For Nine Months Ended September 30, 2010  
     Senior Securities     Re-REMIC Securities  
     Unamortized
Discount
    Credit
Reserve
    Unamortized
Discount
    Credit
Reserve
 

Beginning balance, January 1, 2010

   $ 51,051      $ 2,503      $ 91,610      $ 4,897   

Accretion of discount

     (4,069     —          (5,038     —     

Reclassifications, net

     2,677        (2,677     5,034        (5,034

Acquisitions

     12,331        477        112,584        9,402   

Sales

     (36,068     (191     (47,549     (4,523
                                

Ending balance, September 30, 2010

   $ 25,922      $ 112      $ 156,641      $ 4,742   
                                
     For Three Months Ended September 30, 2009  
     Senior Securities     Re-REMIC Securities  
     Unamortized
Discount
    Credit
Reserve
    Unamortized
Discount
    Credit
Reserve
 

Beginning balance, July 1, 2009

   $ 14,174      $ 876      $ —        $ —     

Accretion of discount

     (632     —          (113     —     

Acquisitions

     12,948        464        41,764        1,630   

Sales

     (1,011     —          —          —     
                                

Ending balance, September 30, 2009

   $ 25,479      $ 1,340      $ 41,651      $ 1,630   
                                
     For Nine Months Ended September 30, 2009  
     Senior Securities     Re-REMIC Securities  
     Unamortized
Discount
    Credit
Reserve
    Unamortized
Discount
    Credit
Reserve
 

Beginning balance, January 1, 2009

   $ —        $ —        $ —        $ —     

Accretion of discount

     (632     —          (113     —     

Acquisitions

     27,122        1,340        41,764        1,630   

Sales

     (1,011     —          —          —     
                                

Ending balance, September 30, 2009

   $ 25,479      $ 1,340      $ 41,651      $ 1,630   
                                

For the securities acquired during the three and nine months ended September 30, 2010, the contractually required payments receivable was $51,772 and $427,280, respectively, the cash flow expected to be collected was $44,360 and $323,652, respectively, and the fair value at the acquisition date was $21,737 and $130,259, respectively.

 

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Other Investments

The Company’s other investments consisted of the following as of the dates indicated:

 

     September 30,
2010
     December 31,
2009
 

Interest-only MBS

   $ 3,752       $ —     

Non-public equity securities

     1,115         1,478   

Investment funds

     990         1,102   
                 
   $ 5,857       $ 2,580   
                 

The Company’s available-for-sale securities consist of MBS. In accordance with accounting principles related to accounting for certain investments in debt and equity securities, the securities are carried at fair value with resulting unrealized gains and losses reflected as other comprehensive income or loss. Gross unrealized gains and losses on these securities were the following as of the dates indicated:

 

     September 30, 2010  
     Amortized
Cost/
Cost Basis(1)
     Unrealized      Fair Value  
        Gains      Losses     

Agency-backed MBS

   $ 182       $ 11       $ —         $ 193   

Private-label MBS

           

Senior securities

     48,643         8,428         —           57,071   

Re-REMIC securities

     130,179         32,960         —           163,139   
                                   

Total

   $ 179,004       $ 41,399       $ —         $ 220,403   
                                   

 

(1)

The amortized cost of MBS includes unamortized net discounts of $187,417 at September 30, 2010.

 

     December 31, 2009  
   Amortized
Cost/
Cost Basis(1)
     Unrealized     Fair Value  
      Gains      Losses    

Agency-backed MBS

   $ 137,839       $ 10       $ (937   $ 136,912   

Private-label MBS

          

Senior securities

     89,894         4,533         (47     94,380   

Re-REMIC securities

     60,851         3,539         (82     64,308   
                                  

Total

   $ 288,584       $ 8,082       $ (1,066   $ 295,600   
                                  

 

(1)

The amortized cost of MBS includes unamortized net discounts of $144,526 at December 31, 2009.

The Company recorded no other-than-temporary impairments on MBS during the three and nine months ended September 30, 2010 and 2009. There were no securities with unrealized losses as of September 30, 2010.

The following table presents the results of sales of MBS during the three and nine months ended September 30, 2010 and 2009.

 

     September 30,  
     Three Months Ended      Nine Months Ended  
     2010      2009      2010      2009  

Proceeds from Sale

   $ 96,054       $ 232,065       $ 349,565       $ 356,012   

Gross Gain

     1,942         2,907         8,265         4,254   

Gross Loss

     23         1,471         1,023         1,554   

 

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3. Borrowings:

Repurchase Agreements

The Company has entered into repurchase agreements to fund its investments in MBS. As of September 30, 2010 and December 31, 2009, the Company had no amount at risk greater than 10% of equity. The following tables provide information regarding the Company’s outstanding repurchase agreement borrowings as of the dates and for the periods indicated:

 

     September 30,
2010
    December 31,
2009
 

Outstanding balance

   $ 164,584      $ 126,830   

Value of assets pledged as collateral

    

Agency-backed MBS

     159,286        133,590   

Private-label MBS

     30,139        —     

Weighted-average rate

     0.41     0.27

Weighted-average term to maturity

     14.3 days        40.6 days   
     September 30,
2010
    September 30,
2009
 

Weighted-average outstanding balance during the three months ended

   $ 168,806      $ 100,575   

Weighted-average rate during the three months ended

     0.41     0.44

Weighted-average outstanding balance during the nine months ended

   $ 153,128      $ 84,060   

Weighted-average rate during the nine months ended

     0.35     0.66

Long-Term Debt

As of September 30, 2010 and December 31, 2009, the Company had $15,000 of outstanding long-term debentures. The long-term debentures accrue and require payments of interest quarterly at an annual rate of three-month LIBOR plus 2.25% to 3.00%. The weighted average interest rate on these long-term debentures was 3.28% and 3.03% as of September 30, 2010 and December 31, 2009, respectively. All of these borrowings mature between 2033 and 2035 and are currently redeemable in whole or in part without penalty. During the three and nine months ended September 30, 2009, the Company extinguished $35,000 and $236,689, respectively, of long-term debt at a gain of $27,982 and $160,435, respectively. There were no extinguishments of long-term debt during the three and nine months ended September 30, 2010.

As of September 30, 2010 and December 31, 2009, the Company had additional outstanding long-term debt of $948 and $1,857, respectively, associated with the Company’s 2001 acquisition of Money Management Associates, LP and Rushmore Trust and Savings. This note matures on January 2, 2011 and carries imputed interest at 9%.

 

4. Derivative Financial Instruments and Hedging Activities:

In the normal course of its operations, the Company is a party to financial instruments that are accounted for as derivative financial instruments in accordance with the amended accounting principles related to accounting for derivative instruments and hedging activities. These instruments may include interest rate swaps, Eurodollar futures contracts, and certain commitments to purchase and sell MBS.

During the three and nine months ended September 30, 2010, the Company entered into Eurodollar futures contracts to hedge certain MBS and related borrowings and other long term debt. These Eurodollar futures contracts are not designated as hedges under the amended accounting principles related to accounting for derivatives and hedging. The changes in fair value on these derivatives are recorded to net investment gain or loss in the statement of operations. For the three and nine months ended September 30, 2010, the Company

 

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recorded net losses of $2,800 and $4,688, respectively, on these derivatives. The Company had no derivative activities during the three and nine months ended September 30, 2009. The Company held the following derivative instruments as of the dates indicated:

 

     September 30, 2010     December 31, 2009  
     Notional Amount      Fair Value     Notional Amount      Fair Value  

No hedge designation:

          

Eurodollar futures contacts(1)

   $ 1,530,000       $ (4,597   $ —         $ —     

 

(1)

The $1,530,000 total notional amount of Eurodollar futures contracts as of September 30, 2010 represents the accumulation of Eurodollar futures contracts that mature on a quarterly basis between 2010 and 2015.

 

5. Income Taxes:

The total income tax benefit from continuing operations for the three and nine months ended September 30, 2010 was $560 and $199, respectively. The total income tax provision from continuing operations for the three and nine months ended September 30, 2009 was $3,584 and $12,029, respectively. The Company generated pre-tax book income from continuing operations of $4,596 and $18,356 for the three and nine months ended September 30, 2010, respectively. The Company generated pre-tax book income from continuing operations of $27,988 and $134,567 for the three and nine months ended September 30, 2009, respectively.

The Company’s effective tax rate for the nine months ended September 30, 2010 and 2009 was (1.1%) and 8.9%, respectively. The effective tax rate during these periods differed from statutory tax rates primarily due to valuation allowances recognized on deferred tax assets and the expected tax liability due to projected taxable income for 2010 that will be subject to alternative minimum tax. The Company expects to realize a portion of the tax benefits of the federal and state net operating losses (NOLs) in 2010, which are reflected in the Company’s projected effective tax rate for the year, along with a corresponding release of the valuation allowance previously recorded against these losses. The Company will continue to provide a valuation allowance against the other deferred tax assets to the extent the Company believes that it is more likely than not that the benefits will not be realized in the future. The Company will continue to assess the need for a valuation allowance at each reporting date.

 

6. Earnings Per Share:

Basic earnings per share includes no dilution and is computed by dividing net income or loss available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share include the impact of dilutive securities such as stock options and unvested shares of restricted stock. The following table presents the computations of basic and diluted earnings per share, adjusted for the 1-for-20 reverse stock split effective October 6, 2009, for the periods indicated:

 

     Three Months Ended September 30,  
     2010      2009  
     Basic      Diluted      Basic      Diluted  

Weighted average shares outstanding (in thousands):

           

Common stock

     7,755         7,755         7,705         7,705   

Stock options and unvested restricted stock

     —           132         —           190   
                                   

Weighted average common and common equivalent shares outstanding

     7,755         7,887         7,705         7,895   
                                   

Net income applicable to common stock

   $ 5,156       $ 5,156       $ 42,437       $ 42,437   
                                   

Earnings per common share

   $ 0.66       $ 0.65       $ 5.51       $ 5.38   
                                   

 

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     Nine Months Ended September 30,  
     2010      2009  
     Basic      Diluted      Basic      Diluted  

Weighted average shares outstanding (in thousands):

           

Common stock

     7,768         7,768         7,673         7,673   

Stock options and unvested restricted stock

     —           136         —           157   
                                   

Weighted average common and common equivalent shares outstanding

     7,768         7,904         7,673         7,830   
                                   

Net income applicable to common stock

   $ 18,555       $ 18,555       $ 111,844       $ 111,844   
                                   

Earnings per common share

   $ 2.39       $ 2.35       $ 14.58       $ 14.28   
                                   

The diluted earnings per share for the three and nine months ended September 30, 2010 did not include the antidilutive effect of 26,541 and 69,382 shares, respectively, of restricted stock units, stock options, and restricted stock. The diluted earnings per share for the three and nine months ended September 30, 2009 did not include the antidilutive effect of 144,395 and 159,356 shares, respectively, of restricted stock units, stock options, and restricted stock.

 

7. Commitments and Contingencies:

Litigation

Except as described below, as of September 30, 2010, the Company was not a defendant nor a plaintiff in any lawsuits or arbitrations nor involved in any governmental or self-regulatory organization matters that are expected to have a material adverse effect on the Company’s financial condition, results of operations or liquidity. The Company is a defendant in a small number of civil lawsuits and arbitrations relating to its business. There can be no assurance that these matters individually or in aggregate will not have a material adverse effect on the Company’s financial condition or results of operations in a future period. However, based on management’s review with counsel, resolution of these matters is not expected to have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

Shareholders’ Derivative Action

Related to a shareholder derivative action captioned Kornfeld, et al. v. Billings, et al., No. 08-1144, the parties executed a Stipulation of Settlement dated August 9, 2010, which was filed for approval with the Circuit Court of Arlington County, Virginia. On September 24, 2010, the Circuit Court entered an Order Preliminarily Approving Derivative Settlement and Providing for Notice. A hearing is scheduled for December 10, 2010 on the parties’ request for final approval.

On September 16, 2008, a shareholder derivative action captioned Kornfeld, et al. v. Billings, et al., No. 08-1144, was filed in the Circuit Court of Arlington County, Virginia, by Bill Kornfeld and Edward Lapinski, two purported shareholders of the Company. The Company was named as a nominal defendant along with certain current and former officers and directors as individual defendants. The complaint asserts claims under Virginia law against the individual defendants for breach of fiduciary duty and against certain of the individual defendants for unjust enrichment in connection with certain decisions concerning executive compensation. The Company’s Board of Directors established a special committee to conduct a review and evaluation of the plaintiffs’ allegations and make a final decision concerning whether maintenance of the litigation was in the Company’s best interests. The special committee concluded that the litigation was not in the Company’s best interests. On December 8, 2008, the Company moved to dismiss the shareholder derivative action based on the special committee’s recommendation and the individual defendants filed demurrers. On March 5, 2009, the court denied the individual defendants’ demurrers, granted the plaintiffs’ motion for certain discovery and denied the Company’s motion to dismiss with leave to renew the motion following discovery. On

 

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July 24, 2009, the plaintiffs filed an amended complaint. The amended complaint contains allegations similar to those in the original complaint and adds a cause of action against certain of the individual defendants for waste. On August 14, 2009, the Company filed an answer to the amended complaint and the individual defendants filed a demurrer to the amended complaint. On January 15, 2010, the parties participated in mediation.

On July 20, 2009, counsel to Bill Kornfeld and Edward Lapinski sent a letter to the Company demanding that the Board of Directors remedy alleged breaches of fiduciary duty by the directors in connection with the sale of a portion of FBR Capital Markets stock to FBR Capital Markets on May 20, 2009. The letter alleges that this sale was completed pursuant to an inappropriate process and resulted in an inadequate price. The letter states that the shareholders will file a lawsuit bringing derivative claims if the Company’s Board of Directors does not take the demanded action within a reasonable period of time. The Company’s Board of Directors established a special committee of independent directors to conduct a review and evaluation of the allegations in the letter and make a final decision concerning whether maintenance of the claims was in the Company’s best interests. The special committee concluded that maintenance of the claims was not in the Company’s best interests. Pursuant to the Stipulation of Settlement referenced above, Kornfield and Lapinski have also agreed to release the claims referenced in their July 20, 2009 letter demand.

Based on management’s review with counsel, resolution of these matters is not expected to have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

 

8. Equity:

Dividends

Pursuant to the Company’s variable dividend policy, the Board of Directors, in its sole discretion, approves the payment of dividends. The Board of Directors approved and the Company declared and paid the following dividends during 2010:

 

Quarter Ended

   Dividend Amount      Declaration Date      Record Date      Pay Date  
September 30    $ 0.60         September 20         September 30         October 29   
June 30      0.35         May 26         June 30         July 30   
March 31      0.35         February 10         March 31         April 30   

The Company did not declare or pay out dividends on our Class A or Class B common stock during 2009.

Share Repurchases

From time to time, the Company repurchased shares of its Class A common stock under a share repurchase program originally authorized by the Board of Directors in April 2003 (the “2003 Repurchase Program”), pursuant to which the Company was authorized to repurchase up to 5,000,000 shares of its Class A common stock from time to time. On July 28, 2010, the Board of Directors replaced the 2003 Repurchase Program, which had remaining authorization for the repurchase of up to 3,782,841 shares, with a new share repurchase program (the “2010 Repurchase Program”) in order to better position the Company to continue share repurchases while preserving its ability to use its NCL and NOL carryforwards. Under the 2010 Repurchase Program, the Company was authorized to repurchase up to 500,000 shares of its Class A common stock.

Repurchases under the 2010 Repurchase Program may be made from time to time on the open market and in private transactions at management’s discretion in accordance with applicable federal securities laws. The timing of repurchases and the exact number of shares of Class A common stock to be repurchased will depend upon market conditions and other factors. The 2010 Repurchase Program will be funded using the Company’s cash on hand and cash generated from operations. The 2010 Repurchase Program has no expiration date and may be suspended or terminated at any time without prior notice.

 

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The following table summarizes the Company’s share repurchase activities for the periods indicated:

 

     September 30, 2010  
     Three Months Ended      Nine Months Ended  
         2010              2009              2010              2009      

Shares Repurchased

     193,824         —           222,846         —     

Total Cost

   $ 3,851         —         $ 4,399         —     

Average Price

     19.84         —           19.71         —     

As of September 30, 2010, 277,154 shares of Class A common stock remain available for repurchases under the 2010 Repurchase Program.

 

9. Recent Accounting Pronouncements:

In January 2010, the Financial Accounting Standards Board (FASB) issued amended accounting principles related to accounting for fair value measurements and disclosures. This amendment improves the disclosure requirements related to fair value measurements and disclosures. The Company adopted this guidance as of June 30, 2010. The Company’s adoption of this guidance did not have a significant impact on its consolidated financial statements.

In June 2009, the FASB issued amended accounting principles related to accounting for transfers of financial assets. This amendment improves financial reporting by eliminating the exceptions for qualified special-purpose entities from the consolidation guidance and the exception that permitted sale accounting for certain mortgage securitizations when a transferor has not surrendered control over the transferred financial assets. In addition, comparability and consistency in accounting for transferred financial assets will be improved through clarifications of the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting. This guidance was effective January 1, 2010 for the Company. The Company’s adoption of this guidance did not have a significant impact on its consolidated financial statements.

In June 2009, the FASB issued amended accounting principles related to the consolidation of variable-interest entities. This amendment replaces the quantitative-based risks and rewards calculation for determining which enterprise, if any, has a controlling financial interest in a variable interest entity with an approach focused on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impacts the entity’s economic performance and the obligation to absorb losses of the entity or the right to receive benefits from the entity. An approach that is expected to be primarily qualitative will be more effective for identifying which enterprise has a controlling financial interest in a variable interest entity. The amendment was effective as of January 1, 2010 for the Company. The Company’s adoption of the amendment did not have a significant impact on its consolidated financial statements.

 

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

Unless the context otherwise requires or provides, references in this Quarterly Report on Form 10-Q to “we,” “us,” “our” and the “Company” refer to Arlington Asset Investment Corp. (Arlington Asset), formerly known as Friedman Billings Ramsey Group, Inc., and its subsidiaries. This discussion and analysis should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2009.

Prior to May 20, 2009, we consolidated the results of operations of FBR Capital Markets Corporation, our former majority owned subsidiary because we owned 56% of the outstanding shares of FBR Capital Markets’ common stock. During 2009, we liquidated all of our interest in FBR Capital Markets, resulting in no remaining holdings in FBR Capital Markets as of October 28, 2009. As a result, effective October 28, 2009, we reported the results of operations of FBR Capital Markets and its subsidiaries as discontinued operations in accordance with the accounting guidance provided for the impairment or disposal of long-lived assets.

The discussion of the Company’s consolidated financial condition and results of operations below may contain forward-looking statements. These statements, which reflect management’s beliefs and expectations, are subject to risks and uncertainties that may cause actual results to differ materially. For a discussion of the risks and uncertainties that may affect our future results, please see “Forward-Looking Statements” immediately following Item 4 of this report on Form 10-Q.

Executive Summary

We had net income of $5.2 million, or $0.65 per share (diluted), for the three months ended September 30, 2010. As of September 30, 2010, the Company’s book value per share was $25.02.

In addition to the financial results reported in accordance with generally accepted accounting principles as consistently applied in the United States (GAAP), we calculate non-GAAP core operating income for the quarter ended September 30, 2010. Our core operating income for the three months ended September 30, 2010 was $7.7 million. In determining core operating income, we excluded non-recurring costs and the following non-cash expenses: (1) compensation costs associated with stock-based awards, (2) accretion of mortgage-backed securities (“MBS”) purchase discounts adjusted for principal repayments in excess of proportionate invested capital, and (3) unrealized mark-to-market adjustments on the trading MBS and interest rate hedge instruments. This non-GAAP measurement is used by management to analyze and assess the operating results and dividends. We believe that this non-GAAP measurement assists investors in understanding the impact of these non-core items and non-cash expenses on the performance of the Company and provides additional clarity around the Company’s forward earnings capacity and trend. A limitation of utilizing this non-GAAP measure is that the GAAP accounting effects of these events do in fact reflect the underlying financial results of our business and these effects should not be ignored in evaluating and analyzing our financial results. Therefore, we believe net income on a GAAP basis and core operating income on a non-GAAP basis should be considered together.

The following is a reconciliation of GAAP net income to core operating income for the following periods (dollars in thousands):

 

     September 30, 2010  
     Three Months Ended     Nine Months Ended  

GAAP net income

   $ 5,156      $ 18,555   

Adjustments:

    

Non-recurring costs(1)

     (610     (436

Stock compensation

     702        2,646   

Net unrealized mark-to-market loss on trading MBS and interest rate hedge instruments

     3,036        3,744   

Adjusted interest related to purchase discount accretion / premium amortization(2)

     (630     (1,006
                

Non-GAAP core operating income

   $ 7,654      $ 23,503   
                

 

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(1)

Non-recurring costs represents the effect of professional costs and income tax effects related to activities that are non-recurring in nature.

(2)

Adjusted interest related to purchase discount accretion represents purchase discount accretion in excess of principal repayment in excess of proportional share of invested capital.

As of September 30, 2010, our private-label MBS portfolio consisted of $373.0 million in face value with an amortized cost basis of $178.8 million, was fair valued at $220.2 million and had $187.4 million in unaccreted purchase discount. During the three and nine months ended September 30, 2010, we recognized net interest income of $8.1 million and $23.8 million, respectively, representing a respective 18.0% and 18.4% annualized yield, including coupon and accretion of purchase discount, from our private-label MBS portfolio. Previously, our agency-backed MBS portfolio was structured to substantially eliminate market price risk and had a nominal impact on income. However, during the three months ended September 30, 2010, we completed the migration of our agency-backed MBS portfolio to a position in which our funding is hedged with Eurodollar futures to mitigate interest rate risk. These Eurodollar futures mature through September 30, 2015 and have a weighted average rate of 2.58% as of September 30, 2010. As of September 30, 2010, we owned $163.3 million in fair value of securities in our leveraged agency-backed MBS portfolio.

Our private-label MBS are primarily senior and re-REMIC tranches in securitization trusts issued between 2005 and 2010. The senior securities represent interests in securitizations that have the first right to cash flows and absorb losses last. The re-REMIC securities category represents interests in re-securitizations of senior residential mortgage-backed securities (RMBS) and pro-rata mezzanine securities. For re-REMIC securities, the cash flows from, and any credit losses absorbed by, the underlying RMBS are allocated among the re-REMIC securities issued in the re-securitization transactions based on the re-REMIC structure. For example, prime and non-prime residential senior securities have been resecuritized to create a two-tranche structure with a re-REMIC senior security and a re-REMIC subordinated security. In these re-REMIC securities, all principal payments from the underlying securities are directed to the re-REMIC senior security until the face value is fully paid off. Thereafter, all principal payments are directed to the re-REMIC subordinated security. For pro-rata mezzanine securities, principal payments from the underlying RMBS are typically allocated concurrently and proportionally to the mezzanine securities along with senior securities. The re-REMIC subordinated and mezzanine securities absorb credit losses first, if any, however, these credit losses occur only when credit losses exceed the credit protection provided to the underlying securities. Senior, re-REMIC, and mezzanine securities receive interest while any face value is outstanding. Our private-label MBS have approximately 10% credit enhancement, which provides protection to our invested capital in addition to our purchase discount.

Due to the nature of these securities, we generally purchase these private-label MBS at a discount. We estimate the future expected cash flows based on our observation of current information and events and applying a number of assumptions related to prepayment rates, interest rates, default rates, and the timing and amount of credit losses. These assumptions are difficult to predict as they are subject to uncertainties and contingencies related to future events that may impact our estimates and interest income.

Based on our estimates of the expected cash flows associated with our discounted private-label MBS, to the extent that a security has a probability of incurring credit loss, a portion of the purchase discount that we are entitled to earn which we consider to be a credit reserve against future potential credit losses, may not be accreted into interest income. The amount designated as credit reserve may be adjusted over time, based on the actual performance of the security, its underlying collateral, actual and projected cash flow from such collateral, economic conditions and other factors. If the performance of a security with a credit reserve is more favorable than forecasted, a portion of the amount designated as credit reserve may be accreted into interest income over time. Conversely, if the performance of a security with a credit reserve is less favorable than forecasted, additional amounts of the purchase discount may be designated as a credit reserve, or impairment charges and write-downs of such securities to a new cost basis could result. As of September 30, 2010, we designated $4.9 million as a credit reserve of the $187.4 million purchase discount on such securities.

 

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We have been and will continue to evaluate the potential impact of recent developments related to foreclosure suspensions, affidavit errors, and various state and federal government actions on the market price of MBS and related derivative securities. While it is predictably difficult to foresee the short-term and long-term impact from the foreclosure issues given all the uncertainties, we anticipate the current foreclosure issues to not have a material negative effect on our overall position and results of operations at this time.

In our private-label MBS, we have continued to benefit from the increased allocation of capital to re-REMIC mezzanine securities as well as an average purchase price basis of 50% of face value. Continued expectations of stabilization and improvement in housing, increased liquidity and available leverage have raised prices for private-label MBS, particularly among re-REMIC mezzanine securities. Our re-REMIC securities are predominantly held in the subordinate tranches and we will continue to closely monitor the performance of these securities. We believe we have constructed a private-label MBS portfolio with attractive characteristics and will continue to monitor relative value between the various classes of MBS including agency-backed MBS and may re-allocate our portfolio at any time based on management’s view of the market. We will continue to seek to identify potential opportunities to strengthen our position and to maximize return to our shareholders.

The following is a summary of our income statement for the periods indicated:

 

     Three Months  Ended
September 30,
     Nine Months Ended
September 30,
 
(Dollars in thousands)    2010     2009      2010     2009  

Net interest income

   $ 9,826      $ 3,409       $ 28,573      $ 4,304   

Other (loss) income, net

     (2,092     29,566         632        161,920   

Other expenses

     3,138        4,987         10,849        31,657   
                                 

Income from continuing operations before income taxes

     4,596        27,988         18,356        134,567   

Income tax (benefit) provision

     (560     3,584         (199     12,029   
                                 

Income from continuing operations

     5,156        24,404         18,555        122,538   

Income (loss) from discontinued operations, net of taxes

     —          18,033         —          (22,153
                                 

Net income

     5,156        42,437         18,555        100,385   

Net loss attributable to noncontrolling interests

     —          —           —          (11,459
                                 

Net income attributable to Arlington Asset Investment Corp. shareholders

   $ 5,156      $ 42,437       $ 18,555      $ 111,844   
                                 

For the three months ended September 30, 2010, our income from continuing operations was $5.2 million compared to $24.4 million for the three months ended September 30, 2009. Our income from continuing operations includes net interest income of $9.8 million for the three months ended September 30, 2010 compared to $3.4 million for the three months ended September 30, 2009. Our other expenses decreased to $3.1 million during the three months ended September 30, 2010 compared to $5.0 million for the three months ended September 30, 2009, primarily as a result of our effort to reduce expenses. Our net income attributable to the shareholders of Arlington Asset Investment Corp. for the three months ended September 30, 2009 included income from discontinued operations of $18.0 million.

For the nine months ended September 30, 2010, our income from continuing operations was $18.6 million compared to $122.5 million for the nine months ended September 30, 2009. Our income from continuing operations includes net interest income of $28.6 million for the nine months ended September 30, 2010 compared to $4.3 million and gain on extinguishment of long-term debt of $160.4 million for the nine months ended September 30, 2009. Our other expenses decreased to $10.8 million during the nine months ended September 30, 2010 compared to $31.7 million for the nine months ended September 30, 2009, primarily as a result of a $5.6 million reduction in compensation and benefits primarily related to a $1.9 million reduction in bonus accrual and a $3.2 million reduction in non-cash compensation amortization of restricted stock and our effort to reduce

 

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operating expenses in all categories and a $12.8 million reduction in expenses associated with professional services and business development, including a $7.8 million elimination in 2010 of costs that were attributable to the FBR Open. Our net income attributable to the shareholders of Arlington Asset Investment Corp. for the nine months ended September 30, 2009 included a loss from discontinued operations of $10.7 million. The following provides analysis of our continuing operations for the three and nine months ended September 30, 2010.

Principal Investing

As of September 30, 2010, our principal investing activity consisted primarily of investments in non-agency or private-label MBS and a leveraged portfolio of agency-backed MBS.

We periodically evaluate the rates of return that can be achieved in each asset category and for each individual asset in which we participate. Historically, based on market conditions, we believe our MBS assets have provided us with higher relative risk-adjusted rates of return than most other portfolio opportunities we have evaluated. Consequently, we have maintained a high allocation of our assets and capital in this sector. We intend to continue to evaluate acquisition opportunities against the returns available in each of our asset alternatives and endeavor to allocate our assets and capital with an emphasis toward what we believe will generate the highest risk-adjusted return available. This strategy may cause us to have different allocations of capital in different environments.

As of September 30, 2010, the average purchase price of these private-label MBS was 49.55% of par value with a weighted average coupon of 5.59%.

The following table summarizes our principal investing portfolio including principal receivable on MBS, as of September 30, 2010 (dollars in thousands):

 

     Face Amount      Fair Value  

Trading

     

Agency-backed MBS

     

Fannie Mae

   $ 155,469       $ 163,151   

Available-for-sale

     

Agency-backed MBS

     

Fannie Mae

     182         193   

Private-label MBS

     

Senior securities

     74,677         57,071   

Re-REMIC securities

     298,309         163,139   

Other mortgage related assets

     260,199         3,752   
                 

Total

   $ 788,836       $ 387,306   
                 

Income from Continuing Operations

Our income from continuing operations consists primarily of net interest income, net investment gain, dividends from investments and investment fund earnings.

Expenses

Interest expense includes the costs of our repurchase agreement borrowings and long-term debt securities. Interest expense also includes costs of subordinated credit lines, bank deposits and other financing, when used.

Compensation and benefits expense includes base salaries as well as incentive compensation. Salaries, payroll taxes and employee benefits are relatively fixed in nature. In addition, compensation and benefits includes non-cash expenses associated with all stock-based awards granted to employees.

 

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Professional services expense includes legal and consulting fees. Many of these expenses, such as legal fees, are to a large extent variable related to level of transactions, ongoing litigation and initiatives.

Business development expense includes primarily travel and entertainment expenses.

Occupancy and equipment includes rental costs for our facilities, depreciation and amortization of equipment and software. These expenses are largely fixed in nature.

Communications expenses include voice, data and internet service fees, and data processing costs.

Other operating expenses include professional liability and property insurance, directors fees including cash and stock awards, printing and copying, business licenses and taxes, offices supplies, penalties and fees, charitable contributions and other miscellaneous office expenses.

Results of Operations

Three months ended September 30, 2010 compared to three months ended September 30, 2009

We reported net income attributable to Arlington Asset Investment Corp. shareholders of $5.2 million for the three months ended September 30, 2010 compared to $42.4 million for the three months ended September 30, 2009 and included the following results for the periods indicated (dollars in thousands):

 

     For the Three Months Ended
September 30,
 
       2010             2009      

Interest income

   $ 10,150      $ 3,719   

Interest expense

     324        310   
                

Net interest income

     9,826        3,409   

Other (loss) income, net

    

Investment (loss) gain

     (2,089     1,588   

Gain on extinguishment of long-term debt

     —          27,982   

Other loss

     (3     (4
                

Total other (loss) income, net

     (2,092     29,566   

Other expenses

     3,138        4,987   
                

Income from continuing operations before income taxes

     4,596        27,988   

Income tax (benefit) provision

     (560     3,584   
                

Income from continuing operations

     5,156        24,404   

Income from discontinued operations, net of taxes

     —          18,033   
                

Net income attributable to Arlington Asset Investment Corp. shareholders

   $ 5,156      $ 42,437   
                

Net income attributable to Arlington Asset Investment Corp. shareholders decreased $37.2 million (87.7%) from net income of $42.4 million for the three months ended September 30, 2009 to net income of $5.2 million for the three months ended September 30, 2010 due to the following changes:

Net interest income increased $6.4 million from $3.4 million in the three months ended September 30, 2009 to $9.8 million in the three months ended September 30, 2010. The increase is the result of fully deploying our investable capital to our MBS portfolio.

Total other (loss) income decreased $31.7 million from income of $29.6 million in the three months ended September 30, 2009 to a loss of $2.1 million in the three months ended September 30, 2010. During the three months

 

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ended September 30, 2009, we extinguished $35.0 million of long term debt at a gain of $28.0 million. There was no similar debt reduction during the three months ended September 30, 2010. See below for additional discussion on the results of our principal investing portfolio.

The following table summarizes the components of income from our principal investment activities, net of related interest expense (dollars in thousands):

 

     For the Three Months Ended
September 30,
 
       2010             2009      

Net interest income

   $ 9,972      $ 3,605   

Net investment (loss) gain

     (2,089     1,588   
                
   $ 7,883      $ 5,193   
                

The components of net interest income from our MBS related portfolio is summarized in the following table (dollars in thousands):

 

     For the Three Months Ended September 30,  
     2010     2009  
   Average
Balance
     Income
(Expense)
    Yield/
Cost
    Average
Balance
     Income
(Expense)
    Yield/
Cost
 

MBS

   $ 341,817       $ 10,133        11.76   $ 166,271       $ 3,717        8.87

Other investments

     484         17        13.71     —           —          —     
                                      
   $ 342,301         10,150        11.86   $ 166,271         3,717        8.87
                          

Other(1)

        —               2     
                          
        10,150             3,719     

Repurchase agreements

   $ 168,806         (178     (0.41 )%    $ 100,575         (114     (0.44 )% 
                                      

Net interest income/spread

      $ 9,972        11.45      $ 3,605        8.43
                          

 

(1)

Includes interest income on cash and other miscellaneous interest-earning assets.

The change in the composition of our MBS portfolio from the three months ended September 30, 2009 to the three months ended September 30, 2010 and related increase in net interest income by $6.4 million from the same periods in 2009 to 2010 was due to the repositioning of the portfolio as discussed above. Interest income from other investments represents interest on interest-only MBS securities.

For the three months ended September 30, 2010 and 2009, we realized net investment loss of $2.1 million and a net investment gain of $1.6 million, respectively. The following table summarizes the components of net investment (loss) gain for the periods indicated (dollars in thousands):

 

     For the Three Months Ended
September 30,
 
       2010             2009      

Realized gains on sale of available-for-sale investments, net

   $ 1,942      $ 1,822   

Available-for-sale and cost method securities—other-than-temporary impairments

     —          (86

Losses on trading investments, net

     (1,235     —     

Gains (losses) from investment funds

     5        (399

Loss from derivative instruments

     (2,800     —     

Other, net

     (1     251   
                
   $ (2,089   $ 1,588   
                

 

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As part of our quarterly assessments of unrealized losses in our MBS portfolio for potential other-than-temporary impairment, we recognized no other-than-temporary impairment charges for the three months ended September 30, 2010 and 2009.

As part of our quarterly assessments of unrealized losses in our portfolio of marketable equity securities for other-than-temporary impairments and our assessment of cost method investments, the Company recorded $0.1 million of other-than-temporary impairment losses during the three months ended September 30, 2009. No other-than-temporary impairment charges relating to marketable equity securities and cost method investments were recorded for the three months ended September 30, 2010.

The realized gains on sale of available-for-sale investments, net, recognized for the three months ended September 30, 2010 were primarily the result of sales of $24.0 million in MBS at a net gain of $1.9 million as compared to the result of sales of $230.6 million in MBS at a net gain of $1.4 million for the three months ended September 30, 2009.

The losses on trading investments, net, recognized for the three months ended September 30, 2010 were primarily the result of realized net losses of $0.5 million from sales of trading investments and mark-to-market loss adjustments of our trading MBS portfolio of $0.7 million.

Loss from derivative instruments recognized for the three months ended September 30, 2010 was the result of realized net losses on mark-to-market adjustments of our Eurodollar futures contracts. There were no derivative related transactions during the three months ended September 30, 2009.

Other net investment gains (losses) primarily includes miscellaneous activities related to various investment portfolios such as liquidation proceeds on previously impaired investments.

Interest expense unrelated to our principal investing activity relates to long-term debt. These costs decreased to $0.1 million for the three months ended September 30, 2010 from $0.2 million for the three months ended September 30, 2009 as a result of extinguishments of the related debt in 2009.

Other expenses decreased by $1.9 million (38.0%) from $5.0 million for the three months ended September 30, 2009 to $3.1 million for the three months ended September 30, 2010 as a result of our effort to reduce operating expenses in all categories, especially in professional services, insurance, and business development, including elimination in 2010 of costs that were attributable to the FBR Open.

Total income tax benefit increased from a provision of $3.6 million for the three months ended September 30, 2009 to a benefit of $0.6 million for the three months ended September 30, 2010. The tax benefit for the three months ended September 30, 2010 is a result of a 2009 tax return reconciliation and refund, offset by interest accrued on uncertain tax positions. Our effective tax rate was (12.2%) for the three months ended September 30, 2010 as compared to 12.8% for the same period in 2009. The effective tax rates for the three months ended September 30, 2010 and 2009 represent adjustments to statutory tax rates primarily due to valuation allowances recognized on deferred tax assets and liabilities and the gain recognized from the extinguishment of trust preferred debt during the three and nine months ended September 30, 2009.

 

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Results of Operations

Nine months ended September 30, 2010 compared to nine months ended September 30, 2009

We reported net income attributable to Arlington Asset Investment Corp. shareholders of $18.6 million for the nine months ended September 30, 2010 compared to $111.8 million for the nine months ended September 30, 2009 and included the following results for the periods indicated (dollars in thousands):

 

     For the Nine Months Ended
September 30,
 
       2010             2009      

Interest income

   $ 29,401      $ 7,708   

Interest expense

     828        3,404   
                

Net interest income

     28,573        4,304   

Other income, net

    

Investment gain

     642        1,632   

Gain on extinguishment of long-term debt

     —          160,435   

Other loss

     (10     (147
                

Total other income, net

     632        161,920   

Other expenses

     10,849        31,657   
                

Income from continuing operations before income taxes

     18,356        134,567   

Income tax (benefit) provision

     (199     12,029   
                

Income from continuing operations

     18,555        122,538   

Loss from discontinued operations, net of taxes

     —          (22,153
                

Net income

     18,555        100,385   

Net loss attributable to noncontrolling interests

     —          (11,459
                

Net income attributable to Arlington Asset Investment Corp. shareholders

   $ 18,555      $ 111,844   
                

Net income attributable to Arlington Asset Investment Corp. shareholders decreased $93.2 million (83.4%) from $111.8 million for the nine months ended September 30, 2009 to $18.6 million for the nine months ended September 30, 2010 due to the following changes:

We recorded a $160.4 million gain on extinguishment of $236.7 million in long-term debt for the nine months ended September 30, 2009. There were no such extinguishments for the nine months ended September 30, 2010.

Net interest income increased $24.3 million from $4.3 million in the nine months ended September 30, 2009 to $28.6 million in the nine months ended September 30, 2010. The increase is the result of fully deploying our investable capital to our MBS portfolio.

Investment gain decreased $1.0 million from $1.6 million in the nine months ended September 30, 2009 to $0.6 million in the nine months ended September 30, 2010. See below for additional discussion on the results of our principal investing portfolio.

The following table summarizes the components of income from our principal investment activities, net of related interest expense (dollars in thousands):

 

     For the Nine Months Ended
September 30,
 
       2010              2009      

Net interest income

   $ 28,996       $ 7,182   

Net investment gain

     642         1,632   

Dividend income

     —           108   
                 
   $ 29,638       $ 8,922   
                 

 

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The components of net interest income from our MBS related portfolio is summarized in the following table (dollars in thousands):

 

     For the Nine Months Ended September 30,  
     2010     2009  
   Average
Balance
     Income
(Expense)
    Yield/
Cost
    Average
Balance
     Income
(Expense)
    Yield/
Cost
 

MBS

   $ 325,740       $ 29,384        12.06   $ 116,643       $ 7,579        8.69

Other investments

     161         17        41.13     —           —          —     
                                      
   $ 325,901         29,401        12.03   $ 116,643         7,579        8.69
                          

Other(1)

        —               21     
                          
        29,401             7,600     

Repurchase agreements

   $ 153,128         (405     (0.35 )%    $ 84,060         (418     (0.66 )% 
                                      

Net interest income/spread

      $ 28,996        11.68      $ 7,182        8.03
                          

 

(1)

Includes interest income on cash and other miscellaneous interest-earning assets.

The change in the composition of our MBS portfolio from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 and related increase in net interest income by $21.8 million from the same periods in 2009 to 2010 was due to the repositioning of the portfolio as discussed above. Interest income from other investments represents interest on interest-only MBS securities.

As discussed above, we realized net investment gain of $0.6 million for the nine months ended September 30, 2010 compared to $1.6 million for the nine months ended September 30, 2009. The following table summarizes the components of net investment gain (dollars in thousands):

 

     For the Nine Months Ended
September 30,
 
       2010             2009      

Realized gains on sale of available-for-sale investments, net

   $ 7,288      $ 3,087   

Available-for-sale and cost method securities—other-than-temporary impairments

     —          (1,086

Losses on trading investments, net

     (2,752     —     

Gains (losses) from investment funds

     5        (946

Loss from derivative instruments

     (4,688     —     

Other, net

     789        577   
                
   $ 642      $ 1,632   
                

As part of our quarterly assessments of unrealized losses in our MBS portfolio for potential other-than-temporary impairment, we recognized no other-than-temporary impairment charges for the nine months ended September 30, 2010 and 2009.

As part of our quarterly assessments of unrealized losses in our portfolio of marketable equity securities for other-than-temporary impairments and our assessment of cost method investments, we recognized other-than-temporary impairment charges of $1.1 million relating to marketable equity securities and cost method investments for the nine months ended September 30, 2009. No other-than-temporary impairment charges were recognized for the nine months ended September 30, 2010.

The gains on sale of available-for-sale investments, net, recognized for the nine months ended September 30, 2010 were primarily the result of sales of $230.5 million in MBS at a net gain of $7.3 million as compared to realized gains recognized for the nine months ended September 30, 2009 which were primarily the result of sales of $354.2 million in MBS at a net gain of $2.7 million.

 

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The losses on trading investments, net, recognized for the nine months ended September 30, 2010 were primarily the result of realized net losses of $4.6 million from sales of trading investments offset by realized net gains on mark-to-market adjustments of our trading MBS portfolio of $1.8 million.

Loss from derivative instruments recognized for the nine months ended September 30, 2010 was the result of realized net losses on mark-to-market adjustments of our Eurodollar futures contracts. There were no derivative related transactions during the nine months ended September 30, 2009.

Other net investment gain primarily includes miscellaneous activities related to various investment portfolios such as liquidation proceeds on previously impaired investments.

Interest expense unrelated to our principal investing activity relates to long-term debt. These costs decreased to $0.4 million for the nine months ended September 30, 2010 from $3.0 million for the nine months ended September 30, 2009 as a result of extinguishments as discussed above.

Other expenses decreased by $20.9 million (65.9%) from $31.7 million for the nine months ended September 30, 2009 to $10.8 million for the nine months ended September 30, 2010, primarily as a result of significant reductions in compensation and benefits related to reduction in bonus accrual and non-cash compensation amortization of restricted stock and our effort to reduce operating expenses in all categories and a reduction in expenses associated with professional services and business development, including elimination in 2010 of costs that were attributable to the FBR Open.

The total income tax benefit increased from a provision of $12.0 million for the nine months ended September 30, 2009 to a benefit of $0.2 million for the nine months ended September 30, 2010 due to the gain on extinguishment of trust preferred debt recognized in the nine months ended September 30, 2009. Our effective tax rate was (1.1%) for the nine months ended September 30, 2010 as compared to 8.9% for the same period in 2009. The effective tax rates for the nine months ended September 30, 2010 and 2009 reflect adjustments to statutory tax rates primarily due to valuation allowances recognized on deferred tax assets and the gain recognized from the extinguishment of trust preferred debt during the nine months ended September 30, 2009.

Liquidity and Capital Resources

Liquidity is a measurement of our ability to meet potential cash requirements including ongoing commitments to repay borrowings, fund investments, and for other general business purposes. Our primary sources of funds for liquidity have historically consisted of short-term borrowings (e.g., repurchase agreements), principal and interest payments on MBS, dividends on equity securities and proceeds from sales of MBS.

Potential future sources of liquidity for us include existing cash balances, borrowing capacity through margin accounts and repurchase agreements and cash flows from operations, future issuances of common stock, preferred stock or debt securities. Funding for agency MBS through repurchase agreements continues to be available to us at rates we consider to be attractive from multiple counterparties and we have observed increased availability for funding for private-label MBS through repurchase agreements. Although the availability of the third-party sources of liquidity has improved, we have observed that market conditions are still constraining access to debt capital relative to pre-crisis levels of 2007. As a result, the availability of certain short-term liquidity such as commercial paper borrowings was still limited as of September 30, 2010.

Liquidity, or ready access to funds, is essential to our business. Failures of similar businesses have often been attributable in large part to insufficient liquidity. Liquidity is of particular importance to our business and perceived liquidity issues may affect our clients’ and counterparties’ willingness to engage in transactions with us. Our liquidity could be impaired due to circumstances that we may be unable to control, such as a general market disruption or an operational problem that affects us or third parties. Further, our ability to sell assets may be impaired if other market participants are seeking to sell similar assets at the same time. If we cannot obtain funding from third parties or from our subsidiaries, our results of operations could be negatively impacted.

 

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Cash Flows

As of September 30, 2010, our cash and cash equivalents from continuing operations totaled $8.2 million, representing a net decrease in the balance of $1.9 million from $10.1 million as of December 31, 2009. The cash provided from operating activities of $8.1 million was attributable primarily to net income and increase in liabilities. The cash used in investing activities of $38.1 million relates primarily to purchase of MBS, net of sales of MBS. The cash provided by financing activities of $28.1 million relates primarily to proceeds from repurchase agreements used to finance a portion of the MBS portfolio.

Sources of Funding

We believe that our existing cash balances, investment in private-label MBS, net investments in agency-backed MBS, cash flows from operations, borrowing capacity and other sources of liquidity will be sufficient to meet our cash requirements for at least the next 12 months. We have obtained, and believe we will be able to continue to obtain, short-term financing in amounts and at interest rates consistent with our financing objectives. We may, however, seek debt or equity financings, in public or private transactions, to provide capital for corporate purposes and/or strategic business opportunities, including possible acquisitions, joint ventures, alliances or other business arrangements which could require substantial capital outlays. Our policy is to evaluate strategic business opportunities, including acquisitions and divestitures, as they arise. There can be no assurance that we will be able to generate sufficient funds from future operations, or raise sufficient debt or equity on acceptable terms, to take advantage of investment opportunities that become available. Should our needs ever exceed these sources of liquidity, we believe that most of our investments could be sold, in most circumstances, to provide cash. However, we may be required to sell our assets at depressed prices.

As of September 30, 2010, our liabilities totaled $274.5 million. In addition to other payables and accrued expenses, our indebtedness consisted of repurchase agreements and long-term debentures. These long-term debt securities accrue and require payments of interest quarterly at annual rates of three-month LIBOR plus 2.25% to 3.00%, mature between 2033 and 2035, and are currently redeemable by us, in whole or in part, without penalty. As of September 30, 2010, we had $15.9 million of total long-term debt.

We also have short-term financing facilities that are structured as repurchase agreements with various financial institutions to primarily fund our portfolio of agency-backed MBS. As of September 30, 2010, the weighted average interest rate under these agreements was 0.41%. Our repurchase agreements include provisions contained in the standard master repurchase agreement as published by the Bond Market Association and may be amended and supplemented in accordance with industry standards for repurchase facilities. Our repurchase agreements include financial covenants, with which the failure to comply would constitute an event of default under the applicable repurchase agreement. Similarly, each repurchase agreement includes events of insolvency and events of default on other indebtedness. As provided in the standard master repurchase agreement as typically amended, upon the occurrence of an event of default or termination event the applicable counterparty has the option to terminate all repurchase transactions under such counterparty’s repurchase agreement and to demand immediate payment of any amount due from us to the counterparty.

Under our repurchase agreements, we may be required to pledge additional assets to our repurchase agreement counterparties in the event the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral (i.e., a margin call), which may take the form of additional securities or cash. Margin calls on repurchase agreements collateralized by our MBS investments primarily result from events such as declines in the value of the underlying mortgage collateral caused by factors such as rising interest rates or prepayments.

To date, we have not had any margin calls on our repurchase agreements that we were not able to satisfy with either cash or additional pledged collateral. However, should we encounter increases in interest rates or prepayments, margin calls on our repurchase agreements could result in a manner that could cause a material adverse change in our liquidity position.

 

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In the event that market conditions are such that we are unable to obtain financing for our investments in MBS in amounts and at interest rates consistent with our financing objectives, to the extent deemed appropriate, we may use cash to finance our investments or we may liquidate such investments. Accordingly, depending on market conditions, we may incur significant losses on any such sales of MBS.

The following table provides information regarding our outstanding repurchase agreement borrowings as of the dates and periods indicated (dollars in thousands):

 

     September 30,
2010
    December 31,
2009
 

Outstanding balance

   $ 164,584      $ 126,830   

Weighted-average rate

     0.41     0.27

Weighted-average term to maturity

     14.3 days        40.6 days   

Maximum amount outstanding at any month-end during the year

   $ 176,244      $ 126,830   

Assets

Our principal assets consist of MBS, cash and cash equivalents, receivables, and other investments. As of September 30, 2010, liquid assets consisted primarily of cash and cash equivalents of $8.2 million, and net investments in MBS of $222.7 million. Cash equivalents consist primarily of money market funds invested in debt obligations of the U.S. government. Our total assets increased from $313.6 million at December 31, 2009 to $465.6 million as of September 30, 2010. The increase in total assets reflects the increase in our MBS portfolio.

As of September 30, 2010, the total par and fair value of the MBS portfolio was $560.7 million and $383.6 million, respectively. As of September 30, 2010, the weighted average coupon of the portfolio was 5.35%.

Dividends

On September 20, the Company’s Board of Directors approved a $0.60 dividend for the third quarter of 2010. The dividend was paid on October 29, 2010 to shareholders of record on September 30, 2010. The Company recorded the dividend payable as of September 30, 2010.

 

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market Risk

We monitor market and business risk, including credit, interest rate, equity, operations, liquidity, compliance, legal, reputational, and equity ownership risks through a number of control procedures designed to identify and evaluate the various risks to which our business and assets are exposed.

Market risk generally represents the risk of loss through a change in realizable value that can result from a change in the prices of securities, a change in the value of financial instruments as a result of changes in interest rates, a change in the volatility of interest rates or a change in the credit rating of an issuer. We are exposed to the following market risks as a result of our investments in MBS and equity investments.

Credit Risk

Although we do not expect to encounter credit risk in our agency-backed MBS portfolio assuming Fannie Mae and Freddie Mac remain solvent, we are exposed to credit risk in our private-label MBS portfolio. With respect to our private-label MBS, credit support contained in these MBS deal structures provides a level of protection from losses, as do the discounted purchase prices in the event of the return of less than 100% of par. We also evaluate the impact of credit risk on our investments through a comprehensive investment review and a selection process, which is predominantly focused on quantifying and pricing credit risk. We review our private-label MBS based on quantitative and qualitative analysis of the risk-adjusted returns on such investments. Through modeling and scenario analysis, we seek to evaluate each investment’s credit risk. Credit risk is also monitored through our ongoing asset surveillance. Despite these measures to manage credit risk, unanticipated credit losses could nevertheless occur which could adversely impact our operating results.

Our private-label MBS are generally purchased at a discount. We estimate the future expected cash flows based on our observation of current information and events and applying a number of assumptions related to prepayment rates, interest rates, default rates, and the timing and amount of credit losses. These assumptions are difficult to predict as they are subject to uncertainties and contingencies related to future events that may impact our estimates and interest income.

Based on the expected cash flows, to the extent that a security has a probability of incurring credit loss, a portion of the purchase discount that we are entitled to earn which we consider to be a credit reserve against future potential credit losses, may not be accreted into interest income. The amount designated as credit reserve may be adjusted over time, based on the actual performance of the security, its underlying collateral, actual and projected cash flow from such collateral, economic conditions and other factors. If the performance of a security with a credit reserve is more favorable than forecasted, a portion of the amount designated as credit reserve may be accreted into interest income over time. Conversely, if the performance of a security with a credit reserve is less favorable than forecasted, additional amounts of the purchase discount may be designated as credit reserve, or impairment charges and write-downs of such securities to a new cost basis could result. As of and for the three months ended September 30, 2010, we designated $4.9 million as credit reserve on such securities which is net of a $0.6 million reclassification from credit reserve to accretable discount as a result of improvements in actual and projected performance of the securities.

The following table represents certain statistics of our non-agency MBS portfolio as of and for three months ended September 30, 2010:

 

     Senior
Securities
    Re-REMIC
Securities
    Total  

Yield (% of Amortized Cost)

     16.0     19.1     18.2

Average cost (% of Face Value)

     65.1     43.7     48.0

Weighted Average Coupon

     5.1     5.7     5.6

Delinquencies Greater Than 60 Plus Days

     27.4     17.1     19.9

Credit Enhancement

     14.2     8.0     9.7

Severity (Three Months Average)

     44.7     42.0     42.7

Constant Prepayment Rate (Three Months Average)

     15.2     15.6     15.5

 

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Key credit and prepayment measures in our non-agency MBS portfolio continued a positive trend during the three months ended September 30, 2010. Total 60 day plus delinquencies in the Company’s non-agency MBS portfolio declined to 19.9% at September 30, 2010 from 20.8% at June 30, 2010 and trailing three month average loss severities on liquidated loans declined to 42.7% at September 30, 2010 from 42.8% at June 30, 2010.

The table that follows shows the expected change in fair value for our current MBS related to our principal investing activities under several hypothetical credit loss scenarios. As required under GAAP, our private-label MBS are classified as Level 3 assets of the fair value hierarchy and are valued using present value techniques based on estimated cash flows of the security taking into consideration various assumptions derived by management and used by other market participants. These assumptions include interest rates, prepayment rates, discount rates, credit loss rates, and the timing of credit losses. Credit default and loss severity rates can significantly affect the prices of private-label MBS. While it is impossible to project exact amount of changes in value, the table below illustrates the impact a 10% increase and a 10% decrease in the credit default and loss severity rates, from those used as our valuation assumptions, would have on the value of our total assets and our book value as of September 30, 2010. The changes in rates are assumed to occur instantaneously. Actual changes in market conditions are likely to be different from these assumptions (dollars in thousands, except per share amounts).

 

    Value at
September 30,
2010
    Value at
September 30,
2010 with
10%
Increase in
Default Rate
    Percent
Change
    Value at
September 30,
2010 with
10%
Decrease in
Default Rate
    Percent
Change
    Value at
September 30,
2010 with
10%
Increase in
Loss Severity
Rate
    Percent
Change
    Value at
September 30,
2010 with
10%
Decrease in
Loss Severity
Rate
    Percent
Change
 

Assets

                 

MBS

  $ 383,554      $ 379,748        (0.99 )%    $ 387,292        0.97   $ 376,489        (1.84 )%    $ 390,333        1.77

Other

    82,067        82,067        —          82,067        —          82,067        —          82,067        —     
                                               

Total assets

  $ 465,621      $ 461,815        (0.82 )%    $ 469,359        0.80   $ 458,556        (1.52 )%    $ 472,400        1.46
                                               

Liabilities

  $ 274,497      $ 274,497        —        $ 274,497        —        $ 274,497        —        $ 274,497        —     

Equity

    191,124        187,318        (1.99 )%      194,862        1.96     184,059        (3.70 )%      197,903        3.55
                                               

Total liabilities and equity

  $ 465,621      $ 461,815        (0.82 )%    $ 469,359        0.80   $ 458,556        (1.52 )%    $ 472,400        1.46
                                               

Book value per share

  $ 25.02      $ 24.52        (1.99 )%    $ 25.51        1.96   $ 24.10        (3.70 )%    $ 25.91        3.55
                                               

Interest Rate Risk

Leveraged MBS

We are also subject to interest-rate risk as a result of our principal investment activities. Through our principal investment activities, we invest in agency-backed MBS and finance these investments with repurchase agreements which are interest rate sensitive financial instruments. We are exposed to interest rate risk that fluctuates based on changes in the level or volatility of interest rates and mortgage prepayments and in the shape and slope of the yield curve. We attempt to hedge a portion of our exposure to interest rate fluctuations primarily through the use of interest rate swaps and Eurodollar futures. The counterparties to the Company’s derivative agreements at September 30, 2010 are U.S. financial institutions. The Company assesses and monitors the counterparties’ non-performance risk and credit risk on a regular basis.

Our primary risk is related to changes in both short- and long-term interest rates, which affect us in several ways. As interest rates increase, the market value of the MBS may be expected to decline, prepayment rates may be expected to go down, and duration may be expected to extend. An increase in interest rates is beneficial to the market value of our derivative instruments. For example, for interest rate swap positions, the cash flows from receiving the floating rate portion increase and the fixed rate paid remains the same under this scenario. If interest rates decline, the reverse is true for MBS, paying fixed and receiving floating interest rate swaps, interest rate caps, and Eurodollar futures and put option contracts.

 

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The table that follows shows the expected change in fair value for our current MBS and derivatives related to our principal investing activities under several hypothetical interest-rate scenarios. Interest rates are defined by the U.S. Treasury yield curve. The changes in rates are assumed to occur instantaneously. It is further assumed that the changes in rates occur uniformly across the yield curve and that the level of LIBOR changes by the same amount as the yield curve. Actual changes in market conditions are likely to be different from these assumptions.

Changes in value are measured as percentage changes from their respective values presented in the column labeled “Value at September 30, 2010.” Management’s estimate of change in value for MBS is based on the same assumptions it uses to manage the impact of interest rates on the portfolio. Actual results could differ significantly from these estimates. For MBS, the estimated change in value of the MBS reflects an effective duration of 0.85 in a rising interest rate environment and 0.64 in a declining interest rate environment.

The effective durations are based on observed market value changes, as well as management’s own estimate of the effect of interest rate changes on the fair value of the investments including assumptions regarding prepayments based, in part, on age of and interest rate on the mortgages underlying the MBS, prior exposure to refinancing opportunities, and an overall analysis of historical prepayment patterns under a variety of past interest rate conditions (dollars in thousands, except per share amounts).

 

     Value at
September 30,
2010
     Value at
September 30,
2010 with 100
basis point
increase in
interest rates
     Percent
Change
    Value at
September 30,
2010 with 100
basis point
decrease in
interest rates
     Percent
Change
 

Assets

             

MBS

   $ 383,554       $ 380,294         (0.85 )%    $ 386,009         0.64

Other

     82,067         82,067         —          82,067         —     
                               

Total assets

   $ 465,621       $ 462,361         (0.70 )%    $ 468,076         0.53
                               

Liabilities

             

Repurchase agreements

   $ 164,584       $ 164,584         —        $ 164,584         —     

Derivative liability

     4,597         872         (81.03 )%      8,322         81.03

Other

     105,316         105,316         —          105,316         —     
                               

Total liabilities

     274,497         270,772         (1.36 )%      278,222         1.36

Equity

     191,124         191,589         0.24     189,854         (0.66 )% 
                               

Total liabilities and equity

   $ 465,621       $ 462,361         (0.70 )%    $ 468,076         0.53
                               

Book value per share

   $ 25.02       $ 25.08         0.24   $ 24.86         (0.66 )% 
                               

As shown above, our portfolio of MBS generally will be more adversely affected by a 10% decrease in interest rates than the same scale increase in interest rates.

Equity Price Risk

Although limited, we are exposed to equity price risk as a result of our investments in marketable equity securities and investment partnerships. Equity price risk changes as the volatility of equity prices changes or the values of corresponding equity indices change.

 

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While it is impossible to exactly project what factors may affect the prices of equity sectors and how much the effect might be, the table below illustrates the impact a 10% increase and a 10% decrease in the price of the equities held by us would have on the value of our total assets and our book value as of September 30, 2010 (dollars in thousands, except per share amounts).

 

     Value at
September 30,
2010
     Value of Equity at
September 30, 2010
with 10% Increase
in Price
     Percent
Change
    Value of Equity at
September 30, 2010
with 10% Decrease
in Price
     Percent
Change
 

Assets

             

Equity and cost method investments

   $ 2,105       $ 2,316         10.00   $ 1,894         (10.00 )% 

Other

     463,516         463,516         —          463,516         —     
                               

Total assets

   $ 465,621       $ 465,832         0.05   $ 465,410         (0.05 )% 
                               

Liabilities

   $ 274,497       $ 274,497         —        $ 274,497         —     

Equity

     191,124         191,335         0.11     190,913         (0.11 )% 
                               

Total liabilities and equity

   $ 465,621       $ 465,832         0.05   $ 465,410         (0.05 )% 
                               

Book value per share

   $ 25.02       $ 25.05         0.11   $ 25.00         (0.11 )% 
                               

Except to the extent that we sell our marketable equity securities or other investments, or a decrease in their fair value is deemed to be other-than-temporary, an increase or decrease in the fair value of those assets will not directly affect our earnings; however, an increase or decrease in the value of equity method investments will directly affect our earnings.

 

Item 4. Controls and Procedures

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

As of the end of the period covered by this report on Form 10-Q, our management, with the participation of our Chief Executive Officer, Eric F. Billings, and our Chief Financial Officer, Kurt R. Harrington, carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined under Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) pursuant to Rule 13a-15(b) of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures, as of the end of the period covered by this report on Form 10-Q, are effective to ensure that 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 the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding disclosure.

There has been no change in our internal control over financial reporting during the quarter ended September 30, 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Forward-Looking Statements

This report on Form 10-Q and the information incorporated by reference in this Quarterly Report on Form 10-Q include forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (Securities Act), and Section 21E of the Exchange Act. Some of the forward-looking statements can be identified by the use of forward-looking words such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “plans,” “estimates” or “anticipates” or the negative of those words or other

 

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comparable terminology. Statements concerning projections, future performance developments, events, revenues, expenses, earnings, run rates, and any other guidance on present or future periods constitute forward-looking statements. Such statements include, but are not limited to, those relating to the effects of our current strategy, our principal acquisitions activities, levels of assets under management and our equity capital levels and liquidity. Forward-looking statements involve risks and uncertainties and you should not unduly rely on these statements. You should be aware that a number of important factors could cause our actual results to differ materially from those in the forward-looking statements. These factors include, but are not limited to:

 

   

the revocation of our status as a real estate investment trust for federal income tax purposes effective as of January 1, 2009 and our ability to use net operating losses (NOLs) and net capital losses (NCLs) to reduce our taxable income;

 

   

our ability to forecast our tax attributes, which are based upon various facts and assumptions, and our ability to protect and use our NOLs and NCLs to offset future taxable income and gains, including whether our recently adopted shareholder rights plan will be effective in preventing an ownership change that would significantly limit our ability to utilize such losses;

 

   

the availability and terms of, and our ability to deploy, capital and our ability to grow our business through a strategy focused on acquiring primarily MBS issued by private organizations (private-label MBS), generally on a non-leveraged basis, and MBS that are either issued by a U.S. government agency or guaranteed as to principal and interest by U.S. government agencies or U.S. government sponsored agencies (agency-backed MBS), on a leveraged basis;

 

   

our ability to implement our current strategy;

 

   

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;

 

   

mortgage loan modification programs and future legislative action;

 

   

the overall environment for interest rates, changes in interest rates, interest rate spreads, the yield curve and prepayment rates;

 

   

ability to realize any reflation of our assets;

 

   

current conditions in the residential mortgage market and further adverse developments in that market;

 

   

current economic conditions and further adverse developments in the overall economy;

 

   

potential risk attributable to our mortgage-related or merchant banking portfolios, including changes in fair value;

 

   

our use of leverage and our dependence on repurchase agreements and other short-term borrowings to finance our mortgage-related holdings;

 

   

the availability of certain short-term liquidity;

 

   

changes in our acquisition, hedging and leverage strategies, changes in our asset allocation and changes in our operational policies, all of which may be changed by us without shareholder approval;

 

   

competition for investment opportunities, including competition from the U.S. Treasury for investments in agency-backed MBS;

 

   

our decisions with respect to, and ability to make, future dividends;

 

   

competition for qualified personnel;

 

   

available technologies;

 

   

malfunctioning or failure in our operations and infrastructure;

 

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the effect of government regulation and of general economic conditions on our business;

 

   

fluctuating quarterly operating results;

 

   

our ability to retain key professionals;

 

   

effects of litigation against us, our officers and directors, including the potential settlement and litigation of such claims;

 

   

risk from strategic investments or acquisitions and joint ventures or our entry into new business areas;

 

   

failure to maintain effective internal controls;

 

   

changes in laws and regulations and industry practices that may adversely affect our business;

 

   

the loss of our exclusion from the definition of “investment company” under the Investment Company Act of 1940, as amended;

 

   

volatility of the securities markets; and

 

   

activity in the secondary securities markets.

We will not necessarily update the information presented in this Form 10-Q if any of these forward-looking statements turn out to be inaccurate. For a more detailed discussion of the risks affecting our business, any of which could cause our actual results to differ materially from those in the forward-looking statements, see our Annual Report on Form 10-K for the year ended December 31, 2009, including the section entitled “Risk Factors” in that report, and any other reports or documents we file with the SEC from time to time.

 

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PART II

OTHER INFORMATION

 

Item 1. Legal Proceedings

Related to a shareholder derivative action captioned Kornfeld, et al. v. Billings, et al., No. 08-1144, the parties executed a Stipulation of Settlement dated August 9, 2010, which was filed for approval with the Circuit Court of Arlington County, Virginia. On September 24, 2010, the Circuit Court entered an Order Preliminarily Approving Derivative Settlement and Providing for Notice. A hearing is scheduled for December 10, 2010 on the parties’ request for final approval.

On September 16, 2008, a shareholder derivative action captioned Kornfeld, et al. v. Billings, et al., No. 08-1144, was filed in the Circuit Court of Arlington County, Virginia, by Bill Kornfeld and Edward Lapinski, two purported shareholders of our company. We were named as a nominal defendant along with certain current and former officers and directors as individual defendants. The complaint asserts claims under Virginia law against the individual defendants for breach of fiduciary duty and against certain of the individual defendants for unjust enrichment in connection with certain decisions concerning executive compensation. Our Board of Directors established a special committee to conduct a review and evaluation of the plaintiffs’ allegations and make a final decision concerning whether maintenance of the litigation was in our best interests. The special committee concluded that the litigation was not in our best interests. On December 8, 2008, we moved to dismiss the shareholder derivative action based on the special committee’s recommendation and the individual defendants filed demurrers. On March 5, 2009, the court denied the individual defendants’ demurrers, granted the plaintiffs’ motion for certain discovery and denied our motion to dismiss with leave to renew the motion following discovery. On July 24, 2009, the plaintiffs filed an amended complaint. The amended complaint contains allegations similar to those in the original complaint and adds a cause of action against certain of the individual defendants for waste. On August 14, 2009, we filed an answer to the amended complaint and the individual defendants filed a demurrer to the amended complaint. On January 15, 2010, the parties participated in mediation.

On July 20, 2009, counsel to Bill Kornfeld and Edward Lapinski sent a letter to us demanding that the Board of Directors remedy alleged breaches of fiduciary duty by the directors in connection with the sale of a portion of our FBR Capital Markets stock to FBR Capital Markets on May 20, 2009. The letter alleges that this sale was completed pursuant to an inappropriate process and resulted in an inadequate price. The letter states that the shareholders will file a lawsuit bringing derivative claims if our Board of Directors does not take the demanded action within a reasonable period of time. Our Board of Directors established a special committee of independent directors to conduct a review and evaluation of the allegations in the letter and make a final decision concerning whether maintenance of the claims was in our best interests. The special committee concluded that maintenance of the claims was not in our best interests. Pursuant to the Stipulation of Settlement referenced above, Kornfield and Lapinski have also agreed to release the claims referenced in their July 20, 2009 letter demand.

Based on management’s review with counsel, resolution of these matters is not expected to have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

 

Item 1A. Risk Factors

As of September 30, 2010, there have been no material changes in the Company’s risk factors as previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

 

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Purchases of Equity Securities by the Issuer

The following table provides information on the Company’s share repurchases during the quarter ended September 30, 2010:

 

Period

   Total Number
of Shares
Purchased
     Average
Price Paid
Per Share
     Total Number of Shares
Purchased as Part of
Publicly Announced
Plans or Programs(1)
     Maximum Number of
Shares that May
Yet Be Purchased  Under
the Plans or Programs(1)
 

July 1 to July 31, 2010

     —         $ —           —           —     

August 1 to August 31, 2010

     174,616         19.68         174,616         296,362   

September 1 to September 30, 2010

     19,208         21.28         19,208         277,154   
                             

Total

     193,824       $ 19.84         193,824         277,154   
                                   

 

(1)

Repurchases under the 2010 Repurchase Program may be made from time to time on the open market and in private transactions at management’s discretion in accordance with applicable federal securities laws. The timing of repurchases and the exact number of shares of Class A common stock to be purchased will depend upon market conditions and other factors. The 2010 Repurchase Program will be funded using the Company’s cash on hand and cash generated from operations. The 2010 Repurchase Program has no expiration date and may be suspended or terminated at any time without prior notice.

During the three months ended September 30, 2010, the Company repurchased 193,824 shares of its Class A common stock at an average price of $19.84 per share and a total cost of $3.9 million. During the nine months ended September 30, 2010, the Company repurchased 222,846 shares of its Class A common stock at an average price of $19.71 per share and a total cost of $4.4 million.

 

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Item 6. Exhibits

 

Exhibit
Number

  

Exhibit Title

  3.1      Amended and Restated Articles of Incorporation of the Company, as amended (incorporated by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q filed on November 9, 2009).
  3.2      Bylaws of Company, as amended (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on April 16, 2010).
31.01    Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended, adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.02    Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended, adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.01    Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.02    Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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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.

 

ARLINGTON ASSET INVESTMENT CORP.
By:   /s/    KURT R. HARRINGTON        
  Kurt R. Harrington
 

Executive Vice President, Chief Financial Officer, and

Chief Accounting Officer

(Principal Financial Officer)

Date: November 5, 2010

 

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EXHIBIT INDEX

 

Exhibit
Number

  

Exhibit Title

  3.1      Amended and Restated Articles of Incorporation of the Company, as amended (incorporated by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q filed on November 9, 2009).
  3.2      Bylaws of Company, as amended (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on April 16, 2010).
31.01    Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended, adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.02    Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended, adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.01    Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.02    Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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