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, 2013

OR

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

For the transition period from      to    

Commission File Number: 001-34374

 

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 (Address of Principal Executive Offices)		22209 (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 o

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

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

Large accelerated filer o		Accelerated filer x		Non-accelerated filer o		Smaller reporting company o

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

Number of shares outstanding of each of the registrant’s classes of common stock, as of October 31, 2013:

Title		Outstanding
Class A Common Stock		16,047,965 shares
Class B Common Stock		554,055 shares

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
 
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2013
INDEX

		Page
PART I — FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements and Notes — (unaudited)			1
Consolidated Balance Sheets — September 30, 2013 and December 31, 2012			1
Consolidated Statements of Comprehensive Income — Three and Nine Months Ended September 30, 2013 and 2012			2
Consolidated Statements of Changes in Equity — Nine Months Ended September 30, 2013 and Year Ended December 31, 2012			3
Consolidated Statements of Cash Flows — Nine Months Ended September 30, 2013 and 2012			4
Notes to Consolidated Financial Statements			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			22
Item 3. Quantitative and Qualitative Disclosures about Market Risk			38
Item 4. Controls and Procedures			42
PART II — OTHER INFORMATION
Item 1. Legal Proceedings			45
Item 1A. Risk Factors			45
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			46
Item 3. Defaults Upon Senior Securities			46
Item 4. Mine Safety Disclosures			46
Item 5. Other Information			46
Item 6. Exhibits			47
Signatures			48

TABLE OF CONTENTS

PART I
FINANCIAL INFORMATION

Item 1.  Financial Statements (unaudited)

ARLINGTON ASSET INVESTMENT CORP.
 
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
(Unaudited)

		September 30, 2013				December 31, 2012
ASSETS
Cash and cash equivalents		$	16,347			$	35,837
Receivables
Interest			5,271				4,869
Sold securities receivable			—				26,773
Other			461				644
Mortgage-backed securities, at fair value
Available-for-sale			344,165				199,156
Trading			1,633,263				1,556,440
Other investments			2,180				2,347
Derivative assets, at fair value			1,851				—
Deferred tax assets, net			151,255				162,281
Deposits			63,869				85,652
Prepaid expenses and other assets			1,437				159
Total assets		$	2,220,099			$	2,074,158
LIABILITIES AND EQUITY
Liabilities:
Repurchase agreements		$	1,574,244			$	1,497,191
Interest payable			791				582
Accrued compensation and benefits			4,025				1,542
Dividend payable			14,633				—
Derivative liabilities, at fair value			43,034				76,850
Accounts payable, accrued expenses and other liabilities			13,719				17,837
Long-term debt			40,000				15,000
Total liabilities			1,690,446				1,609,002
Commitments and contingencies			—				—
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, 16,047,965 and 12,560,970 shares issued and outstanding, respectively			160				126
Class B common stock, $0.01 par value, 100,000,000 shares authorized, 554,055 shares issued and outstanding			6				6
Additional paid-in capital			1,726,518				1,638,061
Accumulated other comprehensive income, net of taxes of $7,652 and $429, respectively			49,378				38,985
Accumulated deficit			(1,246,409	)			(1,212,022	)
Total equity			529,653				465,156
Total liabilities and equity		$	2,220,099			$	2,074,158

 
 
See notes to consolidated financial statements.

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
 
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in thousands, except per share data)
(Unaudited)

		Three Months Ended September 30,								Nine Months Ended September 30,
		2013				2012				2013				2012
Interest income		$	22,995			$	15,519			$	64,468			$	44,913
Interest expense
Interest on short-term debt			1,758				1,125				5,061				2,811
Interest on long-term debt			556				123				1,077				371
Total interest expense			2,314				1,248				6,138				3,182
Net interest income			20,681				14,271				58,330				41,731
Other loss, net
Investment loss, net			(11,100	)			(5,663	)			(35,882	)			(11,532	)
Other loss			(3	)			(3	)			(11	)			(11	)
Total other loss, net			(11,103	)			(5,666	)			(35,893	)			(11,543	)
Operating income before other expenses			9,578				8,605				22,437				30,188
Other expenses
Compensation and benefits			3,042				3,519				8,034				7,580
Professional services			297				862				1,973				3,337
Business development			45				39				107				111
Occupancy and equipment			96				110				328				355
Communications			49				49				142				154
Other operating expenses			501				453				1,142				1,351
Total other expenses			4,030				5,032				11,726				12,888
Income before income taxes			5,548				3,573				10,711				17,300
Income tax provision			2,455				450				1,247				1,271
Net income		$	3,093			$	3,123			$	9,464			$	16,029
Basic earnings per share		$	0.19			$	0.31			$	0.60			$	1.74
Diluted earnings per share		$	0.18			$	0.31			$	0.59			$	1.74
Dividends declared per share		$	0.875			$	0.875			$	2.625			$	2.625
Weighted-average shares outstanding (in thousands)
Basic			16,669				9,977				15,761				9,192
Diluted			16,845				10,041				15,934				9,219
Other comprehensive income, net of taxes
Unrealized gains (losses) for the period on available-for-sale securities (net of taxes of $1,471, $-0-, $9,863, and $-0-, respectively)		$	2,116			$	(3,903	)		$	14,192			$	(12,994	)
Reclassification
Included in investment loss, net, in the statement of comprehensive income related to sales of available-for-sale securities (net of taxes of $1,654, $-0-, $3,161, and $-0-, respectively)			(2,380	)			—				(4,548	)			—
Included in investment loss, net, in the statement of comprehensive income related to other-than-temporary impairment charges on available-for-sale securities (net of taxes of $156, $-0-, $521, and $-0-, respectively)			224				6,900				749				11,431
Comprehensive income		$	3,053			$	6,120			$	19,857			$	14,466

 
 
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				Accumulated Deficit				Total
Balances, December 31, 2011			7,099,336			$	71				566,112			$	6			$	1,508,713			$	38,367			$	(1,363,785	)		$	183,372
Net income			—				—				—				—				—				—				191,826				191,826
Conversion of Class B shares to Class A shares			12,057				—				(12,057	)			—				—				—				—				—
Issuance of Class A common stock			5,493,750				55				—				—				129,194				—				—				129,249
Repurchase of Class A common stock			(41,790	)			—				—				—				(786	)			—				—				(786	)
Forfeitures of Class A common stock			(2,383	)			—				—				—				(55	)			—				—				(55	)
Amortization of Class A common shares issued as stock-based awards			—				—				—				—				995				—				—				995
Other comprehensive income
Net change in unrealized gain on available-for-sale investment securities, (net of taxes of $429)			—				—				—				—				—				618				—				618
Dividends declared			—				—				—				—				—				—				(40,063	)			(40,063	)
Balances, December 31, 2012			12,560,970				126				554,055				6				1,638,061				38,985				(1,212,022	)			465,156
Net income			—				—				—				—				—				—				9,464				9,464
Issuance of Class A common stock			3,492,667				34				—				—				86,930				—				—				86,964
Forfeitures of Class A common stock			(5,672	)			—				—				—				(142	)			—				—				(142	)
Amortization of Class A common shares issued as stock-based awards			—				—				—				—				1,669				—				—				1,669
Other comprehensive income
Net change in unrealized gain on available-for-sale investment securities, (net of taxes of $7,223)			—				—				—				—				—				10,393				—				10,393
Dividends declared			—				—				—				—				—				—				(43,851	)			(43,851	)
Balances, September 30, 2013			16,047,965			$	160				554,055			$	6			$	1,726,518			$	49,378			$	(1,246,409	)		$	529,653

 
 
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,
		2013				2012
Cash flows from operating activities:
Net income		$	9,464			$	16,029
Adjustments to reconcile net income to net cash provided by operating activities
Net investment loss, net			35,882				11,532
Net discount accretion on mortgage-backed securities			(6,332	)			(7,912	)
Deferred tax provision			3,803				—
Other			1,581				614
Changes in operating assets
Interest receivable			(402	)			(611	)
Other receivables			183				(491	)
Prepaid expenses and other assets			(1,156	)			(160	)
Changes in operating liabilities
Accounts payable and other liabilities			(3,955	)			451
Accrued compensation and benefits			2,483				(1,224	)
Net cash provided by operating activities			41,551				18,228
Cash flows from investing activities:
Purchases of available-for-sale mortgage-backed securities			(167,682	)			(22,681	)
Purchases of trading mortgage-backed securities			(1,139,008	)			(602,264	)
Proceeds from sales of available-for-sale mortgage-backed securities			54,884				985
Proceeds from sales of trading mortgage-backed securities			837,013				288,950
Receipt of principal payments on available-for-sale mortgage-backed securities			4,124				4,813
Receipt of principal payments on trading mortgage-backed securities			132,478				52,702
Payments for purchased securities payable			—				(15,820	)
Proceeds from sold securities receivable			26,773				41,321
Proceeds (payments) from derivatives and deposits, net			31,527				(26,926	)
Other			15				1,636
Net cash used in investing activities			(219,876	)			(277,284	)
Cash flows from financing activities:
Proceeds from repurchase agreements, net			77,053				219,079
Proceeds from stock issuance, net			86,964				129,367
Proceeds from long-term debt issuance, net			24,038				—
Dividends paid			(29,220	)			(23,670	)
Net cash provided by financing activities			158,835				324,776
Net (decrease) increase in cash and cash equivalents			(19,490	)			65,720
Cash and cash equivalents, beginning of period			35,837				20,018
Cash and cash equivalents, end of period		$	16,347			$	85,738
Supplemental cash flow information
Cash payments for interest		$	5,474			$	3,284
Cash payments for taxes		$	452			$	545

 
 
See notes to consolidated financial statements.

TABLE OF CONTENTS

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) 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, 2013 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, 2012.

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 accounting principles related to fair value measurements define 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. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures (ASC 820), establishes a fair value hierarchy that prioritizes the inputs to valuation 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:

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

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

Mortgage-backed securities (MBS), at fair value — 

Agency-backed MBS — The Company’s agency-backed MBS, the principal and interest payments on which are guaranteed by the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac), 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 or specialists with expertise in the valuation of these financial instruments.

Private-label MBS — The Company classifies private-label MBS within Level 3 of the fair value hierarchy because they trade infrequently and, therefore, have little or no price transparency. 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. The significant inputs in the Company’s valuation process include default rate, loss severity, prepayment rate and discount rate. In general, significant increases (decreases) in default rate, loss severity or discount rate, in isolation, would result in a significantly lower (higher) fair value measurement. However, significant increases (decreases) in prepayment rate may result in a significantly higher (lower) fair value measurement. It is difficult to generalize the interrelationships between these significant inputs as the actual results could differ considerably on an individual security basis. For example, an increase in the default rate may not increase the loss severity rate if actual losses are lower than the average. Also, changes in discount rates may be greatly influenced by market expectation at any given point based upon many variables not directly related to the MBS market. Therefore, each significant input is closely analyzed to ascertain the reasonableness for the Company’s valuation purposes.

Establishing fair value is inherently subjective given the volatile and sometimes illiquid markets for these private-label 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 cash flows and credit losses. The assumptions the Company applies are specific to each security. Although the Company relies on the internal calculations to compute the fair value of these private-label MBS, the Company requests and considers indications of value (mark) from third-party dealers and the actual sales of private-label MBS to assist in the valuation process and calibrate our model.

Other investments — The Company’s other investments, which is classified within Level 3 of the fair value hierarchy, consists of investments in equity securities, investment funds, interest-only MBS, and other MBS-related securities.

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 ASC 815, Derivatives and Hedging (ASC 815). The derivative instruments that trade in active markets or exchanges are classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices. Other derivative instruments 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.

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

Other — Cash and cash equivalents, interest receivable, deposits, other receivable, interest payable, 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, and classified within Level 1 of the fair value hierarchy except for certain cash equivalents that are held in money market funds, which is classified within Level 2 of the fair value hierarchy.

           — Sold securities receivable, repurchase agreements and purchased securities payable are reflected in the consolidated balance sheets at the cost basis, which approximates fair value because of the short term nature of these instruments, and classified within Level 2 of the fair value hierarchy.

           — Long-term debt represents remaining balances of trust preferred debt and senior debt issued by the Company. Trust preferred debt is classified within Level 3 of the fair value hierarchy and senior debt, which is publicly traded on New York Stock Exchange, is classified within Level 1 of the fair value hierarchy.

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

		September 30, 2013								December 31, 2012
		Carrying Amount				Estimated Fair Value				Carrying Amount				Estimated Fair Value
Financial assets
Cash and cash equivalents		$	16,347			$	16,347			$	35,837			$	35,837
Interest receivable			5,271				5,271				4,869				4,869
Sold securities receivable			—				—				26,773				26,773
Other receivables			461				461				644				644
MBS
Agency-backed MBS			1,633,310				1,633,310				1,556,510				1,556,510
Private-label MBS
Senior securities			7,037				7,037				7,519				7,519
Re-REMIC securities			337,081				337,081				191,567				191,567
Derivative assets			1,851				1,851				—				—
Other investments			2,180				2,180				2,347				2,347
Deposits			63,869				63,869				85,652				85,652
Financial liabilities
Repurchase agreements			1,574,244				1,574,244				1,497,191				1,497,191
Interest payable			791				791				582				582
Long-term debt			40,000				37,250				15,000				15,000
Derivative liabilities			43,034				43,034				76,850				76,850
Accounts payable, accrued expenses and other liabilities			13,719				13,719				17,837				17,837

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ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

Fair Value Hierarchy

The following tables set forth financial instruments accounted for under ASC 820 by level within the fair value hierarchy as of September 30, 2013 and December 31, 2012. As required by ASC 820, 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, 2013
		Total				Level 1				Level 2				Level 3
MBS, at fair value
Trading
Agency-backed MBS		$	1,633,263			$	—			$	1,633,263			$	—
Available-for-sale
Agency-backed MBS			47				—				47				—
Private-label MBS
Senior securities			7,037				—				—				7,037
Re-REMIC securities			337,081				—				—				337,081
Total available-for-sale			344,165				—				47				344,118
Total MBS			1,977,428				—				1,633,310				344,118
Derivative assets, at fair value			1,851				1,667				184				—
Derivative liabilities, at fair value			(43,034	)			(43,034	)			—				—
Interest-only MBS, at fair value			349				—				—				349
Total		$	1,936,594			$	(41,367	)		$	1,633,494			$	344,467

		December 31, 2012
		Total				Level 1				Level 2				Level 3
MBS, at fair value
Trading
Agency-backed MBS		$	1,556,440			$	—			$	1,556,440			$	—
Available-for-sale
Agency-backed MBS			70				—				70				—
Private-label MBS
Senior securities			7,519				—				—				7,519
Re-REMIC securities			191,567				—				—				191,567
Total available-for-sale			199,156				—				70				199,086
Total MBS			1,755,596				—				1,556,510				199,086
Derivative liabilities, at fair value			(76,850	)			(76,850	)			—				—
Interest-only MBS, at fair value			478				—				—				478
Total		$	1,679,224			$	(76,850	)		$	1,556,510			$	199,564

The total financial assets measured and reported at fair value on a recurring basis and classified within Level 3 were $344,467, or 15.52%, and $199,564, or 9.62%, of the Company’s total assets as of September 30, 2013 and December 31, 2012, respectively.

There were no transfers of securities in or out of Levels 1, 2 or 3 during the three and nine months ended September 30, 2013 or the year ended December 31, 2012.

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

Level 3 Financial Assets and Liabilities

Financial Instruments Measured at Fair Value on a Recurring Basis

The fair value of the Company’s Level 3, available-for-sale, private-label MBS was $344,118 and $199,086 as of September 30, 2013 and December 31, 2012, respectively. 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 represent interests in re-securitizations of senior MBS and pro-rata mezzanine securities. For re-REMIC securities, the cash flows from, and any credit losses absorbed by, the underlying MBS 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 MBS are typically allocated concurrently and proportionally to the mezzanine securities along with senior securities. The re-REMIC subordinated and mezzanine securities absorb credit losses, if any, first; 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.

The Company’s senior securities and re-REMIC securities were collateralized by residential Prime and Alt-A mortgage loans and had the following weighted-averages, based on face value, as of the dates indicated:

		September 30, 2013				December 31, 2012
Original loan-to-value			70	%			70	%
Original FICO score			726				730
Three-month prepayment rate			18	%			17	%
Three-month loss severities			41	%			46	%
Weighted average coupon			3.44	%			4.40	%

The significant unobservable inputs for the valuation model include the following weighted-averages, based on face value, as of the dates indicated:

		September 30, 2013								December 31, 2012
		Senior Securities				Re-REMIC Securities				Senior Securities				Re-REMIC Securities
Discount rate			6.00	%			6.71	%			6.50	%			7.43	%
Default rate			9.30	%			3.87	%			9.30	%			5.00	%
Loss severity rate			55.00	%			45.27	%			60.00	%			46.60	%
Prepayment rate			16.30	%			11.78	%			16.30	%			13.75	%

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

The ranges of the significant unobservable inputs for the valuation model were as follows as of the dates indicated:

		September 30, 2013								December 31, 2012
		Senior Securities				Re-REMIC Securities				Senior Securities				Re-REMIC Securities
Discount rate			6.00	%			6.00 – 10.00	%			6.50	%			6.50 – 13.25	%
Default rate			9.30	%			0.95 – 9.45	%			9.30	%			0.95 – 11.10	%
Loss severity rate			55.00	%			28.36 – 57.50	%			60.00	%			28.26 – 57.50	%
Prepayment rate			16.30	%			6.35 – 19.55	%			16.30	%			6.95 – 20.40	%

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, 2013 and 2012.

		Three Months Ended September 30, 2013
		Senior Securities				Re-REMIC Securities				Total
Beginning balance, July 1, 2013		$	7,246			$	321,674			$	328,920
Total net gains (losses)
Included in earnings			—				4,509				4,509
Included in other comprehensive income			(117	)			72				(45	)
Purchases			—				36,479				36,479
Sales			—				(27,086	)			(27,086	)
Payments, net			(313	)			(5,446	)			(5,759	)
Accretion of discount			221				6,879				7,100
Ending balance, September 30, 2013		$	7,037			$	337,081			$	344,118
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		$	—			$	(380	)		$	(380	)

		Three Months Ended September 30, 2012
		Senior Securities				Re-REMIC Securities				Total
Beginning balance, July 1, 2012		$	8,498			$	164,450			$	172,948
Total net gains (losses)
Included in earnings			(1,914	)			(4,937	)			(6,851	)
Included in other comprehensive income			1,423				1,628				3,051
Purchases			—				26,686				26,686
Sales			—				(985	)			(985	)
Payments, net			(342	)			(4,476	)			(4,818	)
Accretion of discount			352				5,574				5,926
Ending balance, September 30, 2012		$	8,017			$	187,940			$	195,957
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		$	(1,914	)		$	(4,986	)		$	(6,900	)

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ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

		Nine Months Ended September 30, 2013
		Senior Securities				Re-REMIC Securities				Total
Beginning balance, January 1, 2013		$	7,519			$	191,567			$	199,086
Total net gains (losses)
Included in earnings			—				12,299				12,299
Included in other comprehensive income			(204	)			17,875				17,671
Purchases			—				167,682				167,682
Sales			—				(54,884	)			(54,884	)
Payments, net			(950	)			(16,205	)			(17,155	)
Accretion of discount			672				18,747				19,419
Ending balance, September 30, 2013		$	7,037			$	337,081			$	344,118
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		$	—			$	(1,270	)		$	(1,270	)

		Nine Months Ended September 30, 2012
		Senior Securities				Re-REMIC Securities				Total
Beginning balance, January 1, 2012		$	9,311			$	170,116			$	179,427
Total net gains (losses)
Included in earnings			(1,914	)			(9,468	)			(11,382	)
Included in other comprehensive income			742				(2,145	)			(1,403	)
Purchases			—				27,156				27,156
Sales			—				(985	)			(985	)
Payments, net			(1,181	)			(14,291	)			(15,472	)
Accretion of discount			1,059				17,557				18,616
Ending balance, September 30, 2012		$	8,017			$	187,940			$	195,957
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		$	(1,914	)		$	(9,517	)		$	(11,431	)

Gains and losses included in earnings for the three and nine months ended September 30, 2013 and 2012 are reported in the following statement of comprehensive income line descriptions:

		Other Loss, Investment Loss, net
		Three Months Ended September 30,								Nine Months Ended September 30,
		2013				2012				2013				2012
Total gains (losses) included in earnings for the period		$	4,509			$	(6,851	)		$	12,299			$	(11,382	)
Change in unrealized gains (losses) relating to assets still held at reporting date		$	(380	)		$	(6,900	)		$	(1,270	)		$	(11,431	)

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

Level 3 Financial Instruments Measured at Fair Value on a Non-Recurring Basis

The Company also measures certain financial assets 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 impairments. 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. As of September 30, 2013 and December 31, 2012, these financial assets are classified within the other investments category, represent the Company’s interest in non-public equity securities and investment funds and are valued at $1,831 and $1,869, respectively. For the nine months ended September 30, 2013, the Company recorded losses of $138, respectively, in the carrying value of these financial assets. For the three and nine months ended September 30, 2012, the Company recorded losses of $64 in the carrying value of these financial assets. For the three months ended September 30, 2013, there were no changes to the carrying value of these financial assets.

MBS, at Fair Value

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

		September 30, 2013																				December 31, 2012
		Fair Value				Net Unamortized Premium (Discount)				Percent of Total Fair Value				Weighted Average Life				Weighted Average Rating(3)				Fair Value				Net Unamortized Premium (Discount)				Percent of Total Fair Value				Weighted Average Life				Weighted Average Rating(3)
Trading
Fannie Mae		$	1,046,994			$	—				52.95	%			9.4				AAA			$	1,083,810			$	—				61.73	%			4.9				AAA
Freddie Mac			586,269				—				29.65	%			9.4				AAA				472,630				—				26.92	%			5.1				AAA
Available-for-sale:
Agency-backed
Fannie Mae			47				—				—				5.0				AAA				70				—				0.01	%			2.8				AAA
Private-label
Senior securities			7,037				(5,247	)			0.35	%			4.9				C-				7,519				(6,519	)			0.43	%			5.2				C
Re-REMIC securities			337,081				(219,520	)			17.05	%			11.7				NR				191,567				(164,422	)			10.91	%			11.4				NR
		$	1,977,428			$	(224,767	)			100.00	%										$	1,755,596			$	(170,941	)			100.00	%

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ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

The Company has generally purchased private-label MBS at a discount. The Company, at least on a quarterly basis, estimates the future expected cash flows based on the Company’s observation of current information and events and applies a number of assumptions related to prepayment rates, interest rates, default rates, loss severity rates, and the timing and amount of cash flows and 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.

Interest income on the private-label MBS that were purchased at a discount to face value is recognized based on the security’s expected effective interest rate. At acquisition, the accretable yield is calculated as the difference between the undiscounted expected cash flows and the purchase price which is expected to be accreted into interest income over the remaining life of the security on a level-yield basis. The difference between the contractually required payments and the undiscounted expected cash flows represents the non-accretable difference. Based on actual payment activities and changes in estimates of undiscounted expected future cash flows, the accretable yield and the non-accretable difference can change over time. Significant increases in the amount or timing of undiscounted expected future cash flows are recognized prospectively as an adjustment to the accretable yield.

The following table presents the changes in the accretable yield on available-for-sale, private-label MBS for the three and nine months ended September 30, 2013 and 2012:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2013				2012				2013				2012
Beginning balance		$	317,695			$	180,201			$	207,853			$	194,619
Accretion of discount			(7,099	)			(5,926	)			(19,418	)			(18,617	)
Reclassifications, net			18,639				1,746				51,248				(1,731	)
Acquisitions			36,901				38,721				150,646				40,471
Sales			(27,372	)			(92	)			(51,565	)			(92	)
Ending balance		$	338,764			$	214,650			$	338,764			$	214,650

For the available-for-sale, private-label MBS acquired during the three and nine months ended September 30, 2013 and 2012, the contractually required payments receivable, the cash flow expected to be collected, and the fair value at the acquisition date were as follows for the dates indicated:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2013				2012				2013				2012
Contractually required payments receivable		$	87,640			$	95,073			$	420,500			$	97,292
Cash flows expected to be collected			73,380				65,341				318,328				67,560
Basis in acquired securities			36,479				26,620				167,682				27,089

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ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

The Company’s available-for-sale MBS are carried at fair value in accordance with ASC 320, Debt and Equity Securities (ASC 320), 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, 2013
		Amortized Cost/ Cost Basis(1)				Unrealized
						Gains				Losses				Fair Value
Agency-backed MBS		$	43			$	4			$	—			$	47
Private-label MBS
Senior securities			5,332				1,705				—				7,037
Re-REMIC securities			281,707				55,480				(106	)			337,081
Total		$	287,082			$	57,189			$	(106	)		$	344,165

		December 31, 2012
		Amortized Cost/ Cost Basis(1)				Unrealized
						Gains				Losses				Fair Value
Agency-backed MBS		$	64			$	6			$	—			$	70
Private-label MBS
Senior securities			5,611				1,908				—				7,519
Re-REMIC securities			154,067				37,500				—				191,567
Total		$	159,742			$	39,414			$	—			$	199,156

For the three and nine months ended September 30, 2013, the Company recorded other-than-temporary impairment charges of $380 and $1,270, respectively, as a component of investment loss, net on the consolidated statements of comprehensive income related to deterioration in credit quality on available-for-sale, private-label MBS with a cost basis of $10,104 and $11,688, respectively, prior to recognizing the other-than-temporary impairment charges. For the three and nine months ended September 30, 2012, the Company recorded other-than-temporary impairment charges of $6,900 and $11,431, respectively, as a component of investment loss, net, on the consolidated statements of comprehensive income related to deterioration in credit quality on available-for-sale, private-label MBS with a cost basis on $24,044 and $36,076, respectively, prior to recognizing the other-than-temporary impairment charges.

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

The following table presents a summary of other-than-temporary impairment charges included in earnings for the periods indicated and cumulative other-than-temporary impairment charges recognized on the MBS held as of the dates indicated:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2013				2012				2013				2012
Cumulative other-than-temporary impairment, beginning balance		$	23,283			$	13,125			$	23,768			$	8,594
Additions
Other-than-temporary impairments not previously recognized			380				6,533				380				10,792
Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments			—				367				890				639
Reductions
Decreases related to other-than-temporary impairments on sold securities with previously recognized other-than-temporary impairments			—				—				(1,375	)			—
Cumulative other-than-temporary impairment, ending balance		$	23,663			$	20,025			$	23,663			$	20,025

The following table presents the results of sales of MBS for the periods indicated:

		Three Months Ended September 30,																Nine Months Ended September 30,
		2013								2012								2013								2012
		Agency- Backed MBS				Private- Label MBS				Agency- Backed MBS				Private- Label MBS				Agency- Backed MBS				Private- Label MBS				Agency- Backed MBS				Private- Label MBS
Proceeds from sales		$	309,518			$	27,085			$	189,095			$	985			$	837,257			$	54,884			$	301,223			$	985
Gross gains			238				4,778				1,624				49				531				13,267				4,041				49
Gross losses			4,118				—				106				—				26,469				—				251				—

Other Investments

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

		September 30, 2013				December 31, 2012
Interest-only MBS		$	349			$	478
Non-public equity securities			975				975
Investment funds			856				894
Total other investments		$	2,180			$	2,347

3. Borrowings:

Repurchase Agreements

The Company has entered into repurchase agreements to fund its investments in MBS. Securities sold under agreements to repurchase, which are treated as financing transactions for financial reporting purposes, are collateralized by MBS and are carried at their contractual amounts, including accrued interest, as specified in the respective agreements. Under the repurchase agreements, the Company pledges its securities as

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ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

3. Borrowings:  – (continued)

collateral to secure the borrowing, which is equal in value to a specified percentage of the fair value of the pledged collateral, while the Company retains beneficial ownership of the pledged collateral. The counterparty to the repurchase agreements may require that the Company pledge additional securities or cash as additional collateral to secure borrowings when the value of the collateral declines.

As of September 30, 2013, the Company had no amount at risk with a single repurchase agreement counterparty or lender greater than 10% of equity. As of December 31, 2012, the amount at risk related to $482,097 of repurchase agreements with Credit Suisse Securities (USA) LLC was $50,171, or 10.79%, of the Company’s equity with a weighted-average maturity of 15 days. The amount at risk is defined as the excess of the higher of carrying amount or market value of the collateral provided under repurchase agreements, including any cash or other assets on deposit to secure the repurchase obligation, over the amount of the repurchase liability. The following tables provide information regarding the Company’s outstanding repurchase agreement borrowings as of the dates and for the periods indicated:

		September 30, 2013				December 31, 2012
Outstanding balance		$	1,574,244			$	1,497,191
Value of assets pledged as collateral
Agency-backed MBS			1,618,029				1,547,760
Private-label MBS			130,137				67,661
Net amount(1)			173,922				118,230
Weighted-average rate			0.44	%			0.52	%
Weighted-average term to maturity			10.9 days				14.5 days

		September 30, 2013				September 30, 2012
Weighted-average outstanding balance during the three months ended		$	1,581,663			$	926,746
Weighted-average rate during the three months ended			0.44	%			0.48	%
Weighted-average outstanding balance during the nine months ended		$	1,504,878			$	821,625
Weighted-average rate during the nine months ended			0.44	%			0.45	%

Long-Term Debt

As of September 30, 2013 and December 31, 2012, the Company had $40,000 and $15,000, respectively, of outstanding long-term debentures. On May 1, 2013, the Company completed a public offering of $25,000 of its 6.625% Senior Notes due in 2023 and received net proceeds of $24,038 after payment of underwriting discounts and commissions and expenses. These Senior Notes will mature on May 1, 2023, and may be redeemed in whole or in part at any time and from time to time at the Company’s option on or after May 1, 2016, at a redemption price equal to the principal amount redeemed plus accrued and unpaid interest. The interest payments on these Senior Notes are payable quarterly on February 1, May 1, August 1, and November 1 of each year, beginning on August 1, 2013. These Senior Notes are publicly traded on the New York Stock Exchange under the ticker symbol “AIW”. The Company’s long-term debentures consisted of the following as of the dates indicated:

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ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

3. Borrowings:  – (continued)

		September 30, 2013								December 31, 2012
		Senior Notes				Trust Preferred Debt				Senior Notes				Trust Preferred Debt
Outstanding Principal		$	25,000			$	15,000			$	—			$	15,000
Annual Interest Rate			6.625	%			LIBOR+2.25 -3.00%				—				LIBOR+2.25 -3.00%
Interest Payment Frequency			Quarterly				Quarterly				—				Quarterly
Weighted-Average Interest Rate			6.625	%			3.02	%			—				3.09	%
Maturity			May 1, 2023				2033 - 2035				—				2033 - 2035
Early Redemption Date			May 1, 2016				2008 - 2010				—				2008 - 2010

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 ASC 815. These instruments may include interest rate swaps, Eurodollar futures, swap futures, and U.S. Treasury futures contracts, put options and certain commitments to purchase and sell MBS. The exchange traded derivatives such as Eurodollar futures and swap futures are cash settled on a daily basis. The Company may be required to pledge collateral for margin requirements with third-party custodians in connection with certain derivative transactions. These transactions are not under master netting agreements.

During the three and nine months ended September 30, 2013, the Company entered into various financial contracts to hedge certain MBS and related borrowings and other long-term debt. These financial contracts are not designated as hedges under ASC 815. The changes in fair value on these derivatives are recorded to net investment gain or loss in the statement of comprehensive income. For the three and nine months ended September 30, 2013, the Company recorded net (losses) gains of $(14,457) and $44,577, respectively, on these derivatives. For the three and nine months ended September 30, 2012, the Company recorded net losses of $10,972 and $27,966, respectively, on these derivatives. The Company held the following derivative instruments as of the dates indicated:

		September 30, 2013								December 31, 2012
		Notional Amount				Fair Value				Notional Amount				Fair Value
No hedge designation
Eurodollar futures
Derivative assets		$	1,883,000			$	1,667			$	—			$	—
Derivative liabilities			14,350,000				(41,440	)			17,525,000				(76,850	)
Total Eurodollar futures(1)			16,233,000				(39,773	)			17,525,000				(76,850	)
10-year swap futures(2)			640,000				(1,500	)			—				—
10-year U.S. Treasury note futures(3)			12,000				(56	)			—				—
5-year U.S. Treasury note futures(4)			10,000				(38	)			—				—
Commitment to purchase MBS(5)			25,000				184				—				—

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

4. Derivative Financial Instruments and Hedging Activities:  – (continued)

5. Income Taxes:

The total income tax provision for the three and nine months ended September 30, 2013 was $2,455 and $1,247, respectively. The total income tax provision for the three and nine months ended September 30, 2012 was $450 and $1,271, respectively.

The Company’s effective tax rate for the nine months ended September 30, 2013 and 2012 was 11.64% and 7.35%, respectively. The effective tax rate during the nine months ended September 30, 2013 was lower than the statutory tax rate due to the realization of previously unrecognized tax benefits, including related accrued interest, that were fully reserved. The effective tax rate during the nine months ended September 30, 2012 was lower than the statutory tax rate due to the realization of deferred tax assets that were offset by a full valuation allowance. The Company will continue to provide a valuation allowance against the portion of the capital loss carryforwards which the Company believes that it is more likely than not that the benefits will not be realized prior to expiration. The Company will continue to assess the need for a valuation allowance at each reporting date.

The Company is subject to examination by the U.S. Internal Revenue Service (IRS) and other taxing jurisdictions. In March 2013, an IRS examination of the Company’s tax years 2009 and 2010 was completed without any adjustment. As a result, the Company reversed $3,200 of unrecognized federal tax benefit related to an uncertain tax position and $544 of related accrued interest as of March 31, 2013. The Company believes that the statute of limitation on the 2009 state tax return expired as of October 15, 2013. As a result, during the quarter ending December 31, 2013, the Company expects to reverse $9,600 of unrecognized state tax benefit related to an uncertain tax position and $2,867 of related accrued interest.

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ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

6. Earnings Per Share:

Basic earnings per share includes no dilution and is computed by dividing net income or loss applicable to common stock by the weighted-average number of common shares outstanding for the respective period. Diluted earnings per share includes the impact of dilutive securities such as stock options, unvested shares of restricted stock, and performance share units. The following tables present the computations of basic and diluted earnings per share for the periods indicated:

(Shares in thousands)		Three Months Ended September 30,
		2013								2012
		Basic				Diluted				Basic				Diluted
Weighted-average shares outstanding
Common stock			16,669				16,669				9,977				9,977
Stock options, performance share units, and unvested restricted stock			—				176				—				64
Weighted-average common and common equivalent shares outstanding			16,669				16,845				9,977				10,041
Net income applicable to common stock		$	3,093			$	3,093			$	3,123			$	3,123
Net income per common share		$	0.19			$	0.18			$	0.31			$	0.31

(Shares in thousands)		Nine Months Ended September 30,
		2013								2012
		Basic				Diluted				Basic				Diluted
Weighted-average shares outstanding
Common stock			15,761				15,761				9,192				9,192
Stock options, performance share units, and unvested restricted stock			—				173				—				27
Weighted-average common and common equivalent shares outstanding			15,761				15,934				9,192				9,219
Net income applicable to common stock		$	9,464			$	9,464			$	16,029			$	16,029
Net income per common share		$	0.60			$	0.59			$	1.74			$	1.74

The diluted earnings per share for the three and nine months ended September 30, 2013 did not include the antidilutive effect of 43,598 and 23,796 shares, respectively, of stock options, unvested shares of restricted stock, and performance share units. The diluted earnings per share for the three and nine months ended September 30, 2012 did not include the antidilutive effect of 10,364 and 29,786 shares, respectively, of stock options, unvested shares of restricted stock, and performance share units.

7. Equity:

Equity Offering

During the nine months ended September 30, 2013, the Company completed a public offering of its Class A Common Stock as follows:

Closing date of the offering			March 13, 2013
Shares sold to public			3,000,000
Shares sold pursuant to the underwriter over-allotment			450,000
Total shares of Class A common stock			3,450,000
Public offering price per share		$	25.50
Net proceeds(1)		$	86,964

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ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

7. Equity:  – (continued)

Dividends

Pursuant to the Company’s variable dividend policy, the Board of Directors evaluates dividends on a quarterly basis and, in its sole discretion, approves the payment of dividends. The Company’s dividend payments, if any, may vary significantly from quarter to quarter. The Board of Directors has approved and the Company has declared the following dividends to date in 2013:

Quarter Ended

Dividend Amount

Declaration Date

Record Date

Pay Date

September 30

$

0.875

September 18

September 30

October 31

June 30

0.875

June 17

June 28

July 31

March 31

0.875

March 15

March 28

April 30

The Board of Directors approved and the Company declared and paid the following dividends for 2012:

Quarter Ended

Dividend Amount

Declaration Date

Record Date

Pay Date

December 31

$

0.875

December 5

December 17

December 31

September 30

0.875

September 13

September 28

October 31

June 30

0.875

June 15

June 29

July 31

March 31

0.875

March 16

March 26

April 30

Long-Term Incentive Plan

On April 13, 2011, the Board of Directors adopted the Arlington Asset Investment Corp. 2011 Long-Term Incentive Plan (2011 Plan). The 2011 Plan was approved by the Company’s shareholders and became effective on June 2, 2011. Under the 2011 Plan, shares of Class A common stock of the Company may be issued to employees, directors, consultants and advisors of the Company and its affiliates. As of September 30, 2013 and December 31, 2012, 443,504 and 489,448 shares, respectively, remained available for issuance under the 2011 Plan.

Performance-Based Long-Term Incentive Program

On August 13, 2012, the Compensation Committee of the Board of Directors of the Company adopted a performance-based long-term incentive program (Performance-based Program) that provides for the issuance of two types of performance share units (PSUs) pursuant to the Company’s 2011 Plan.

The Compensation Committee established performance goals under the Performance-based Program. Two types of PSUs may be awarded under the Performance-based Program: Book Value PSUs and Total Shareholder Return Units (TSR PSUs). The Book Value PSUs are eligible to vest based on the compound annualized growth in the Company’s book value per share (i.e., book value change plus dividends on a reinvested basis) during the applicable performance period. The TSR PSUs are eligible to vest based on the Company’s compound annualized total shareholder return (i.e., share price change plus dividends on a reinvested basis) during the applicable performance period.

On July 1, 2013, the Company granted an aggregate of 34,221 Book Value PSUs and 34,567 TSR PSUs to the participants in the Performance-based Program (2013 PSU Grants). For the 2013 PSU grants, the Compensation Committee awarded PSUs with an aggregate grant date fair value equal to 100% of the awardee’s base salary, with 50% of the total grant date fair value represented by Book Value PSUs and 50% of the total grant date fair value represented by TSR PSUs. The 2013 PSU Grants have a three-year performance period.

The actual number of shares of Class A common stock that will be issued to each participant at the end of the applicable performance period will vary between 0% and 250% of the number of PSUs granted, depending on performance results. If the threshold level of performance goals are not achieved, no PSUs are

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ARLINGTON ASSET INVESTMENT CORP.
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

7. Equity:  – (continued)

earned. Participants will earn 50% of the granted PSUs for Company performance at the threshold level, 100% of the granted PSUs for Company performance at the target level and 250% of the granted PSUs for Company performance at the maximum level, with linear interpolation for achievement falling between the performance levels.

The Company recorded $398 and $915, in compensation expenses related to the Performance-based Program during the three and nine months ended September 30, 2013, respectively. The Company recorded $96 in compensation expenses related to the Performance-based Program during the three and nine months ended September 30, 2012.

Restricted Stock

The following tables present the activities and balances related to restricted stock for the dates and periods indicated:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2013				2012				2013				2012
Shares granted			—				25,500				36,000				25,500
Weight-average share price		$	—			$	22.99			$	26.74			$	22.99
Compensation expense recognized during the period		$	223			$	75			$	432			$	161

		September 30, 2013				December 31, 2012
Restricted Class A shares outstanding, unvested			57,673				34,835
Unrecognized compensation cost related to unvested shares			$1,038				$507
Weighted-average vesting period remaining			2.30 years				2.22 years

8. Recent Accounting Pronouncements:

On July 18, 2013, the FASB issued Accounting Standards Update 2013-11, Income Taxes (Topic 740), Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. This standard requires the netting of unrecognized tax benefits against a deferred tax asset for a loss or other carryforward that would apply in settlement of the uncertain tax positions. Under the new standard, unrecognized tax benefits will be netted against all available same- jurisdiction loss or other tax carryforward that would be utilized, rather than only against carryforwards that are created by the unrecognized tax benefits. This standard will be effective for the Company beginning on January 1, 2014. The Company is assessing the impact of this standard on the Company’s financial statements.

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Unless the context otherwise requires or provides, references in this Quarterly Report on Form 10-Q to “we,” “us,” “our” and “our company” refer to Arlington Asset Investment Corp. (Arlington Asset) and its subsidiaries. This discussion and analysis should be read in conjunction with our financial statements and accompanying notes included in Item 1 of this Quarterly Report on Form 10-Q, as well as our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2012.

The discussion of our 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 “Cautionary Statement About Forward-Looking Statements” immediately following Item 4 of Part I of this Quarterly Report on Form 10-Q and the risk factors included in Item 1A of Part II of this Quarterly Report on Form 10-Q and our Quarterly Report on Form 10-Q for the three months ended June 30, 2013, and in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2012.

Our Company

We are a principal investment firm that currently acquires and holds primarily mortgage-related assets and holds certain other assets. We acquire residential mortgage-backed securities (MBS), either issued by U.S. government agencies or guaranteed as to principal and interest by U.S. government agencies or U.S. government-sponsored entities (agency-backed MBS). We also acquire MBS issued by private organizations (private-label MBS) subject to maintaining our exemption from regulation as an investment company under the Investment Company Act of 1940, as amended (1940 Act). In the future, we may acquire and hold other types of assets, including commercial mortgage-backed securities, asset backed securities, other structured securities, commercial mortgage loans, commercial loans, residential mortgage loans, and other real estate-related loans and securities. In addition, we also may pursue other business activities that will utilize our experience in analyzing investment opportunities and applying similar portfolio management skills. We are a Virginia corporation and taxed as a C corporation for federal income tax purposes. We operate primarily in the United States.

Factors that Affect our Results of Operations and Financial Condition

Our business is materially affected by a variety of industry and economic factors, including:

Adverse market conditions and actions by governmental authorities could adversely affect our business in many ways, including but not limited to making it more difficult for us to analyze our investment portfolio, adversely affecting our ability to maintain targeted amounts of leverage on our MBS portfolio and successfully implement our hedging strategy, and limiting our ability to follow our current investment and financing strategies. While uncertain, these potentially adverse market conditions and actions by governmental authorities may adversely affect our liquidity, financial position and results of operations. We have been and will continue to evaluate the potential impact of recent government actions, including developments relating to various state and federal government actions affecting the market price of MBS, related derivative securities, and interest rates. For further discussions on how market conditions and government actions may adversely affect our business, see “Item 1A — Risk Factors” of our Quarterly Report on Form 10-Q for the three months ended June 30, 2013, this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2012.

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Our MBS portfolio is affected by general U.S. residential real estate market conditions and the overall U.S. economic environment. In particular, our MBS strategy and the performance of our MBS portfolio is influenced by the specific characteristics of these markets, including prepayment rates, credit losses, interest rates and the interest rate yield curve. Our results of operations with respect to our MBS portfolio primarily depend on, among other things, the level of our interest income and the amount and cost of borrowings we may obtain by pledging our investment portfolio as collateral for the borrowings. Our interest income, which includes the amortization of purchase premiums and accretion of discounts, if any, varies primarily as a result of changes in prepayment speeds of the securities in our MBS portfolio. Our borrowing cost varies based on changes in interest rates and changes in the amount we can borrow, which is generally based on the fair value of the MBS portfolio and the advance rate the lenders are willing to lend against the collateral provided.

The payment of principal and interest on the agency-backed MBS that we acquire and hold is guaranteed by the Federal Home Loan Mortgage Corporation (Freddie Mac) or the Federal National Mortgage Association (Fannie Mae). The payment of principal and interest on agency-backed MBS issued by Freddie Mac or Fannie Mae is not guaranteed by the U.S. government. Any failure to honor its guarantee of agency-backed MBS by Freddie Mac or Fannie Mae or any downgrade of securities issued by Freddie Mac or Fannie Mae by the rating agencies could cause a significant decline in the value of and cash flow from any agency-backed MBS we own that are guaranteed by such entity.

Current Market Conditions and Trends

In September 2012, the U.S. Federal Reserve announced a third round of quantitative easing, known as QE3, pursuant to which it would purchase additional agency-backed MBS at a pace of $40 billion per month until further notice. The Federal Reserve also announced that it would maintain its policy of reinvesting principal payments from its existing holdings of agency-backed MBS into new purchases of agency-backed MBS until the employment rate, among other economic indicators, showed signs of improvement. The Federal Reserve further stated that it would maintain the target range for the Federal Funds Rate between zero and 0.25% through at least mid-2015, which is six months longer than previously announced. The Federal Reserve provided further guidance to the market in December 2012 that it intended to keep the Federal Funds Rate close to zero while the unemployment rate is above 6.5% and as long as inflation does not rise above 2.5%. In December 2012, the Federal Reserve also announced that it would initially begin purchasing $45 billion of long-term Treasury bonds each month and noted that such amount may increase in the future.

The economic news for the third quarter of 2013 was dominated by the effects of the sequester, government shutdown and debt ceiling and the reaction of the market to the Federal Reserve’s continuation of QE3, which primarily consists of asset purchases, despite market expectations that tapering its asset purchases would begin in September 2013. While there are signs of the private sector recovering some sustainable growth, inflation continues to be very low and the unemployment rate of approximately 7.2% in September 2013 remains higher than the 6.5% target threshold previously indicated by the Federal Reserve as one of the key drivers of tapering of its asset purchases. Interest rates during the quarter were extremely volatile with the 10-year Treasury Rate starting at 2.52% then reaching close to 3.0% in early September, but then declining to below 2.7% once the Federal Reserve indicated in its September meeting that it was going to postpone the commencement of its tapering. Uncertainty around who would be nominated for the next Fed Chairman magnified the interest rate volatility during the third quarter of 2013, though this has since been resolved with the nomination of Janet Yellen by President Obama on October 9, 2013.

The threat of a government shutdown and debate over the debt ceiling appeared to have been built into the market, as the bond market began to stabilize in the latter part of September and only exhibited a slight reaction when the government shut down commenced on October 1, 2013. Even though a temporary resolution was reached on the debt ceiling on October 16, 2013 and the government reopened on October 17, 2013, we expect the volatility in the bond market may continue until these issues have been resolved.

The Federal Reserve Open Market Committee (the FOMC) meeting minutes released on April 10, 2013 revealed that the FOMC had begun considering when the Federal Reserve should begin tapering the pace of agency-backed MBS purchases set in September 2012. The FOMC meeting minutes released on May 22, 2013 announced that the Federal Reserve was considering beginning to taper such purchases as early as June 2013. In minutes released on June 25, 2013, the FOMC introduced more formal unemployment rate and inflation

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targets, stating that the Federal Reserve would begin to scale back agency-backed MBS purchases later in 2013 and that such purchases would cease entirely when the unemployment rate reached 7%. The Federal Reserve’s current expectation is that 7% unemployment is achievable by midyear 2014.

At the July 30 – 31, 2013 FOMC meeting, the Committee, despite some improvement in the labor market and modest economic expansion, decided to continue asset purchases. At the September 17 – 18, 2013 FOMC meeting, against many market participants' expectations, the Committee decided to hold back on tapering, causing a rapid move downward in interest rates with the 10-Year Treasury Rate ending the quarter at 2.61%. The Federal Reserve continues to maintain its position that the timing and scope of tapering is dependent upon improving economic indicators. The economic projections of Federal Reserve Board Members included in the minutes of the Federal Reserve's September 2013 meeting show inflation running below the Federal Reserve's target inflation rate of 2% through 2016. In addition, the projections show estimates for real GDP growth at 2.2% to 3.3% for 2014. In the minutes from the October 29 – 30, 2013 FOMC meeting, the Committee maintained this assessment, decided to keep QE3 in place for the time being, and provided no additional guidance as to when tapering QE3 might begin. Given the low inflation projections, monetary policy, including the timing of tapering asset purchases, will likely be dependent on actual growth in employment rather than inflation concerns. It’s important to note that over the past several years, actual employment growth has been consistently below the Federal Reserve’s projections.

While there are signs of a recovery, uncertainty continues to dominate the market, due to the continued historically low interest rate environment and actions by the Federal Reserve. We believe the general business environment will continue to be challenging in the fourth quarter of 2013 and future periods. Our growth outlook is dependent, in part, on the strength of the financial markets, the impact of fiscal and monetary policy actions by the United States and other countries, the overall market value of U.S. equities and liquidity in the financial system. Depending on recent market developments and movements, we may seek to re-align our strategy and our portfolio. We will continue to closely monitor the developments in the market and evaluate the opportunities across the spectrum in the mortgage industry and other types of assets and seek the highest risk-adjusted returns for our capital.

We believe the limited liquidity and volatility in the credit markets will continue while the markets seek to determine the right equilibrium levels for benchmark interest rates as the Federal Reserve stimulus leaves the market place.

Recent Government Activity

On June 25, 2013, Senators Bob Corker (R-TN) and Mark Warner (D-VA), with Senators Mike Johanns (R-NE), Jon Tester (D-MT), Dean Heller (R-NV), Heidi Heitkamp (D-ND), Jerry Moran (R-KS) and Kay Hagan (D-NC) formally introduced the Housing Finance Reform and Taxpayer Protection Act of 2013 (the Corker-Warner Bill) into the U.S. Senate. While the current draft of the Corker-Warner Bill will likely undergo significant changes as it is debated, it is expected to serve as a basis of discussion for congressional efforts to reform Fannie Mae and Freddie Mac.

As currently drafted, the Corker-Warner Bill has three key provisions:

The FMIC would be a government guarantor modeled after the Federal Deposit Insurance Corporation (the FDIC) in that it would collect insurance premiums and maintain a deposit fund on all outstanding obligations. Every mortgage-backed security issued through the FMIC would have a private investor bearing the first risk of loss and holding at least $0.10 in equity capital for every dollar of risk. This private capital buffer would serve to protect taxpayers from the risk of default on the mortgages underlying securities issued by the FMIC. Thus, the ultimate purpose of the FMIC would be to bring in credit investors to bear the risk of default while providing liquidity, transparency and access to mortgage credit for the housing finance system.

The Federal Housing Finance Authority (the FHFA) would be abolished after the establishment of the FMIC, and all current responsibilities of the FHFA, as well as its resources, would be transferred to the

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FMIC. In particular, the Corker-Warner Bill specifies that the FMIC would maintain a database of uniform loan-level information on eligible mortgages, develop standard uniform securitization agreements and oversee the common securitization platform currently being developed by the FHFA.

In the event losses due to default on underlying mortgages exceed the first position losses of private credit investors in securities issued by the FMIC, the FMIC would cover such losses out of the Fund. The Corker-Warner Bill specifies that the FMIC would endeavor to attain a reserve balance of 1.25% of the aggregate outstanding principal balance of covered securities within five years of the establishment of the FMIC and 2.50% of such amount within ten years of the establishment of the FMIC. The Fund would be paid with insurance premiums, akin to user fees, paid by private investors with various reporting and transparency requirements.

As currently proposed, the Corker-Warner Bill would revoke the charters of Fannie Mae and Freddie Mac upon the establishment of the FMIC. Fannie Mae and Freddie Mac would wind down as expeditiously as possible while maximizing returns to taxpayers as their assets are sold off.

On July 11, 2013, U.S. Representatives introduced the Protecting American Taxpayers and Homeowners Act (PATH), a broad financing reform bill that serves as a counterpart to the Corker-Warner Bill. PATH would also revoke the charters of Fannie Mae and Freddie Mac and remove barriers to private investment. However, PATH would maintain the FHFA and give it oversight over a new non-government, not-for-profit National Mortgage Market Utility, the mission of which would be to develop best practices standards for the private origination, servicing, pooling and securitizing of mortgages and operate a publicly accessible securitization outlet to match loan originators with investors. Additional provisions of PATH include the reduction in size and scope of the Federal Housing Administration, tailoring its mission specifically to first-time borrowers and low- and moderate-income borrowers except in periods of significant credit contraction.

There is no way to know if either proposal will become law or should one of the proposals become law if and how the enacted law will differ from the current draft of the bill. It is unclear how this proposal would impact housing finance, and what impact, if any, it would have on companies that invest in MBS. The passage of any new legislation affecting Fannie Mae and Freddie Mac may create market uncertainty and reduce the actual or perceived credit quality of securities issued or guaranteed by the U.S. government through a new or existing successor entity to Fannie Mae and Freddie Mac. If the charters of Fannie Mae and Freddie Mac were revoked, it is unclear what effect, if any, this would have on the value of the existing Fannie Mae and Freddie Mac agency-backed MBS. It is also possible that the above-referenced proposed legislation, if made law, could adversely impact the market for securities issued or guaranteed by the U.S. government and the spreads at which they trade. The foregoing could materially adversely affect the pricing, supply, liquidity and value of our target assets and otherwise materially adversely affect our business, operations and financial condition.

Executive Summary

Given the uncertainty around the Federal Reserve policies and reversal or tapering of QE3, coupled with uncertainly regarding the ability of U.S. lawmakers to reach an agreement on the national debt ceiling or a national budget, the market was characterized by increased market and interest rate volatility. As a result, we experienced increased fluctuations in our asset prices and hedge positions during the quarter ended September 30, 2013. On October 16, 2013, Congress passed legislation to reopen the government through January 15, 2014 and effectively suspend the debt ceiling through February 7, 2014. As the Federal Reserve policy environment regains clarity and the U.S. budget negotiations reach a settlement, we expect less volatility in the market which in turn will diminish the variability in the value of our assets and hedge positions; however, it is difficult to determine the longer term effects of the uncertainty and the volatility existing in the current market.

Based on current economic indicators and trends in underlying credit and housing data, we continue to review the allocation of our available capital to maximize return to our shareholders. As of September 30, 2013, our MBS portfolio consisted of $2.0 billion in fair value, with $1.6 billion of agency-backed MBS and $344.1 million of private-label MBS.

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As we previously disclosed in the quarter ended March 31, 2013, we are subject to examination by the U.S. Internal Revenue Service (IRS), and other taxing jurisdictions. In March 2013, an IRS examination of the tax years 2009 and 2010 was completed without any adjustment. As a result, we reversed $3.2 million of unrecognized federal tax benefit related to an uncertain tax position and $0.5 million of related accrued interest as of March 31, 2013. We believe that the statute of limitation on the 2009 state tax return expired as of October 15, 2013. As a result, during the quarter ending December 31, 2013, we expect to reverse $9.6 million of unrecognized state tax benefit related to an uncertain tax position and $2.9 million of related accrued interest.

For the three months ended September 30, 2013, we had net income of $3.1 million, or $0.18 per share (diluted). As of September 30, 2013, our book value per share was $31.77.

In addition to the financial results reported in accordance with generally accepted accounting principles as consistently applied in the United States (GAAP), we calculated non-GAAP core operating income for the three and nine months ended September 30, 2013. Our non-GAAP core operating income for the three and nine months ended September 30, 2013 was $17.3 million and $50.8 million, respectively. In determining core operating income, we excluded certain legacy litigation expenses and the following non-cash expenses: (1) compensation costs associated with stock-based awards, (2) accretion of MBS purchase discounts adjusted for contractual interest and principal repayments in excess of proportionate invested capital, (3) unrealized mark-to-market adjustments on the trading MBS and hedge instruments, (4) other-than-temporary impairment charges recognized, (5) non-cash income tax provisions, and (6) benefit from the reversal of previously accrued federal tax liability and accrued interest related to uncertain tax positions. 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 our performance and provides additional clarity around our forward earnings capacity and trends. 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 non-GAAP core operating income for the three and nine months ended September 30, 2013 (dollars in thousands):

		September 30, 2013
		Three Months Ended				Nine Months Ended
GAAP net income		$	3,093			$	9,464
Adjustments
Legacy litigation expenses(1)			(24	)			551
Stock compensation			729				1,666
Non-cash interest income related to purchase discount accretion(2)			(1,915	)			(3,091	)
Net unrealized mark-to-market loss on trading MBS and hedge instruments			12,898				40,221
Other-than-temporary impairment charges			380				1,270
Non-cash income tax provisions			2,170				4,469
Benefit from the reversal of federal tax liability and accrued interest related to uncertain tax position			—				(3,744	)
Non-GAAP core operating income		$	17,331			$	50,806

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As of September 30, 2013, our agency-backed MBS consisted of $1.6 billion in face value with a cost basis of $1.7 billion and had a fair value of $1.6 billion. Our agency-backed MBS had a weighted-average coupon of 4.08% and a weighted-average cost of funding of 0.37% at September 30, 2013. During the three months ended September 30, 2013, we received proceeds of $309.5 million from the sale of $297.7 million in face value of our agency-backed MBS, realizing $3.9 million in net losses, or realized net losses of $16.0 million from the acquisition price. During the nine months ended September 30, 2013, we received proceeds of $837.3 million from the sale of $787.6 million in face value of our agency-backed MBS, realizing $25.9 million in net losses, or realized net losses of $16.8 million from the acquisition price.

We have entered into Eurodollar futures and swap futures to mitigate the interest rate sensitivity which directly impacts our cost of borrowing and the market value of our agency-backed MBS. The Eurodollar futures mature through September 30, 2018 and have a lifetime weighted-average rate of 3.08%, as compared to a lifetime weighted-average market rate of 2.10% as of September 30, 2013. The value of these five-year hedge instruments is expected to fluctuate inversely relative to the agency-backed MBS portfolio and decrease in value during periods of declining interest rates and/or widening mortgage spreads. Conversely, during periods of increasing rates and/or tightening mortgage spreads, these instruments are expected to increase in value. The cost of these Eurodollar hedges will increase over their five-year term. The swap futures mature in December 2013 and have a weighted-average rate of 2.89%, as compared to a weighted-average market rate of 2.85% as of September 30, 2013.

As of September 30, 2013, our private-label MBS portfolio consisted of $511.8 million in face value with an amortized cost basis of $287.0 million and had a fair value at $344.1 million. The unamortized net discount on our private-label MBS portfolio was $224.8 million as of September 30, 2013. During the three months ended September 30, 2013, we recognized net interest income of $6.8 million, representing a 9.8% annualized yield, including coupon and accretion of purchase discount based on the current accretable yield rate, from our private-label MBS portfolio. During the three months ended September 30, 2013, we received proceeds of $27.1 million from the sale of $49.0 million in face value of our private-label MBS, realizing $4.8 million in gains. We also recognized $0.4 million in other-than-temporary impairment charges during the three months ended September 30, 2013. This charge does not affect non-GAAP core operating income or book value, but does reduce our net income and lowers the accounting basis used to record future discount accretion.

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 represent interests in re-securitizations of senior MBS and pro-rata mezzanine securities. For re-REMIC securities, the cash flows from, and any credit losses absorbed by, the underlying MBS 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 MBS are typically allocated concurrently and proportionally to the mezzanine securities along with senior securities. The re-REMIC subordinated and mezzanine securities absorb credit losses, if any, first; 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 0.3% credit enhancement on a weighted-average basis, which, in addition to our purchase discount, provides protection to our invested capital.

We generally purchased the private-label MBS in our portfolio at a discount to face value. We estimate, at least on a quarterly basis, the future expected cash flows based on our observation and assessment of current information and events and by applying a number of assumptions related to prepayment rates, interest rates, default rates, discount rates and the timing and amount of cash flows and credit losses. These

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assumptions, which are disclosed in note 2 to our financial statements, are difficult to predict as they are subject to uncertainties and contingencies related to future events that may impact our estimates and interest income.

We recognize interest income on our private-label MBS based on each security’s expected effective interest rate. At acquisition, the accretable yield is calculated as the difference between the undiscounted expected cash flows and the purchase price which is expected to be accreted into interest income over the remaining life of the security on a level-yield basis. The difference between the contractually required payments and the undiscounted expected cash flows represents the non-accretable difference. Based on actual payment activities and changes in estimates of undiscounted expected future cash flows, the accretable yield and the non-accretable difference can change over time. Significant increases in the amount or timing of undiscounted expected future cash flows are recognized prospectively as an adjustment to the accretable yield. As a result, we may recognize higher non-cash interest income over the security’s holding period and may not realize the level of interest income recognized using the higher accretion rates. In addition, we may be subject to more frequent and higher non-cash other-than-temporary-impairment charges than actual losses realized on the security as a result.

We evaluate available-for-sale securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. In general, when the fair value of an available-for-sale security is less than its amortized cost at the reporting date, the security is considered impaired. In evaluating these available-for-sale securities for other-than-temporary impairment, consideration is given to (1) the length of time and the extent to which the fair value has been lower than carrying value, (2) the severity of the decline in fair value, (3) the financial condition and near-term prospects of the issuer, (4) our intent to sell, and (5) whether it is more likely than not we would be required to sell the security before anticipated recovery.

For available-for-sale, agency-backed MBS, if it is determined that the impairment is other-than- temporary, then the amount that the fair value is below its amortized cost basis is recorded as an impairment charge and recorded through earnings. For unrealized losses that are determined to be temporary, a further evaluation is performed to determine the credit portion of the other-than-temporary impairment and the credit portion is recorded through our statement of comprehensive income.

For available-for-sale, private-label MBS that have been acquired at discounts to face value due in part to credit deterioration since origination, we re-evaluate the undiscounted expected future cash flows and the changes in cash flows from those originally projected at the time of purchase or last revised. For those securities in an unrealized loss position, the difference between the carrying value and the net present value of expected future cash flows discounted using current expected rate of return is recorded as other-than- temporary impairment charges through our statement of comprehensive income.

Continued expectations of stabilization and improvement in the housing market, increased liquidity and available leverage have stabilized prices for our private-label MBS, particularly among re-REMIC mezzanine securities. Our re-REMIC securities are predominantly held in the subordinate tranches. 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.

We have been evaluating, and will continue to evaluate, the opportunities across the spectrum in the mortgage industry and seek the highest risk-adjusted returns for our capital. We evaluate and prioritize the risk-adjusted return we expect to receive on every asset based upon a current cash yield perspective as well as from a total yield perspective that includes expected reflation, which is defined as an increase in value between the amortized cost basis and the par value of the security. 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

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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.

The following is a summary of our net income for the periods indicated (dollars in thousands):

		Three Months Ended September 30,								Nine Months Ended September 30,
		2013				2012				2013				2012
Net interest income		$	20,681			$	14,271			$	58,330			$	41,731
Other loss, net			(11,103	)			(5,666	)			(35,893	)			(11,543	)
Other expenses			4,030				5,032				11,726				12,888
Income before income taxes			5,548				3,573				10,711				17,300
Income tax provision			2,455				450				1,247				1,271
Net income		$	3,093			$	3,123			$	9,464			$	16,029