Arlington Asset Investment Corp. - Quarter Report: 2015 June (Form 10-Q)

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

FORM 10-Q

For the quarterly period ended June 30, 2015

OR

For the transition period from           to

Commission File Number: 001-34374

ARLINGTON ASSET INVESTMENT CORP.

(Exact name of Registrant as specified in its charter)

(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.

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 July 31, 2015:

ARLINGTON ASSET INVESTMENT CORP.

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2015

INDEX

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements

ARLINGTON ASSET INVESTMENT CORP.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

See notes to consolidated financial statements.

ARLINGTON ASSET INVESTMENT CORP.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in thousands, except per share data)

(Unaudited)

See notes to consolidated financial statements.

ARLINGTON ASSET INVESTMENT CORP.

CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

(Dollars in thousands)

(Unaudited)

See notes to consolidated financial statements.

ARLINGTON ASSET INVESTMENT CORP.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

Note 1. Basis of Presentation:

The consolidated financial statements of Arlington Asset Investment Corp. (“Arlington Asset”) and its consolidated 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 six months ended June 30, 2015 are not necessarily indicative of the operating results for the entire year or any other subsequent interim period. The Company’s unaudited 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, 2014.

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.

Note 2. Updates to Significant Accounting Policies:

Interest Income Recognition for Investments in Private-label Mortgage-backed Securities Classified as Trading Securities

In the second quarter of 2015, the Company acquired private-label mortgage-backed securities (“MBS”) that it classified as trading securities. Interest income on private-label MBS classified as trading securities that, at the time of acquisition, are not considered to be of high credit quality or may be contractually prepaid or otherwise settled in such a way that the Company would not recover substantially all of its initial recorded investment is recognized using the prospective effective interest method. In applying the prospective effective interest method, the Company, at the time of acquisition, determines the security’s effective interest rate by solving for the single discount rate that equates the present value of the Company’s estimate of the amount and timing of the cash flows expected to be collected from the security to its purchase price. Subsequent to acquisition, the amount of periodic interest income recognized is determined by applying the security’s effective interest rate to its amortized purchase price, or “reference amount.”

In each subsequent reporting period, the Company will re-estimate the amount and timing of cash flows expected to be collected from the security. If actual cash flows exceed prior estimates and/or a positive change occurs in the estimate of expected remaining cash flows, a revised effective interest rate will be calculated such that the positive change in cash flows is recognized as incremental interest income over the remaining life of the security. If actual cash flows fall short of prior estimates and/or an adverse change occurs in the estimate of expected remaining cash flows, the amount of periodic interest income recognized over the remaining life of the security will be reduced accordingly. Specifically, if an adverse change in cash flows occurs for a security that is impaired (that is, its reference amount exceeds its fair value), the reference amount to which the security’s existing effective interest rate will be prospectively applied will be reduced to the present value of cash flows expected to be collected, discounted at the security’s existing effective interest rate. If an adverse change in cash flows occurs for a security that is not impaired, the security’s effective interest rate will be reduced accordingly and applied on a prospective basis.

Note 3. 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:

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

Mortgage-backed securities, at fair value — 

Agency-backed MBS — The Company’s MBS for which the principal and interest payments are guaranteed by the Federal National Mortgage Association (“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”) (collectively, “agency-backed MBS”), are classified within Level 2 of the fair value hierarchy as they are valued using inputs primarily from third-party pricing services as well as considering quoted market prices for similar assets provided by a broker or dealer with reasonable levels of price transparency. In determining fair value, third party pricing sources use various valuation approaches including market and income approaches. The Company makes inquiries of the third party pricing sources to understand the significant inputs and assumptions they used to determine their prices. The Company reviews the various third party fair value estimates and performs procedures to validate their reasonableness, including comparison to recent trading activity for similar securities and management review for consistency with market conditions observed as of the measurement date.

Private-label MBS — The Company classifies non-agency-backed, or private-label, MBS within Level 3 of the fair value hierarchy because they trade infrequently and, therefore, have little or no price transparency. In determining fair value, the Company primarily uses an income approach as well as market approaches. The Company utilizes present value techniques based on estimated cash flows of the instrument taking into consideration various assumptions derived by management based on their observations of assumptions used by 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 purposes of fair value measurement.

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 judgments about the assumptions that a market participant would use, including assumptions about future 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 its internal calculations to compute the fair value of these private-label MBS, the Company considers indications of value from actual sales of private-label MBS to assist in the valuation process and calibrate the Company’s model.

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

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 observable market-based inputs, including, but not limited to, contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs.

Other  — Cash and cash equivalents, deposits, receivables, repurchase agreements, payables, and other assets and liabilities are reflected in the consolidated balance sheets at their cost, which, due to the short-term nature of these instruments and their limited inherent credit risk, approximates fair value.

Long-term debt represents remaining balances of trust preferred debt and senior debt issued by the Company. Our estimate of the fair value of long-term debt is $74,930 and $39,200 as of June 30, 2015 and December 31, 2014, respectively. Trust preferred debt is classified within Level 3 of the fair value hierarchy as the fair value is determined after considering quoted prices provided by a broker or dealer for similar, infrequently traded instruments. The independent brokers or dealers providing market prices are those who make markets in, or are specialists with expertise in the valuation of, these financial instruments. The Company’s senior debt, which is publicly traded on the New York Stock Exchange, is classified within Level 1 of the fair value hierarchy.

Fair Value Hierarchy

Financial Instruments Measured at Fair Value on a Recurring Basis

The following tables set forth financial instruments accounted for under ASC 820 by level within the fair value hierarchy as of June 30, 2015 and December 31, 2014. 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.

There were no transfers of securities in or out of Levels 1, 2 or 3 during the three and six months ended June 30, 2015 or the year ended December 31, 2014.

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, private-label MBS was $152,162 and $267,437 as of June 30, 2015 and December 31, 2014, respectively. As of June 30, 2015, the private-label MBS portfolio consists entirely of tranches of beneficial interests in underlying, resecuritized private-label MBS issued by re-REMIC securitization trusts between 2005 and 2014. During 2014, the Company’s private-label MBS portfolio also included senior class MBS, which represent beneficial interests in securitized mortgage loans that have the first right to cash flows and absorb losses last. The underlying collateral of our re-REMIC securities are senior and pro-rata mezzanine class MBS. 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 resecuritization 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. Re-REMIC and mezzanine securities receive interest while any face value is outstanding.

The Company’s private-label MBS were collateralized by residential prime and Alt-A mortgage loans and had the following weighted average characteristics, based on face value, as of the dates indicated:

The significant unobservable inputs used to develop the estimated cash flows and discount rates in the valuation models for the Company’s private-label MBS include the following weighted-averages, based on face value, as of the dates indicated:

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

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 six months ended June 30, 2015 and 2014.

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 June 30, 2015 and December 31, 2014, these financial assets are classified within the other investments category and represent the Company’s interest in non-public equity securities and investment funds and are valued at $1,558 and $1,625, respectively. For the three and six months ended June 30, 2015 and 2014, there were no changes to the carrying value of these financial assets.

The Company has generally purchased private-label MBS at a discount to face value. 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 is recognized 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. Actual cash collections that exceed our prior estimates and/or positive changes in our periodic estimates of expected future cash flows increase the accretable yield and are recognized prospectively as incremental interest income over the remaining life of the security.

The following table presents the changes in the accretable yield on available-for-sale, private-label MBS for the three and six months ended June 30, 2015 and 2014:

The Company did not acquire any available-for-sale, private-label MBS during the three and six months ended June 30, 2015 and 2014. The Company did acquire private-label MBS during the three months ended June 30, 2015 that it elected to classify as trading securities.

The Company’s available-for-sale MBS are carried at fair value in accordance with ASC 320, Investments - 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:

The Company recorded no other-than-temporary impairment charges on available-for-sale MBS during the three and six months ended June 30, 2015. For the three and six months ended June 30, 2014, the Company recorded other-than-temporary impairment charges of $51 as a component of investment (loss) gain, 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 $2,174, prior to recognizing the other-than-temporary impairment charges. The following table presents a summary of cumulative credit related other-than-temporary impairment charges recognized on the available-for-sale MBS held as of the dates indicated:

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

Other Investments

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

Note 4. 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 as specified in the respective agreements. Under the repurchase agreements, the Company pledges its securities as 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 June 30, 2015 and December 31, 2014, the Company had no amount at risk with a single repurchase agreement counterparty or lender greater than 10% of equity. The following table provides information regarding the Company’s outstanding repurchase agreement borrowings as of June 30, 2015 and December 31, 2014:

The following table provides information regarding the Company’s outstanding repurchase agreement borrowings during the three and six months ended June 30, 2015 and 2014:

Long-Term Debt

As of June 30, 2015 and December 31, 2014, the Company had $75,300 and $40,000, respectively, of outstanding long-term debentures. On March 18, 2015, the Company completed a public offering of $35,300 of its 6.75% Senior Notes due in 2025 and received net proceeds of $34,063 after payment of underwriting discounts, commissions, and expenses. These Senior Notes will mature on March 15, 2025, 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 March 15, 2018, at a redemption price equal to the principal amount plus accrued and unpaid interest. The interest payments on these Senior Notes are payable quarterly in arrears on March 15, June 15, September, 15, and December 15 of each year, beginning on June 15, 2015. The indenture governing these Senior Notes contains certain covenants, including limitations on the Company’s ability to merge or consolidate with other entities or sell or otherwise dispose of all or substantially all of the Company’s assets. The Senior Notes due 2025 and the Senior Notes due 2023 are publicly traded on the New York Stock Exchange under the ticker symbol “AIC” and “AIW”, respectively.

The Company’s long-term debentures consisted of the following as of the dates indicated:

Note 5. Derivative Financial Instruments and Economic Hedging Activities:

In the normal course of its operations, the Company is a party to financial instruments that are accounted for as derivative instruments in accordance with ASC 815. These instruments may include Eurodollar futures, interest rate swap futures, U.S. Treasury futures contracts, interest rate swaps, put options and certain commitments to purchase and sell MBS. The exchange traded derivatives such as Eurodollar futures and interest rate swap futures are, in effect, settled on a daily basis by the exchange of cash variation margin. Cash variation margin posted by the Company is included in the financial statement line item deposits in the accompanying consolidated balance sheets. The Company may be required to pledge collateral for margin requirements with third-party custodians in connection with certain of its other derivative transactions. These transactions are not under master netting agreements.

During the three and six months ended June 30, 2015 and 2014, the Company entered into various financial contracts to economically hedge certain MBS and related borrowings and other long-term debt. These financial contracts are not designated as cash flow hedges under ASC 815. The changes in fair value on these derivatives are recorded to investment (loss) gain, net in the consolidated statements of comprehensive income. For the three and six months ended June 30, 2015, the Company recorded net gains of $30,391 and net losses of $45,728, respectively, on these derivatives. For the three and six months ended June 30, 2014, the Company recorded net losses of $46,585 and $70,065, respectively, on these derivatives. The Company held the following derivative instruments as of the dates indicated:

Note 6. Income Taxes:

Arlington Asset is subject to taxation as a corporation under Subchapter C of the Internal Revenue Code of 1986, as amended (the “Code”). The Company’s consolidated subsidiary, Rosslyn REIT Trust (“Rosslyn REIT”), operates to qualify as a real estate investment trust (“REIT”) under the Code. The investments of Rosslyn REIT primarily consist of a portion of the Company’s private-label MBS portfolio. Arlington Asset owns all of the common shares of Rosslyn REIT and all of the preferred shares of Rosslyn REIT are owned by outside investors. Rosslyn REIT periodically distributes all of its income to its shareholders. The Company’s agency-backed MBS and remaining private label MBS investment portfolios are held by Arlington Asset.

The Company currently has net operating loss (“NOL”) and net capital loss (“NCL”) carry-forwards that can be applied against the Company’s current taxable ordinary income and net capital gains.

As of June 30, 2015 and December 31, 2014, the Company had a net deferred tax asset of $113,121 and $122,365, respectively, net of a valuation allowance on NCL carry-forwards of $54,814 and $26,027, respectively. The Company continues to provide a valuation allowance against the portion of NCL carry-forwards for which the Company believes is more likely than not that the benefits will not be realized prior to expiration. The Company’s NCL carry-forwards expire in 2019, and any net capital loss generated in the current year will expire in 2020. During the six months ended June 30, 2015, the Company recorded an increase to its valuation allowance of $28,787. The increase in the valuation allowance was primarily due to realized and unrealized net capital losses generated during the period from certain of its derivative hedge instruments. The Company will continue to assess the need for a valuation allowance at each reporting date.

As of June 30, 2015, the Company has assessed the need for recording a provision for any uncertain tax position and has made the determination that such provision is not necessary.

The Company is subject to examination by the U.S. Internal Revenue Service (“IRS”) and state and local taxing jurisdictions where the Company has significant business operations. As of June 30, 2015, there are no on-going examinations.

Note 7. 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 unvested shares of restricted stock and performance share units. The following tables present the computations of basic and diluted earnings (loss) per share for the periods indicated:

The diluted earnings per share for the six months ended June 30, 2015 did not include the antidilutive effect of 120,868 unvested shares of restricted stock and performance share units.

Note 8. Equity:

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 2015:

The Board of Directors approved and the Company declared and paid the following dividends for 2014:

Conversion of Class B Common Stock to Class A Common Stock

During the three and six months ended June 30, 2015, a holder of the Company's common stock converted an aggregate of 1,153 shares of Class B common stock into 1,153 shares of Class A common stock. Holders of shares of Class A common stock are entitled to one vote for each share on all matters voted on by shareholders, and the holders of shares of Class B common stock are entitled to three votes per share on all matters voted on by shareholders. Under the Company's Articles of Incorporation, shares of Class B common stock are convertible into shares of Class A common stock on a one-for-one basis.

Note 9. Recent Accounting Pronouncements:

On April 7, 2015, the FASB issued Accounting Standards Update (“ASU”) No. 2015-03, Interest — Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs, which requires debt issuance costs to be presented in the balance sheet as a direct reduction from the associated debt liability rather than as a separate asset. For public business entities, the standard is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted for financial statements that have not been previously issued. The new guidance will be applied on a retrospective basis. The Company does not believe that the change in the balance sheet presentation of debt issuance costs required by ASU No. 2015-03 will have a material impact on its consolidated financial statements.

On February 18, 2015, the FASB issued ASU No. 2015-02, Consolidation (Topic 810) — Amendments to the Consolidation Analysis, which makes targeted amendments to the current consolidation guidance and ends the deferral granted to investment companies from applying variable interest entity guidance. For public business entities, the standard is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted. The Company does not believe the adoption of ASU No. 2015-01 will have a material impact on its consolidated financial statements.

On January 9, 2015, the FASB issued ASU No. 2015-01, Extraordinary and Unusual Items (Subtopic 225-20) — Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items, which eliminates from U.S. GAAP the concept of extraordinary items. The standard is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. The Company does not believe the adoption of ASU No. 2015-01 will have a material impact on its consolidated financial statements.

Note 10. Revisions to Previously Reported Financial Statements:

The Company concluded that the previously reported tax effect of the components of other comprehensive income (loss) was incorrect for the three and six months ended June 30, 2014. Although the error did not have an impact on the previously reported total other comprehensive income (loss), it did have an impact on the previously reported components of other comprehensive income (loss). Although the impact of this change was not material to the consolidated financial statements for the three and six months ended June 30, 2014, the Company has revised its previously reported consolidated financial statements for the three and six months ended June 30, 2014. The following tables set forth the affected line items within the Company’s previously reported consolidated financial statements for the three and six months ended June 30, 2014.

During the first quarter of 2015, the Company concluded that the previously reported income tax provision (benefit) and the related income tax effect on other comprehensive income (loss) was incorrect for the fiscal years ended December 31, 2012 and 2013 with no impact on previously reported total comprehensive income. As a result of these errors, the Company also concluded that the previously reported accumulated other comprehensive income and accumulated deficit was incorrect as of the three fiscal years ended December 31, 2014 for the cumulative impact of the errors, however, with no impact on previously reported total equity. Although the impact of these changes were not material to the consolidated financial statements for the three fiscal years ended December 31, 2014, the Company has revised its previously reported accumulated other comprehensive income and accumulated deficit as of December 31, 2014 and 2013 to reflect the cumulative impact of the errors. The following tables set forth the affected line items within the Company’s previously reported consolidated balance sheets as of December 31, 2014 and 2013.

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

Unless the context otherwise requires or provides, references in this Quarterly Report on Form 10-Q to “we,” “us,” “our” and the “Company” refer to Arlington Asset Investment Corp. (“Arlington Asset”) 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, 2014.

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” in Item 3 of Part I of this Quarterly Report on Form 10-Q and the risk factors included in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2014.

Our Company

We are a principal investment firm that currently acquires and holds primarily residential mortgage-related 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 residential 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 (the “1940 Act”). In the future, we may acquire and hold other types of assets, including commercial MBS, 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 U.S. federal tax purposes. We operate 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, reducing the market value of our MBS and hedge 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 evaluating, and will continue to evaluate, the potential impact of recent government actions affecting the market price and availability 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 Annual Report on Form 10-K for the year ended December 31, 2014.

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 primarily depend on, among other things, the level of our interest income, the amount and cost of borrowings we may obtain by pledging our investment portfolio as collateral for the borrowings and the cost and impact of our hedging transactions. 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 at which the lenders are willing to lend against the collateral provided. We have entered into various hedging transactions to mitigate the interest rate sensitivity which directly impacts our cost of borrowing and the value of our MBS portfolio. Periodic changes in the market value of these hedging instruments is expected to fluctuate inversely relative to changes in the value of the MBS portfolio that are attributable to changes in interest rates. That is, the aggregate market value of our hedging instruments is expected to increase during periods of increasing interest rates and, conversely, decrease during periods of declining interest rates. However, the degree of correlation between price movements of our hedging instruments and price movements of our MBS portfolio may vary. While our hedging instruments are designed to protect our agency-backed MBS portfolio from interest rate risk, they are not generally designed to protect our net book value from spread risk, which is the risk of an increase of the market spread between the yield on our agency-backed MBS and the benchmark yield on U.S. Treasury securities or interest rate swaps.

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

Volatility in global interest rates and capital markets continued in the second quarter of 2015. Interest rates rose across all sectors in the global bond markets, thereby depressing bond prices across sectors. Credit spreads incrementally widened during the second quarter, putting downward pressure on book value for many firms in the specialty finance and mortgage REIT space. Both U.S. Treasuries and agency-backed MBS yields ended the second quarter higher than the close of the first quarter 2015. For example, the yield on 10-year notes issued by the U.S. Treasury rose by 41 basis points to 2.35% at June 30, 2015, and the price of Fannie Mae 3.5% 30 year MBS fell by $2.22 to $102.89 over the quarter. The rise in rates was primarily led by growing sentiment that the European economies are recovering somewhat and the need for continued aggressive monetary stimulus by the European Central Bank (the “ECB”) would diminish somewhat over the next few quarters. However, European equities suffered, down 4.5% for the quarter, primarily on fears stoked by uncertainty over Greek sovereign finances. In addition, the ECB, the Bank of Japan and other national banks have implemented programs to increase monetary stimulus. For example, the ECB announced in January 2015 an aggressive bond buying program to stimulate the European Zone economy. This program is expected to continue through September 2016, and the ECB has not expressed to date any expectation to reduce or shorten the time period of this program. Interest rates were also impacted by slowing economic growth in China.

We believe that the U.S. economy appears to be on a trajectory of slow, sustainable growth. The consensus forecast for 2015 economic growth in the U.S. remains at approximately 2.7%, accompanied by moderate growth in payrolls and inflation within the Federal Reserve’s target range. Nevertheless, wage growth and commodity prices remain weak, suggesting continued sluggish economic growth globally. The Federal Reserve continues to guide capital markets to anticipate the possibility of an interest rate hike in September or December 2015. Federal Reserve Chair Yellen, in her June 17, 2015 remarks following the June Federal Reserve Open Market Committee policy meeting, stated that she anticipates a long period of continued accommodative monetary policy following an initial rise in the Federal Funds Rate later this year. These statements, which Chair Yellen reiterated in Congressional testimony on July 15-16, 2015, generally are in line with market participants’ expectations for the balance of 2015. As of June 30, 2015, the bond market appears to have priced in an increase in the Federal Funds Rate in September 2015 and a slow rise over the next few years. With the Federal Reserve ostensibly tying the start of interest rate increases to evidence of further improvement in the economy, data releases remain materially influential events. We believe that data dependency and analysis of the Federal Reserve will continue to drive the direction and volatility of U.S. rates, with the uncertainty that this dynamic creates further enhancing volatility in the interest rate and fixed income markets.

With the Federal Reserve signaling that it may raise rates in September or December 2015, the prospect for higher cost of capital for the Company is evident, which would in the longer-term lead to interest rate spread narrowing and lower yields on existing agency-backed MBS. Home sales and new single-family home construction remain relatively slow due to mortgage lending rules implemented under the Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and bank conservatism in efforts to, among other things, prevent future MBS repurchase requests. These factors have created a shortage of mortgage origination, resulting in low agency-backed MBS issuance. The Federal Reserve’s purchases of agency-backed MBS through reinvesting principal and interest payments it receives on its agency-backed MBS portfolio have continued to dominate the agency-backed MBS markets. The Federal Reserve purchases contributed to strong agency-backed MBS demand and limited new investment opportunities to date in 2015. While the Federal Reserve has not indicated when it will cease or reduce its agency-backed MBS purchases by reinvesting principal and interest payments, private banks have less incentive to purchase Freddie Mac and Fannie Mae MBS because under the Basel III liquidity coverage ratio rules they receive lower quality liquid asset credit for these securities on their balance sheet than for cash, U.S. Treasuries and MBS issued by the Government National Mortgage Association (“Ginnie Mae”).

While there are signs of a recovery, uncertainty continues to dominate the market, due to the continued low interest rate environment and actions by the Federal Reserve. We believe the general business environment will continue to be challenging in 2015 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, particularly Greece and China, 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.

Recent Government Activity

In March 2015, housing and mortgage financial reform legislation, H.R. 1491, was proposed by congressmen John Delaney (D-MD), John Carney (D-DE) and James A. Himes (D-CT), each of whom is a member of the House Financial Services Committee. The bill is called The Partnership to Strengthen Homeownership Act, and is similar to one introduced by the same congressmen in the last Congress (H.R. 5055), which never made it out of committee. Under this proposed legislation, all government guaranteed single-family and multi-family MBS will be supported by a minimum of 5% private sector capital, which will stand in a first loss position. The remaining 95% of the risk will be shared between Ginnie Mae and a private reinsurer on a pari passu basis. Fees paid to Ginnie Mae for providing these securities will be allocated to affordable housing programs. Under the bill, Freddie Mac and Fannie Mae would be wound down over a five-year period, and their multifamily businesses would be spun out as separate entities. Ginnie Mae would be required to create and implement a workable multifamily guarantee that utilizes private sector pricing consistent with the single family model. The GSEs’ current multifamily businesses would continue to function within the new multifamily housing market as purely private organizations with an explicit government guarantee provided by Ginnie Mae and a private sector reinsurer.

In May 2015, Senate Banking Committee Chairman Richard Shelby (R-AL) released a draft bill entitled The Regulatory Relief Bill of 2015 (the “Regulatory Relief Bill”). If enacted, this bill would increase the threshold for a financial institution to be deemed a Systemically Important Financial Institution (“SIFI”) from $50 billion to $500 billion while giving the Financial Stability Oversight Council discretion to designate banks with greater than $50 billion in assets as SIFIs, give non-banks an opportunity to file a remedial plan addressing regulators’ concerns before being designated as SIFIs, require an affirmative vote every five-years to renew the SIFI designation of non-banks, provide regulatory relief for community banks and broaden the Consumer Financial Protection Bureau Qualified Mortgage rule.

We expect debate and discussion on residential housing and mortgage reform to continue in 2015; however, we cannot be certain if H.R. 1491, the Regulatory Relief Bill or any other housing- and/or mortgage-related bill will emerge from committee, or be approved by Congress, and if so, what the effect will be.

Executive Summary

During the second quarter of 2015, the Company’s financial results were significantly impacted by persistent interest rate volatility that resulted in widening of mortgage spreads. The 10-year U.S. Treasury rate increased from 1.94% as of March 31, 2015 to 2.35% as of June 30, 2015 and experienced significant volatility within the quarter. The Company continued to maintain a significant hedge position to protect its agency-backed MBS portfolio from a rise in interest rates. While the Company’s hedge design and structure is intended to mitigate the change in value of its agency-backed MBS investments due to changes in interest rates, other factors, such as the steepness or flatness of the yield curve, will potentially have an effect on the value of the Company’s hedges as compared to its assets. Although the Company’s hedging instruments are designed to protect its agency-backed MBS portfolio from interest rate risk, they are not generally designed to protect the Company’s net book value from spread risk, which is the risk of an increase of the market spread between the yield on agency-backed MBS and the benchmark yield on U.S. Treasury securities or interest rate swaps. During the second quarter, uncertainty surrounding global growth, the outlook for the timing and magnitude of interest rate increases by the U.S. Federal Reserve and European financial conditions, among other factors, contributed to continued interest rate volatility. The option-adjusted spread (“OAS”), a common measure of the spread between a fixed income security rate and a risk-free rate that takes into consideration the impact of interest rate volatility and prepayment risk in residential MBS, widened during the quarter. For example, the Fannie Mae 4.0% 30-year LIBOR OAS widened approximately 13 basis points during the second quarter. As a result of these factors, the Company’s agency-backed MBS portfolio underperformed relative to its hedge portfolio resulting in net realized and unrealized losses on its hedged agency MBS portfolio during the second quarter.

The Company’s agency-backed MBS portfolio continues to be invested in fixed-rate 30-year MBS specifically selected based upon collateral characteristics that demonstrate a lower than average propensity for prepayments. The three-month constant prepayment rate (“CPR”) on the Company’s agency-backed MBS was 12.34% as of June 30, 2015, which compared favorably to CPRs on the Fannie Mae 4.0% coupon universe of 21.87%. However, with the increase in long-term interest rates during the second quarter, the weighted average pay-up premiums for the Company’s specified pools of agency-backed MBS with prepayment protection characteristics declined during the quarter, which also contributed to a decline in the value of the Company’s agency-backed MBS portfolio during the second quarter. Pay-up premiums represent the estimated price premium of agency MBS backed by specified pools over a generic to-be-announced agency security. The increase in interest rates and widening of mortgage spreads had a meaningful negative impact on the value of the Company’s agency-backed MBS portfolio during the second quarter of 2015.

As of June 30, 2015, the Company maintained a hedge position equal to approximately 97% of its outstanding repurchase agreement financing on its agency-backed MBS with an average duration of approximately six years to mitigate adverse impacts to the portfolio as interest rates rise. As of June 30, 2015 and December 31, 2014, 31% and 35%, respectively, of the Company’s total hedge portfolio was comprised of long-term 10-year hedges with the remaining amount of hedges comprised of Eurodollar futures that generally roll on a consecutive quarterly basis over the next four years. The increase in interest rates had a meaningful positive impact on the value of the Company’s derivative hedging instruments during the second quarter of 2015.

As a result of the above factors, the Company recorded net investment losses on its agency-backed MBS of $62.1 million and net investment gains on its related derivative hedging instruments of $30.4 million for a combined net investment loss of $31.7 million, or $1.37 per share, during the second quarter of 2015. This net change in values of the Company’s hedged agency-backed MBS portfolio was a key driver in the decline in the Company’s book value of $1.12 per share from $24.83 per share as of March 31, 2015 to $23.71 per share as of June 30, 2015.

The Company views its agency-backed MBS strategy over an investment cycle. As spreads widen and tighten, and as the curve may steepen or flatten, the Company seeks to invest available capital opportunistically while maintaining sufficient liquidity to stay in the agency-backed MBS investment over an extended period of time. The Company expects that this strategy will allow it to earn its targeted investment spread over the investment cycle, but can result in fluctuations in its book value per share over certain market periods as demonstrated during the second quarter of 2015. However, the Company believes that the primary market driver of this periodic fluctuation in book value per share offers increased opportunity for attractive returns on newly acquired investments in agency-backed MBS due to the widened spread between the yield to be earned on these new investments and the hedged cost to fund their acquisition.

The Company constantly monitors its allocation of its available capital between agency-backed MBS and private-label MBS in an effort to maximize return to its shareholders. As of June 30, 2015, the Company’s available capital was allocated approximately 77% to agency-backed MBS and 23% to private label MBS compared to 61% to agency-backed MBS and 39% to private-label MBS as of December 31, 2014. Overall, the Company believes that returns on its legacy private-label MBS portfolio have plateaued as many of its investments have reached the Company’s price targets. As a result, the Company continued to opportunistically reallocate capital from its legacy private-label MBS into higher returning investments. During the second quarter of 2015, the Company sold private-label MBS for sale proceeds of $89.6 million realizing a gain of $13.1 million for net sale proceeds of $66.8 million after deducting associated repurchase financing. The change in value of the Company’s private-label MBS portfolio during the second quarter inclusive of the sale price for sold private-label MBS contributed to an $0.18 per share decline in book value. The available capital from the sale of private-label MBS was generally reinvested into agency-backed MBS on a levered basis during the quarter at what the Company believes are at attractive risk-adjusted return levels. The Company has seen small pockets of new investment opportunities in private-label MBS having invested $2.9 million of capital into new private-label MBS during the quarter. The Company remains cautiously optimistic that it could see additional investment opportunities in private-label MBS although the volume of new investments at the Company’s targeted investment returns is uncertain. The Company expects to continue to opportunistically reallocate capital from its matured legacy private-label MBS portfolio into new higher returning investments.

As of June 30, 2015, the Company’s debt to equity ratio was 6.8 to 1, an increase from 6.0 to 1 as of March 31, 2015. Including the Company’s net purchased securities payable, the Company’s debt to equity ratio was 7.3 to 1 as of June 30, 2015, an increase from 6.2 to 1 as of March 31, 2015. The increase in the Company’s overall leverage is the result of the reallocation of capital from its private-label MBS portfolio to its agency-backed MBS portfolio.

The Company is subject to taxation as a corporation under Subchapter C of the Internal Revenue Code of 1986, as amended (the “Code”). However, the Company currently has net operating loss (“NOL”) and net capital loss (“NCL”) carry-forwards that can be applied against the Company’s current taxable ordinary income and net capital gains.

The Company declared a dividend of $0.875 per share for the second quarter of 2015. The dividend was paid on July 31, 2015 to shareholders of record as of June 30, 2015. The Company continues to maintain a variable dividend policy pursuant to which the Board of Directors evaluates dividends on a quarterly basis and, in its sole discretion, may approve the payment of dividends. The Company considers many factors in determining the amount of its quarterly dividends, including its net income determined in accordance with GAAP, non-GAAP core operating income measures, book value per share, liquidity, expectations of future performance, among other factors.

Non-GAAP Core Operating Income

In addition to the financial results reported in accordance with GAAP, the Company calculated non-GAAP core operating income measurements for the three and six months ended June 30, 2015 and 2014. In determining core operating income, the Company excludes certain legacy litigation expenses and adjusts net income determined in accordance with GAAP for the following non-cash and other items: (1) compensation costs associated with stock-based awards, (2) non-cash accretion of private-label MBS purchase discounts, (3) private-label MBS purchase discount accretion realized upon sale or repayment, (4) other-than-temporary impairment charges, (5) other-than-temporary impairment charges realized upon sale, (6) both realized and unrealized gains and losses on agency-backed MBS and all related hedge instruments, and (7) non-cash income tax provisions. During the first quarter of 2015, the Company has chosen to modify non-GAAP core operating income to better reflect the attributes of the business and total performance of its MBS portfolio. The Company now includes in core operating income in the period it sells a private-label MBS investment any other-than-temporary impairment (“OTTI”) charges on the investment previously recognized in prior periods. As a result, the Company has revised its previously reported core operating income for the prior periods presented below to conform to the new revised presentation.

The Company’s portfolio strategy on its agency-backed MBS portfolio is to generate a net interest margin on the leveraged assets and hedge the market value of the assets, expecting that the fluctuations in the market value of the agency-backed MBS and related hedges should largely offset each other over time. As a result, the Company excludes both the realized and unrealized fluctuations in the gains and losses in the assets and hedges on its hedged, agency-backed MBS portfolio when assessing the underlying core operating income of the Company. However, the Company’s portfolio strategy on the Company’s private-label MBS portfolio is to generate a total cash return comprised of both coupon interest income collected and the cash return realized when the private-label MBS are sold that equals the difference between the sale price and the discount to par paid at acquisition. Therefore, the Company excludes non-cash accretion of private-label MBS purchase discounts from non-GAAP core operating income, but includes realized cash gains or losses on its private-label MBS portfolio in core operating income to reflect the total cash return on those securities over their holding period. Since the timing of realized cash gains or losses on private-label MBS may vary significantly between periods, the Company also reports non-GAAP core operating income excluding gains on private-label MBS.

These non-GAAP core operating income measurements are used by management to analyze and assess the Company’s operating results on its portfolio and assist with the determination of the appropriate level of dividends. The Company believes that these non-GAAP measurements assist investors in understanding the impact of these non-core items and non-cash expenses on our performance and provides additional clarity around our earnings capacity and trends. A limitation of utilizing these non-GAAP measures 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. Additional limitations of core operating income are that it does not include economic financing costs of the Company’s hedging instruments or amortization of premiums or discounts on the Company’s agency-backed MBS whereas both those amounts are reflected in net income determined in accordance with GAAP within the line item net investment gain (loss) in the statement of comprehensive income. Therefore, the Company believes net income on a GAAP basis and core operating income on a non-GAAP basis should be considered together.

The Company’s non-GAAP core operating income increased to $40.6 million, or $1.76 per diluted share, for the three months ended June 30, 2015 compared to $23.0 million, or $1.15 per diluted share, for the three months ended June 30, 2014. The Company’s non-GAAP core operating income increased to $75.1 million, or $3.25 per diluted share, for the six months ended June 30, 2015 compared to $40.5 million, or $2.18 per diluted share, for the six months ended June 30, 2014. The non-GAAP core operating income for the three and six months ended June 30, 2015 benefited from the cash gains from the sales of private-label MBS. The Company’s non-GAAP core operating income excluding sales of private-label MBS was $30.5 million, or $1.32 per diluted share, and $59.9 million, or $2.59 per diluted share, for the three and six months ended June 30, 2015, respectively. The Company’s non-GAAP core operating income excluding sales of private-label MBS was $23.6 million, or $1.18 per diluted share, and $41.5 million, or $2.23 per diluted share, for the three and six months ended June 30, 2014, respectively. As the Company’s allocation of capital to agency-backed MBS has continued to grow, the higher net interest income associated from that portfolio has also contributed to an increase in the Company’s core operating income per share. The economic costs of the Company’s hedge instruments have generally increased proportionately with the growth in the agency-backed MBS portfolio. However, the economic costs of the Company’s hedge instruments are ultimately reflected through net income per share determined in accordance with GAAP and changes in book value per share rather than core operating income per share.

The following is a reconciliation of GAAP net income to non-GAAP core operating income measures for the three and six months ended June 30, 2015 and 2014 (dollars in thousands, except per share data):