Arlington Asset Investment Corp. - Quarter Report: 2016 September (Form 10-Q)

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

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

Virginia		54-1873198
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

1001 Nineteenth Street North Arlington, VA		22209
(Address of Principal Executive Offices)		(Zip Code)

Large accelerated filer ☐

Accelerated filer ☒

Non-accelerated filer ☐

Smaller reporting company ☐

Title		Outstanding
Class A Common Stock		22,934,421 shares
Class B Common Stock		97,604 shares

						Page
PART I — FINANCIAL INFORMATION
		Item 1.		Consolidated Financial Statements and Notes		1
				Consolidated Balance Sheets — September 30, 2016 (unaudited) and December 31, 2015 (audited)		1
				Consolidated Statements of Comprehensive Income — Three and Nine Months Ended September 30, 2016 and 2015 (unaudited)		2
				Consolidated Statements of Changes in Equity — Nine Months Ended September 30, 2016 (unaudited) and Year Ended December 31, 2015 (audited)		3
				Consolidated Statements of Cash Flows — Nine Months Ended September 30, 2016 and 2015 (unaudited)		4
				Notes to Consolidated Financial Statements (unaudited)		5
		Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		29
		Item 3.		Quantitative and Qualitative Disclosures about Market Risk		47
		Item 4.		Controls and Procedures		51
PART II — OTHER INFORMATION
		Item 1.		Legal Proceedings		52
		Item 1A.		Risk Factors		52
		Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds		52
		Item 3.		Defaults Upon Senior Securities		52
		Item 4.		Mine Safety Disclosures		52
		Item 5.		Other Information		52
		Item 6.		Exhibits		52
				Signatures		54

		September 30, 2016				December 31, 2015
		(unaudited)				(audited)
ASSETS
Cash and cash equivalents		$	42,761			$	36,987
Interest receivable			10,683				11,936
Sold securities receivable			62,516				—
Mortgage-backed securities, at fair value
Private-label			21,304				130,553
Agency			3,669,259				3,865,316
Derivative assets, at fair value			7,870				12,991
Deferred tax assets, net			96,891				97,530
Deposits			120,537				29,429
Other assets			2,776				18,197
Total assets		$	4,034,597			$	4,202,939
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Repurchase agreements		$	3,376,898			$	2,834,780
Federal Home Loan Bank advances			—				786,900
Interest payable			1,449				2,436
Accrued compensation and benefits			4,315				5,170
Dividend payable			15,060				14,504
Derivative liabilities, at fair value			68,084				553
Purchased securities payable			59,763				—
Other liabilities			1,239				1,132
Long-term debt			73,601				73,433
Total liabilities			3,600,409				3,718,908
Commitments and contingencies
Stockholders’ 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, 22,934,421    and 22,874,819 shares issued and outstanding, respectively			229				229
Class B common stock, $0.01 par value, 100,000,000 shares authorized, 97,604 and    102,216 shares issued and outstanding, respectively			1				1
Additional paid-in capital			1,899,754				1,898,085
Accumulated other comprehensive income, net of taxes of $(823) and $3,230,    respectively			4,685				12,371
Accumulated deficit			(1,470,481	)			(1,426,655	)
Total stockholders’ equity			434,188				484,031
Total liabilities and stockholders’ equity		$	4,034,597			$	4,202,939

		Three Months Ended September 30,								Nine Months Ended September 30,
		2016				2015				2016				2015
Interest income
Agency mortgage-backed securities		$	23,917			$	27,989			$	72,980			$	77,575
Private-label mortgage-backed securities			1,655				3,249				7,437				12,458
Other			82				1				342				2
Total interest income			25,654				31,239				80,759				90,035
Interest expense
Short-term debt			6,193				3,989				17,202				10,464
Long-term debt			1,197				1,176				3,584				3,004
Total interest expense			7,390				5,165				20,786				13,468
Net interest income			18,264				26,074				59,973				76,567
Investment gain (loss), net
Realized gain on sale of available-for-sale    investments, net			2,439				969				1,846				17,434
Other-than-temporary impairment charges			—				—				(1,737	)			—
Gain on trading investments, net			2,468				36,889				81,083				5,189
Gain (loss) from derivative instruments, net			15,196				(97,627	)			(119,945	)			(143,138	)
Other, net			619				12				638				433
Total investment gain (loss), net			20,722				(59,757	)			(38,115	)			(120,082	)
General and administrative expenses
Compensation and benefits			3,430				2,071				8,750				7,152
Other general and administrative expenses			1,200				1,379				7,887				3,661
Total general and administrative expenses			4,630				3,450				16,637				10,813
Income (loss) before income taxes			34,356				(37,133	)			5,221				(54,328	)
Income tax provision			15,543				15,497				5,132				33,886
Net income (loss)		$	18,813			$	(52,630	)		$	89			$	(88,214	)
Basic earnings (loss) per share		$	0.82			$	(2.29	)		$	-			$	(3.84	)
Diluted earnings (loss) per share		$	0.81			$	(2.29	)		$	-			$	(3.84	)
Weighted-average shares outstanding (in thousands)
Basic			23,038				23,021				23,011				22,991
Diluted			23,349				23,021				23,154				22,991
Other comprehensive income (loss), net of taxes
Unrealized losses on available-for-sale securities    (net of taxes of $(141), $(1,562), $(3,946),    and $(4,117), respectively)		$	(221	)		$	(2,451	)		$	(6,197	)		$	(6,775	)
Reclassification
Included in investment gain (loss), net, related to sales of available-    for-sale securities (net of taxes of $(639), $(287), $(783),    and $(4,979), respectively)			(2,324	)			(1,122	)			(2,550	)			(17,763	)
Included in investment gain (loss), net, related to other-than-    temporary impairment charges on available-for-sale    securities (net of taxes of $-0-, $-0-, $676, and $-0-,    respectively)			—				—				1,061				—
Comprehensive income (loss)		$	16,268			$	(56,203	)		$	(7,597	)		$	(112,752	)

		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, 2014			22,860,922			$	229				105,869			$	1			$	1,897,027			$	35,872			$	(1,287,855	)		$	645,274
Net loss			—				—				—				—				—				—				(69,403	)			(69,403	)
Conversion of Class B common stock to    Class A common stock			3,653				—				(3,653	)			—				—				—				—				—
Issuance of Class A common stock    under stock-based compensation plans			97,651				—				—				—				—				—				—				—
Repurchase of Class A common stock			(48,695	)			—				—				—				(593	)			—				—				(593	)
Repurchase of Class A common stock    under stock-based compensation plans			(38,712	)			—				—				—				(572	)			—				—				(572	)
Stock-based compensation			—				—				—				—				1,145				—				—				1,145
Income tax benefit from stock-based    compensation			—				—				—				—				1,078				—				—				1,078
Other comprehensive loss			—				—				—				—				—				(23,501	)			—				(23,501	)
Dividends declared			—				—				—				—				—				—				(69,397	)			(69,397	)
Balances, December 31, 2015			22,874,819				229				102,216				1				1,898,085				12,371				(1,426,655	)			484,031
Net income			—				—				—				—				—				—				89				89
Conversion of Class B common stock to    Class A common stock			4,612				—				(4,612	)			—				—				—				—				—
Issuance of Class A common stock    under stock-based compensation plans			73,457				—				—				—				—				—				—				—
Repurchase of Class A common stock    under stock-based compensation plans			(18,467	)			—				—				—				(269	)			—				—				(269	)
Stock-based compensation			—				—				—				—				2,181				—				—				2,181
Income tax provision from stock-based    compensation			—				—				—				—				(243	)			—				—				(243	)
Other comprehensive loss			—				—				—				—				—				(7,686	)			—				(7,686	)
Dividends declared			—				—				—				—				—				—				(43,915	)			(43,915	)
Balances, September 30, 2016			22,934,421			$	229				97,604			$	1			$	1,899,754			$	4,685			$	(1,470,481	)		$	434,188

		Nine Months Ended September 30,
		2016				2015
Cash flows from operating activities:
Net income (loss)		$	89			$	(88,214	)
Adjustments to reconcile net loss to net cash provided by operating activities
Net investment loss			38,115				120,082
Net premium amortization on mortgage-backed securities			19,647				19,374
Deferred tax provision			4,692				31,384
Other			1,913				(295	)
Changes in operating assets
Interest receivable			1,253				(757	)
Other assets			2,246				1,551
Changes in operating liabilities
Interest payable and other liabilities			(2,786	)			(16	)
Accrued compensation and benefits			(855	)			(1,773	)
Net cash provided by operating activities			64,314				81,336
Cash flows from investing activities:
Purchases of private-label mortgage-backed securities			(5,357	)			(2,870	)
Purchases of agency mortgage-backed securities			(2,051,425	)			(1,506,573	)
Proceeds from sales of private-label mortgage-backed securities			106,052				124,637
Proceeds from sales of agency mortgage-backed securities			1,950,728				801,459
Receipt of principal payments on private-label mortgage-backed securities			490				1,741
Receipt of principal payments on agency mortgage-backed securities			351,871				372,457
Payments for derivatives and deposits, net			(138,402	)			(143,359	)
Other			15,891				(5,797	)
Net cash provided by (used in) investing activities			229,848				(358,305	)
Cash flows from financing activities:
Proceeds from (repayments of) repurchase agreements, net			542,118				(26,019	)
(Repayments of) proceeds from Federal Home Loan Bank advances			(786,900	)			308,500
Proceeds from long-term debt issuance, net			—				34,063
Excess tax (provisions) benefits associated with stock-based awards			(243	)			726
Dividends paid			(43,363	)			(60,604	)
Net cash (used in) provided by financing activities			(288,388	)			256,666
Net increase (decrease) in cash and cash equivalents			5,774				(20,303	)
Cash and cash equivalents, beginning of period			36,987				33,832
Cash and cash equivalents, end of period		$	42,761			$	13,529
Supplemental cash flow information:
Cash payments for interest		$	21,605			$	13,228
Cash payments for taxes		$	205			$	433
Non-cash investing activity:
Receipt of non-public equity securities upon dissolution of   investee fund		$	619			$	—

		Fiscal Year 2015
		Total Year				Fourth Quarter				Third Quarter				Second Quarter				First Quarter
Interest income: agency mortgage-backed securities:
As previously reported		$	139,244			$	35,475			$	37,325			$	34,530			$	31,914
Retrospective adjustment			(33,330	)			(7,136	)			(9,336	)			(10,404	)			(6,454	)
As revised		$	105,914			$	28,339			$	27,989			$	24,126			$	25,460
Gain (loss) on trading investments, net:
As previously reported		$	(64,388	)		$	(43,383	)		$	27,553			$	(61,849	)		$	13,291
Retrospective adjustment			33,330				7,136				9,336				10,404				6,454
As revised		$	(31,058	)		$	(36,247	)		$	36,889			$	(51,445	)		$	19,745
Effect to previously reported net income (loss)		$	—			$	—			$	—			$	—			$	—

		Effect on Interest Income Recognition for Investments in Private-Label MBS Classified as:
Scenario:		Available-for-Sale		Trading
A positive change in cash flows occurs.   Actual cash flows exceed prior estimates and/or a positive change occurs in the estimate of expected remaining cash flows.		If the positive change in cash flows is deemed significant, a revised effective interest rate is calculated and applied prospectively such that the positive change is recognized as incremental interest income over the remaining life of the security. This revised effective interest rate is also used in subsequent periods to determine if any declines in the fair value of that security are other-than-temporary.		A revised effective interest rate is calculated and applied prospectively such that the positive change in cash flows is recognized as incremental interest income over the remaining life of the security.
An adverse change in cash flows occurs.   Actual cash flows fall short of prior estimates and/or an adverse change occurs in the estimate of expected remaining cash flows.		The security’s effective interest rate is unaffected. If an adverse change in cash flows occurs for a security that is impaired (that is, its fair value is less than its amortized cost basis), the impairment is considered other-than-temporary due to the occurrence of a credit loss. If a credit loss occurs, the Company writes-down the amortized cost basis of the security to an amount equal to the present value of cash flows expected to be collected, discounted at the security’s existing effective interest rate, and recognizes a corresponding other-than-temporary impairment charge in earnings as a component of “investment gain (loss), net.”		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 fair value is less than its reference amount), 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.

Investments in agency MBS, subsequent measurement	Note 3
Investments in private-label MBS, subsequent measurement	Note 4
Borrowings	Note 5
To-be-announced agency MBS transactions, including “dollar rolls”	Note 6
Derivative instruments	Note 6

Balance sheet offsetting	Note 7
Fair value measurements	Note 8

Standard	Description	Date of Adoption	Effect on the Consolidated Financial Statements
Recently Adopted Accounting Guidance
ASU No. 2015-02, Amendments to the Consolidation Analysis (Topic 810)	This amendment makes targeted changes to the current consolidation guidance and ends the deferral granted to investment companies from applying variable interest entity guidance.	January 1, 2016	This amendment did not have an impact on the Company’s consolidated financial statements.
ASU No. 2015-03, Simplifying the Presentation of Debt Issuance Costs (Subtopic 835-30)	This amendment 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.	January 1, 2016	The adoption of this amendment resulted in an immaterial reclassification of unamortized debt issuance costs from the line item “other assets” to the line item “long-term debt” on the Company’s consolidated balance sheets.
Recently Issued Accounting Guidance Not Yet Adopted
ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606)	This amendment defers the effective date of ASU No. 2014-09 for all entities by one year.   ASU No. 2014-09 requires entities to recognize revenue to depict the transfer of promised goods or services to customers in amounts that reflect the consideration to which the entity expects to be entitled in exchange for those goods or services. Revenue recognition with respect to financial instruments is not within the scope of ASU No. 2014-09.	January 1, 2018	The Company does not expect that the adoption of ASU No. 2015-14 will have a material impact on its consolidated financial statements.
ASU No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (Subtopic 825-10)	This amendment makes targeted changes to certain aspects of guidance applicable to financial assets and financial liabilities. The amendment primarily affects accounting for certain equity investments, financial liabilities measured under the fair value option, and certain financial instrument presentation and disclosure requirements. Accounting for investments in debt securities and financial liabilities not measured under the fair value option is largely unaffected by this amendment.	January 1, 2018	The Company is currently evaluating the impact of this amendment on its consolidated financial statements.

 

 

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

Note 3. Investments in Agency MBS

The Company’s investments in agency MBS are reported in the accompanying consolidated balance sheets at fair value. Substantially all of the Company’s investments in agency MBS are classified as trading securities. The following table provides the fair value of the Company’s available-for-sale and trading investments in agency MBS as of the dates indicated:

 

 

Substantially all of the Company’s investments in agency MBS represent undivided (or “pass-through”) beneficial interests in specified pools of fixed-rate mortgage loans. As of September 30, 2016, the Company’s portfolio of investments in agency MBS classified as trading securities also includes investments in inverse interest-only agency MBS with an aggregate fair value of $4,531. Each of the Company’s investments in inverse interest-only agency MBS represents a beneficial interest in a portion of the interest cash flows of an underlying pool of pass-through agency MBS collateralized by adjustable-rate mortgage loans.

 

All periodic changes in the fair value of trading agency MBS that are not attributed to interest income are recognized as a component of “investment gain (loss), net” in the accompanying consolidated statements of comprehensive income. The following table provides additional information about the gains and losses recognized as a component of “investment gain (loss), net” in the Company’s consolidated statements of comprehensive income for the periods indicated with respect to investments in agency MBS classified as trading securities:

 

 

The Company also invests in and finances fixed-rate agency MBS on a generic pool basis through sequential series of to-be-announced security transactions commonly referred to as “dollar rolls.” Dollar rolls are accounted for as a sequential series of derivative instruments. Refer to “Note 6. Derivative Instruments” for further information about dollar rolls.

 

 

Note 4. Investments in Private-Label MBS

The Company’s investments in private-label MBS are reported in the accompanying consolidated balance sheets at fair value. Investments in private-label MBS acquired prior to 2015 are classified as available-for-sale. The Company has elected to classify its investments in private-label MBS acquired in 2015 or later as trading securities. The following table provides the fair value of the Company’s available-for-sale and trading investments in private-label MBS as of the dates indicated:

 

 

As of September 30, 2016, the private-label MBS portfolio consists primarily of “re-REMIC” securities. The Company’s investments in re-REMIC securities represent “mezzanine” interests in underlying, re-securitized senior class MBS issued by private-

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

label Real Estate Mortgage Investment Conduit (“REMIC”) securitization trusts. The senior class REMIC securities that serve as collateral to the Company’s investments in re-REMIC securities represent beneficial interests in pools of prime or Alt-A residential mortgage loan collateral that hold the first right to cash flows and absorb credit losses only after their respective subordinate REMIC classes have been fully extinguished. The majority of the trusts that issued the Company’s investments in re-REMIC securities employ a “sequential” principal repayment structure, while a minority of the issuing trusts employ a “pro-rata” principal repayment structure. Accordingly, the majority of the Company’s mezzanine class re-REMIC securities are not entitled to receive principal repayments until the principal balance of the senior interest in the respective collateral group has been reduced to zero. Principal shortfalls are allocated on a “reverse sequential” basis. Accordingly, any principal shortfalls on the underlying senior class REMIC securities are first absorbed by the Company’s mezzanine class re-REMIC securities, to the extent of their respective principal balance, prior to being allocated to the senior interest in the respective collateral pool. Periodic interest accrues on each re-REMIC security’s outstanding principal balance at its contractual coupon rate.

The prime and Alt-A residential mortgage loans that serve as collateral to the underlying REMIC securitization trusts of the Company’s private-label MBS had the following weighted average characteristics, based on face value, as of the dates indicated:

 

 

 

 

Available-for-Sale Private-Label MBS

Periodic changes in the fair value of the Company’s available-for-sale private-label MBS that are not attributed to interest income or other-than-temporary impairments represent unrealized holding gains and losses. Unrealized holding gains and losses are accumulated in other comprehensive income until the securities are sold. Gross unrealized gains and losses accumulated in other comprehensive income for the Company’s investments in available-for-sale private-label MBS were the following as of the dates indicated:

 

 

 

Upon the sale of available-for-sale private-label MBS, any gains or losses accumulated in other comprehensive income are recognized in earnings as a component of “investment gain (loss), net.” The Company uses the specific identification method to determine the realized gain or loss that is recognized in earnings upon the sale of an available-for-sale private-label MBS.

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

The following table presents the results of sales of available-for-sale private-label MBS for the periods indicated:

 

 

Accretable Yield

The excess of the Company’s estimate of undiscounted future cash flows expected to be collected over the security’s amortized cost basis represents that security’s accretable yield. The accretable yield is expected to be recognized as interest income over the remaining life of the security on a level-yield basis. The difference between undiscounted future contractual cash flows and undiscounted future expected cash flows represents the non-accretable difference. Based on actual payments received and/or changes in the estimate of future cash flows expected to be collected, the accretable yield and the non-accretable difference can change over time. Actual cash collections that exceed prior estimates and/or positive changes in the Company’s periodic estimate of expected future cash flows result in a reclassification of non-accretable difference to accretable yield. Conversely, actual cash collections that fall short of prior estimates and/or adverse changes in the Company’s periodic estimate of expected future cash flows result in a reclassification of accretable yield to non-accretable difference.

The following table presents the changes in the accretable yield solely for available-for-sale private-label MBS for the periods indicated:

 

 

Other-than-Temporary Impairments

The Company evaluates available-for-sale MBS for other-than-temporary impairment on a quarterly basis. When the fair value of an available-for-sale security is less than its amortized cost at the quarterly reporting date, the security is considered impaired. Impairments determined to be other-than-temporary are recognized as a direct write-down to the security’s amortized cost basis with a corresponding charge recognized in earnings as a component of “investment gain (loss), net.” An impairment is considered other-than-temporary when (i) the Company intends to sell the impaired security, (ii) the Company more-likely-than not will be required to sell the impaired security prior to the recovery of its amortized cost basis, or (iii) a credit loss exists. A credit loss exists when the present value of the Company’s estimate of the cash flows expected to be collected from the security, discounted at the security’s existing effective interest rate, is less than the security’s amortized cost basis.

If the Company intends to sell an impaired security or it more-likely-than-not will be required to sell an impaired security before recovery of its amortized cost basis, the Company writes-down the amortized cost basis of the security to an amount equal to the security’s fair value and recognizes a corresponding other-than-temporary impairment charge in earnings as a component of “investment gain (loss), net.” If a credit loss exists for an impaired security that the Company does not intend to sell nor will it likely be required to sell prior to recovery, the Company writes-down the amortized cost basis of the security to an amount equal to the present value of cash flows expected to be collected, discounted at the security’s existing effective interest rate, and recognizes a corresponding other-than-temporary impairment charge in earnings as a component of “investment gain (loss), net.”

For the three and nine months ended September 30, 2016, the Company recorded credit related other-than-temporary impairment charges of $-0- and $1,737, respectively, as a component of “investment gains (loss), net” on the consolidated statements

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

of comprehensive income on certain available-for-sale private-label MBS. The Company recorded no other-than-temporary impairment charges on available-for-sale private-label MBS during the three and nine months ended September 30, 2015. The following table presents a summary of cumulative credit related other-than-temporary impairment charges recognized on the available-for-sale private-label MBS held as of the dates indicated:

 

 

Trading Private-Label MBS

Periodic changes in the fair value of investments in trading private-label MBS that are not attributable to interest income are recognized as a component of “investment gain (loss), net” in the Company’s consolidated statements of comprehensive income. The following table provides additional information about the gains and losses recognized as a component of “investment gain (loss), net” for the periods indicated with respect to investments in private-label MBS classified as trading securities:

 

 

 

Note 5. Borrowings

Repurchase Agreements

The Company finances the purchase of MBS through repurchase agreements, which are accounted for as collateralized borrowing arrangements. In a repurchase transaction, the Company sells MBS to a counterparty under a master repurchase agreement in exchange for cash and concurrently agrees to repurchase the same security at a future date in an amount equal to the cash initially exchanged plus an agreed-upon amount of interest. MBS sold under agreements to repurchase remain on the Company’s consolidated balance sheets because the Company maintains effective control over such securities throughout the duration of the arrangement. Throughout the contractual term of a repurchase agreement, the Company recognizes a “repurchase agreement” liability on its consolidated balance sheets to reflect the obligation to repay to the counterparty the proceeds received upon the initial transfer of the MBS. The difference between the proceeds received by the Company upon the initial transfer of the MBS and the contractually agreed-upon repurchase price is recognized as interest expense over the term of the repurchase arrangement on a level-yield basis.

Amounts borrowed pursuant to repurchase agreements are equal in value to a specified percentage of the fair value of the pledged collateral. The Company retains beneficial ownership of the pledged collateral throughout the term of the repurchase agreement. 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.

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

As of September 30, 2016 and December 31, 2015, 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 the dates indicated:

 

 

The following table provides information regarding the Company’s outstanding repurchase agreement borrowings during the three and nine months ended September 30, 2016 and 2015:

 

 

Federal Home Loan Bank Advances

In September 2015, the Company’s wholly-owned captive insurance subsidiary, Key Bridge Insurance, LLC (“Key Bridge”), was granted membership to the Federal Home Loan Bank of Cincinnati (“FHLBC”). The FHLBC, like each of the 11 regional Federal Home Loan Banks (collectively, the “FHLB”), is a cooperative that provides its member financial institutions with a number of financial products and services, including short and long-term secured borrowings that are known as “advances.” FHLBC advances may be collateralized by a number of real estate related assets, including agency MBS. As a member of the FHLBC, Key Bridge is required to acquire membership stock as well as activity-based stock (the amount of which is based upon a percentage of the dollar amount of its outstanding advances) in the FHLBC. As of September 30, 2016 and December 31, 2015, Key Bridge held $2 and $15,740 of capital stock in the FHLBC, respectively, which is included in “other assets” in the accompanying consolidated balance sheets. Similar to a repurchase agreement borrowing, the Company pledged agency MBS as collateral to secure the advance to Key Bridge, the amount of which is equal to a specified percentage of the fair value of the pledged collateral. The Company retained beneficial ownership of the pledged collateral throughout the term of the advance arrangement. The FHLBC held the right to require that the Company pledge additional collateral to secure borrowings when the value of the collateral declined.

14

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

On January 12, 2016, the regulator of the FHLB system, the Federal Housing Finance Agency (“FHFA”), released a final rule that amends regulations governing FHLB membership, including an amendment which prevents captive insurance companies from being eligible for FHLB membership. Under the terms of the final rule, Key Bridge is required to terminate its membership and repay its existing advances within one year following the final rule’s effective date of February 19, 2016. In addition, Key Bridge is prohibited from obtaining new advances during the one year transition period. During the first quarter of 2016, the Company repaid all of its outstanding FHLBC advances, funded primarily through proceeds obtained from traditional repurchase agreement financing arrangements.

The following table provides information regarding the Company’s outstanding FHLB advances as of the date indicated:

 

 

Long-Term Debt

As of September 30, 2016 and December 31, 2015, the Company had $73,601 and $73,433, respectively, of outstanding long-term debentures, net of unamortized debt issuance costs of $1,699 and $1,867, respectively. The Company’s long-term debentures consisted of the following as of the dates indicated:

 

 

On March 18, 2015, the Company completed a public offering of $35,300 of 6.75% Senior Notes due in 2025 and received net proceeds of $34,063 after payment of underwriting discounts, commissions, and expenses.

The Senior Notes due 2023 and the Senior Notes due 2025 are publicly traded on the New York Stock Exchange under the ticker symbols “AIW” and “AIC,” respectively. The Senior Notes due 2023 and Senior Notes due 2025 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 and March 15, 2018, respectively, at a redemption price equal to the principal amount plus accrued and unpaid interest. 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.

 

 

Note 6. Derivative Instruments

In the normal course of its operations, the Company is a party to financial instruments that are accounted for as derivative instruments. Derivative instruments are recorded at fair value as either “derivative assets” or “derivative liabilities” in the consolidated

15

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

balance sheets, with all periodic changes in fair value reflected as a component of “investment gain (loss), net” in the consolidated statements of comprehensive income. Cash receipts or payments related to derivative instruments are classified as investing activities within the consolidated statements of cash flows.

Types and Uses of Derivative Instruments

Interest Rate Derivatives

Most of the Company’s derivative instruments are interest rate derivatives that are intended to economically hedge changes, attributable to changes in benchmark interest rates, in certain MBS fair values and future interest cash flows on the Company’s short-term financing arrangements. Interest rate derivatives include centrally cleared interest rate swaps as well as exchange-traded instruments, such as Eurodollar futures, interest rate swap futures, U.S. Treasury note futures, and options on futures. While the Company uses its interest rate derivatives to economically hedge a portion of its interest rate risk, it has not designated such contracts as hedging instruments for financial reporting purposes.

The Company exchanges collateral with the counterparties to its interest rate derivative instruments at least on a daily basis based upon daily changes in fair value (also known as “variation margin”) as measured by the central clearinghouse through which those derivatives are cleared. In addition, the central clearinghouse requires market participants to deposit and maintain an “initial margin” amount which is determined by the clearinghouse and is generally intended to be set at a level sufficient to protect the clearinghouse from the maximum estimated single-day price movement in that market participant’s contracts. Cash initial and variation margin posted by the Company in respect of interest rate derivatives is included in the line item “deposits” in the accompanying consolidated balance sheets.

To-Be-Announced Agency MBS Transactions, Including “Dollar Rolls”

In addition to interest rate derivatives that are used for interest rate risk management, the Company is a party to derivative instruments that economically serve as investments, such as forward contracts to purchase or sell fixed-rate “pass-through” agency MBS on a non-specified pool basis, which are known as to-be-announced (“TBA”) contracts. A TBA contract is a forward contract for the purchase or sale of a fixed-rate agency MBS at a predetermined price, face amount, issuer, coupon, and stated maturity on an agreed upon future date. The specific agency MBS that will be delivered to satisfy the TBA trade is not known at the inception of the trade. The Company accounts for TBA contracts as derivative instruments because the Company cannot assert that it is probable at inception and throughout the term of an individual TBA contract that its settlement will result in physical delivery of the underlying agency MBS, or the individual TBA contract will not settle in the shortest time period possible.

The Company’s agency MBS investment portfolio includes net purchase (or “net long”) positions in TBA securities, which are primarily the result of executing sequential series of “dollar roll” transactions. The Company executes dollar roll transactions as a means of investing in and financing non-specified fixed-rate agency MBS. Such transactions involve effectively delaying (or “rolling”) the settlement of a forward purchase of a TBA agency MBS by entering into an offsetting sale prior to the settlement date, net settling the “paired-off” positions in cash, and contemporaneously entering another forward purchase of a TBA agency MBS of the same characteristics for a later settlement date. TBA securities purchased or sold for a forward settlement month are generally priced at a discount relative to TBA securities purchased for settlement in the current month. This discount, often referred to as the dollar roll “price drop,” reflects compensation for the net interest income (interest income less financing costs) that is foregone as a result of relinquishing beneficial ownership of the MBS for the duration of the dollar roll (also known as “dollar roll income”). By executing a sequential series of dollar roll transactions, the Company is able to create the economic experience of investing in an agency MBS, financed with a repurchase agreement, over a period of time. Forward purchases and sales of TBA securities are accounted for as derivative instruments in the Company’s financial statements. Accordingly, dollar roll income is recognized as a component of “investment gains (losses), net” along with all other periodic changes in the fair value of TBA commitments.

Cash collateral posted by the Company with respect to TBA transactions is included in the line item “deposits” in the accompanying consolidated balance sheets.

In addition to TBA transactions, the Company may, from time to time, enter into commitments to purchase or sell specified agency MBS that do not qualify as regular-way security trades. Such commitments are also accounted for as derivative instruments.

16

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

Derivative Instrument Population and Fair Value

The following table presents the fair value of the Company’s derivative instruments as of the dates indicated:

 

 

Interest Rate Swaps

The Company’s interest rate swap agreements represent agreements to make semiannual interest payments based upon a fixed interest rate and receive quarterly variable interest payments based upon the prevailing three-month LIBOR on the date of reset.

 

The following table presents information about the Company’s interest rate swap agreements that were in effect as of September 30, 2016:

 

 

The following table presents information about the Company’s forward-starting interest rate swap agreements that had yet to take effect as of September 30, 2016:

 

 

The following table presents information about the Company’s interest rate swap agreements as of December 31, 2015, all of which were in effect as of that date:

 

17

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

 

Options on 10-year U.S. Treasury Note Futures

The Company has purchased and sold exchange-traded options on U.S. Treasury note futures contracts as of September 30, 2016 with the objective of hedging a portion of the interest rate sensitivity of the Company’s agency MBS portfolio.  As of September 30, 2016, the Company holds put options which provide the Company with the right to sell 10-year U.S. Treasury note futures to a counterparty with an equivalent notional amount of $600 million that were struck at a weighted average strike price that equates to a 10-year U.S. Treasury rate of approximately 1.71%.  In addition, the Company has sold, or written, call options that provide a counterparty with the option to buy 10-year U.S. Treasury note futures from the Company with an equivalent notional amount of $600 million that were struck at a weighted average strike price per contract that equates to a 10-year U.S. Treasury rate of approximately 1.39%.  In order to limit its exposure on the sold call options from a significant decline in long-term interest rates, the Company also purchased contracts that provide the Company with the option to buy 10-year U.S. Treasury note futures from a counterparty with an equivalent notional amount of $300 million as of September 30, 2016 that were struck at a weighted average strike price per contract that equates to a 10-year U.S. Treasury rate of approximately 1.07%.  The options may be exercised at any time prior to their expiry, which occurs in the fourth quarter of 2016, and, if exercised, will be net settled in cash.  Information about the Company’s outstanding put and call options on 10-year U.S. Treasury note futures contracts as of September 30, 2016 is as follows:

 

 

TBA Commitments

The following tables present information about the Company’s TBA commitments as of the dates indicated:

 

18

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

 

 

 

Derivative Instrument Gains and Losses

The following tables provide information about the derivative gains and losses recognized within the periods indicated:

 

 

 

19

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

Derivative Instrument Activity

The following tables summarize the volume of activity, in terms of notional amount, related to derivative instruments for the periods indicated:

  

 

 

 

 

 

 

 

20

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

Cash Collateral Posted for Derivative Instruments

The following table presents information about the cash collateral posted by the Company in respect of its derivative instruments, which is included in the line item “deposits” in the accompanying consolidated balance sheets, for the periods indicated:

 

 

 

Note 7. Offsetting of Financial Assets and Liabilities

The agreements that govern certain of the Company’s derivative instruments and short-term financing arrangements provide for a right of setoff in the event of default or bankruptcy with respect to either party to such transactions. The Company presents derivative instruments and short-term financing arrangements, including any associated recognized collateral, in its consolidated balance sheets on a gross basis.

The following tables present information, as of the dates indicated, about the Company’s derivative instruments and short-term borrowing arrangements, including those subject to master netting (or similar) arrangements:

 

21

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

 

 

 

 

Note 8. Fair Value Measurements

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. Financial Accounting Standards Board Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures, 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 measures the fair value of the following assets and liabilities:

Mortgage-backed securities

Agency MBS - The Company’s investments in agency MBS are classified within Level 2 of the fair value hierarchy. Inputs to fair value measurements of the Company’s investments in agency MBS include price estimates obtained from third-party pricing services. The inputs used in the fair value measurements performed by the third-party pricing services are based upon readily

22

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

observable transactions for securities with similar characteristics (such as issuer/guarantor, coupon rate, stated maturity, and collateral pool characteristics) occurring on the measurement date. The Company makes inquiries of the third party pricing sources to understand the significant inputs and assumptions used to determine 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 an overall review for consistency with market conditions observed as of the measurement date.

Private-label MBS - The Company’s investments in private-label MBS are classified within Level 3 of the fair value hierarchy as private-label MBS trade infrequently and, therefore, the measurement of their fair value requires the use of significant unobservable inputs. In determining fair value, the Company primarily uses an income approach as well as market approaches. The Company utilizes present value techniques based on the estimated future 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 collateral performance data, evaluation of historical collateral performance data for other securities with comparable or similar risk characteristics, and observed completed or pending transactions in similar instruments, when available. The significant inputs to the Company’s valuation process include collateral default, loss severity, prepayment, and discount rates (i.e., the rate of return demanded by market participants as of the measurement date). In general, significant increases (decreases) in default, loss severity, or discount rate assumptions, in isolation, would result in a significantly lower (higher) fair value measurement. However, significant increases (decreases) in prepayment rate assumptions, in isolation, may result in a significantly higher (lower) fair value measurement depending upon the instrument’s specific characteristics and the overall payment structure of the issuing securitization vehicle. It is difficult to generalize the interrelationships between these significant inputs as the actual results could differ considerably on an individual security basis. Therefore, each significant input is closely analyzed to ascertain its reasonableness for the Company’s purposes of fair value measurement.

Measuring 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 the timing and amount of future cash flows as well as the rate of return required by market participants. The assumptions the Company applies are specific to each security. Although the Company relies on its internal calculations to estimate the fair value of these private-label MBS, the Company considers indications of value from actual sales of similar private-label MBS to assist in the valuation process and to calibrate the Company’s models.

Derivative instruments

Exchange-traded derivative instruments - Exchange-traded derivative instruments, which include Eurodollar futures, U.S. Treasury note futures, interest rate swap futures, and options on futures, are classified within Level 1 of the fair value hierarchy as they are measured using quoted prices for identical instruments in liquid markets.

Centrally cleared interest rate swaps - Centrally cleared interest rate swaps are classified within Level 2 of the fair value hierarchy. The fair values of centrally cleared interest rate swaps are measured using the daily valuations reported by the clearinghouse through which the instrument was cleared. In performing its end-of-day valuations, the clearinghouse constructs forward interest rate curves (for example, three-month LIBOR forward rates) from its specific observations of that day’s trading activity. The clearinghouse uses the applicable forward interest rate curve to develop a market-based forecast of future remaining contractually required cash flows for each interest rate swap. Each market-based cash flow forecast is then discounted using the overnight index swap rate curve (sourced from the Federal Reserve Bank of New York) to determine a net present value amount which represents the instrument’s fair value. The Company reviews the valuations reported by the clearinghouse on an ongoing basis and performs procedures using readily available market data to independently verify their reasonableness.

Forward-settling purchases and sales of TBA securities – Forward-settling purchases and sales of TBA securities are classified within Level 2 of the fair value hierarchy. The fair value of each forward-settling TBA contract is measured using broker or dealer quotations, which are based upon readily observable transaction prices occurring on the measurement date for forward-settling contracts to buy or sell TBA securities with the same guarantor, contractual maturity, and coupon rate for delivery on the same forward settlement date as the contract under measurement.

23

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

Other

Long-term debt - As of September 30, 2016 and December 31, 2015, the carrying value of the Company’s long-term debt was $73,601 and $73,433, respectively, net of unamortized debt issuance costs, and consists of Senior Notes and trust preferred debt issued by the Company. The Company’s estimate of the fair value of long-term debt is $68,029 and $59,130 as of September 30, 2016 and December 31, 2015, respectively. The Company’s Senior Notes, which are publicly traded on the New York Stock Exchange, are classified within Level 1 of the fair value hierarchy. Trust preferred debt is classified within Level 2 of the fair value hierarchy as the fair value is estimated based on the quoted prices of the Company’s publicly traded Senior Notes.

FHLBC capital stock - FHLBC capital stock is initially purchased at par and may only be transferred back to the FHLBC or to another FHLBC member, subject to approval by the FHLBC, also at par. Due to the restrictions placed on transferability, it is not practical to determine the fair value of FHLBC capital stock. The par value and carrying amount of the FHLBC capital stock included in the line item “other assets” on the Company’s consolidated balance sheets is $2 and $15,740 as of September 30, 2016 and December 31, 2015, respectively.

Investments in equity securities of non-public companies and investment funds - As of September 30, 2016 and December 31, 2015, the Company had investments in equity securities and investment funds with a carrying amount of $2,004 and $1,558, respectively, which are included in the line item “other assets” in the accompanying consolidated balance sheets.  As of September 30, 2016, $619 of these investments represent securities for which the Company elected the “fair value option” at the time that the securities were initially recognized on the Company’s consolidated balance sheets; the Company measures the fair value of these securities on a recurring basis, recognizing the periodic change in fair value in earnings.  The remaining $1,385 in investments in equity securities of non-public companies and investment funds as of September 30, 2016, and the entire population of such securities as of December 31, 2015, were measured at cost, net of impairments. The Company’s estimate of the fair value of investments in equity securities and investment funds is $5,916 and $5,989 as of September 30, 2016 and December 31, 2015, respectively. Investments in equity securities and investment funds are classified within Level 3 of the fair value hierarchy. The fair values of the Company’s investments in equity securities and investment funds are not readily determinable. Accordingly, for its investments in equity securities, the Company estimates fair value by estimating the enterprise value of the investee and then waterfalls the enterprise value over the investee’s securities in the order of their preference relative to one another. To estimate the enterprise value of the investee, the Company uses traditional valuation methodologies, including recent investments in, or tender offers for, the equity securities of the investee. For its investments in investment funds, the Company estimates fair value based upon the investee’s net asset value per share.

Financial assets and liabilities for which carrying value approximates fair value - Cash and cash equivalents, deposits, receivables, repurchase agreements, FHLB advances, 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.

24

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

Fair Value Hierarchy

Financial Instruments Measured at Fair Value on a Recurring Basis

The following tables set forth financial instruments measured at fair value by level within the fair value hierarchy as of September 30, 2016 and December 31, 2015. Assets and liabilities 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 financial instruments into or out of Levels 1, 2 or 3 during the three and nine months ended September 30, 2016 or the year ended December 31, 2015.

25

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

Level 3 Financial Assets and Liabilities

The following table provides information about the significant unobservable inputs used to measure the fair value of the Company’s private-label MBS as of the dates indicated:

 

 

The table below sets forth an attribution of the change in the fair value of the Company’s Level 3 investments that are measured at fair value on a recurring basis for the periods indicated.

 

 

 

Note 9. 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. Third-party investors own all of the preferred shares of Rosslyn REIT. Rosslyn REIT periodically distributes all of its income to its shareholders. The Company’s agency 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 September 30, 2016 and December 31, 2015, the Company had a net deferred tax asset of $96,891 and $97,530, respectively, net of a valuation allowance on NCL carry-forwards of $84,261 and $80,663, 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 will continue to assess the need for a valuation allowance at each reporting date.

As of September 30, 2016, 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.

26

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

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 September 30, 2016, there are no on-going examinations.

 

 

Note 10. 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 loss per share for the three and nine months ended September 30, 2015 did not include the antidilutive effect of 44,422 and 49,785 shares, respectively, of unvested shares of restricted stock and performance share units.

 

 

Note 11. Stockholders’ 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 and paid the following dividends to date in 2016:

 

 

The Board of Directors approved and the Company declared and paid the following dividends for 2015:

 

 

Conversion of Class B Common Stock to Class A Common Stock

During the nine months ended September 30, 2016, holders of the Company’s common stock converted an aggregate of 4,612 shares of Class B common stock into 4,612 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.

27

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

Share Repurchase Program

 

In October 2015, the Board of Directors authorized an increase in the Company’s share repurchase program pursuant to which the Company may repurchase up to 2,000,000 shares of Class A common stock (the “Repurchase Program”). Repurchases under the Repurchase Program may be made from time to time on the open market and in private transactions at management’s discretion in accordance with applicable federal securities laws. The timing of repurchases and the exact number of shares of Class A common stock to be repurchased will depend upon market conditions and other factors. The Repurchase Program is funded using the Company’s cash on hand and cash generated from operations. The Repurchase Program has no expiration date and may be suspended or terminated at any time without prior notice. As of September 30, 2016, there remain available for repurchase 1,951,305 shares of Class A common stock under the Repurchase Program.

 

Shareholder Rights Agreement

 

The Board of Directors adopted and the Company’s shareholders approved a shareholder rights agreement (“Rights Plan”). Under the terms of the Rights Plan, in general, if a person or group acquires or commences a tender or exchange offer for beneficial ownership of 4.9% or more of the outstanding shares of our Class A common stock upon a determination by our Board of Directors (an “Acquiring Person”), all of our other Class A and Class B common shareholders will have the right to purchase securities from us at a discount to such securities’ fair market value, thus causing substantial dilution to the Acquiring Person.

 

The Board of Directors adopted the Rights Plan in an effort to protect against a possible limitation on the Company’s ability to use its NOL carry-forwards, NCL carry-forwards, and built-in losses under Sections 382 and 383 of the Code. The Company’s ability to use its NOLs, NCLs and built-in losses would be limited if it experienced an “ownership change” under Section 382 of the Code. In general, an “ownership change” would occur if there is a cumulative change in the ownership of the Company’s common stock of more than 50% by one or more “5% shareholders” during a three-year period. The Rights Plan was adopted to dissuade any person or group from acquiring 4.9% or more of the Company’s outstanding Class A common stock, each, an Acquiring Person, without the approval of the Board of Directors and triggering an “ownership change” as defined by Section 382.

 

The Rights Plan and any outstanding rights will expire at the earliest of (i) June 4, 2019, (ii) the time at which the rights are redeemed or exchanged pursuant to the Rights Plan, (iii) the repeal of Section 382 and 383 of the Code or any successor statute if the Board of Directors determines that the Rights Plan is no longer necessary for the preservation of the applicable tax benefits, and (iv) the beginning of a taxable year to which the Board of Directors determines that no applicable tax benefits may be carried forward.

 

 

 

 

 

28

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

Unless the context otherwise requires or provides, references in this Quarterly Report on Form 10-Q to “we,” “us,” “our” and the “Company” refer to Arlington Asset Investment Corp. (“Arlington Asset”) 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, 2015.

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 Information” 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, 2015.

Our Company

 

We are a principal investment firm that currently acquires and holds a levered portfolio of residential mortgage-backed securities (“MBS”), consisting of agency MBS and private-label MBS. Agency MBS include residential mortgage pass-through certificates for which the principal and interest payments are guaranteed by a U.S. government agency or government sponsored enterprise (“GSE”), such as the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”). Private-label MBS, or non-agency MBS, include residential MBS that are not guaranteed by a GSE or the U.S. government.

 

We leverage prudently our investment portfolio so as to increase potential returns to our shareholders. We fund our investments primarily through short-term financing arrangements, principally through repurchase agreements.  We enter into various hedging transactions to mitigate the interest rate sensitivity of our cost of borrowing and the value of our MBS portfolio.

 

We are a Virginia corporation and taxed as a C corporation for U.S. federal tax purposes. We are an internally managed company and do not have an external investment advisor.

Factors that Affect our Results of Operations and Financial Condition

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

Current Market Conditions and Trends

 

In its September 21, 2016 statement announcing that it was maintaining a target federal funds rate range of 0.25% to 0.50%, the Federal Open Market Committee (“FOMC”) acknowledged that the labor market has continued to strengthen and growth of economic activity has picked up from the modest pace seen in the first half of the year.  However, while the FOMC commented that the case for an increase in the federal funds rate has strengthened, it will wait for further evidence of continued progress toward its objectives of maximum employment and 2% inflation before making further changes to its targeted federal funds rate.  In its statement, the FOMC also commented that it expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.  Based on federal fund futures prices, market participants currently believe that it is likely that the FOMC will raise its target federal funds rate 25 basis points by the end of this year.

 

Following the United Kingdom’s referendum on June 23, 2016 in which a majority of voters voted to exit the European Union (the “Brexit”), there was speculation that Brexit could adversely affect global economic and market conditions. Global financial markets initially experienced severe volatility in response to the Brexit, creating selling pressure in riskier asset classes and increased demand for U.S. Treasuries driving the 10-year U.S. Treasury rate to a historic low during the first few weeks of July.  However, as

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concerns regarding Brexit began to subside and domestic economic and market conditions appeared more favorable, investor demand for risk assets increased during the remaining part of the third quarter.  Prices on U.S. Treasury securities declined during the third quarter driving yields higher with the 10-year U.S. Treasury rate increasing 11 basis points to 1.60% as of September 30, 2016.

 

In a residential mortgage environment characterized by historically low interest rates, steady home price appreciation and increased lender origination capacity, mortgage refinancing volumes have remained high leading to elevated prepayments speeds in residential mortgage loans.  Near term market expectations are that prepayment speeds in residential MBS will remain elevated before returning to normalized levels with the continued concerns regarding prepayment levels leading to pay-up premiums for specified agency MBS remaining relatively unchanged during the third quarter.   The above factors contributed to residential MBS option-adjusted spreads narrowing during the third quarter.

 

 On October 14, 2016, new rules issued by the Securities and Exchange Commission governing money market funds went into effect.  Under the new rules, prime institutional money market funds are now required to mark their daily net asset value and impose temporary redemption gates and fees during volatile periods.  In anticipation of the new rules going effective, many investors began moving toward money market funds that invest only in government securities and away from prime money market funds prior to the effective date of the new rules.  As a result of this diminished demand for prime money market funds during the third quarter, issuers of commercial paper and certificates of deposit that supply prime money market funds have experienced higher funding costs as yields moved higher and funding risk premium widened, while demand increased for high quality short-term assets such as repurchase agreement financing secured by agency MBS.  As a result, many funding benchmark rates, such as LIBOR, have risen significantly while financing rates on repurchase agreement financing secured by agency MBS became more competitive.  In general, this led to improved net funding costs of short-term repurchase agreement financing hedged with interest rate swaps as the three-month LIBOR received on interest rate swaps has increased more than the financing rates paid on repurchase agreement financing during the third quarter of 2016.

 

Housing prices continue to rise on stronger fundamentals and investor-fueled demand, as well as lack of adequate supply.  The S&P CoreLogic Case-Shiller U.S. National Home Price NSA index reported a 5.1% annual gain in July 2016 and is within 0.6% of its record high set in July 2006.  Market expectations are for housing prices to continue to gradually improve from their post-financial crisis lows.

 

Recent Government Activity

 

We expect debate and discussion on residential housing and mortgage reform to continue over the next few years; however, we cannot be certain if or when any existing housing finance reform bill will emerge from committee or be approved by Congress, and if so, what the effects may be. Historically, significant legislation has been difficult to pass in a presidential election year, and we cannot predict what effect the 2016 elections will have on the progress of housing finance reform legislation.

 

 

Executive Summary

As of September 30, 2016, the Company’s book value was $18.83 per share, an increase of 0.3% from $18.77 per share as of June 30, 2016. The Company’s tangible book value, which is calculated as shareholders’ equity less the Company’s net deferred tax asset, was $14.63 per share as of September 30, 2016, an increase of 5.1% from $13.92 per share as of June 30, 2016. The increase in tangible book value per share during the quarter is attributable primarily to an increase in value of the Company’s hedged agency MBS portfolio driven by a rise in interest rates and a narrowing of agency MBS investment spreads resulting in an outperformance of the Company’s interest rate hedges relative to its agency MBS investment portfolio.  

For the third quarter of 2016, the Company had net income of $0.81 per diluted share compared to net income of $0.56 per diluted share in the prior quarter. The Company had non-GAAP core operating income of $0.64 per diluted share for the third quarter of 2016 compared to $0.67 per diluted share in the prior quarter. For further information on the use of non-GAAP core operating income, see “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Non-GAAP Core Operating Income.” The decline in non-GAAP core operating income was driven largely by elevated prepayment speeds in the Company’s agency MBS portfolio.

Since the Company’s fixed-rate agency MBS have generally been purchased at a premium to par value, high prepayments can have a negative impact on the Company’s asset yields and interest income, while slow prepayments can have a positive impact. The actual constant prepayment rate (“CPR”) for the Company’s agency MBS increased to 12.64% for the third quarter of 2016 from 11.40% in the prior quarter, resulting in a decline in the average asset yield to 2.60% during the third quarter compared to 2.73% in the prior quarter.

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During the third quarter of 2016, the Company’s earnings benefited from an improvement in the spread between the three-month LIBOR that the Company receives on its interest rate swap agreements and the funding rates that it pays on its repurchase agreement financing that are generally based on one-month LIBOR.  The average rate the Company receives on its interest rate swap agreements increased more than the average financing rate the Company pays on its repurchase agreement financing during the third quarter.  

The value of the Company’s hedged agency MBS portfolio performed well during the third quarter benefiting from the rise in interest rates and narrowing of agency MBS investment spreads.  During the third quarter of 2016, the net value of the Company’s hedged agency MBS portfolio increased by $0.76 per share, or 5.5% of the Company’s prior quarter tangible book value per share.  

As of September 30, 2016, the Company’s agency investment portfolio totaled $4,839 million, comprised of $3,669 million of specified agency MBS and $1,170 million of net long “to-be-announced” (“TBA”) agency MBS.  During the third quarter, the Company increased its agency investment allocation to TBA agency MBS to take advantage of higher risk adjusted returns in the TBA dollar roll market as compared to owning specified agency MBS financed with repurchase agreement financing.  The Company generated TBA dollar roll income of $5.3 million during the third quarter of 2016 compared to $3.7 million in the prior quarter.

The Company continues to maintain a substantial hedge position with the intent to protect the Company’s capital and earnings potential against increased interest rates over the long-term. As of September 30, 2016, the Company’s interest rate hedge position consisted solely of interest rate swaps coupled with put and call options on 10-year U.S. Treasury note futures.  During the third quarter, the Company modified the composition of its hedge position in options on 10-year U.S. Treasury note futures by effectively moving the option strike prices closer to the money with the goal of improving the responsiveness of the position to rising interest rates, while still maintaining flexibility in a declining rate environment and reducing the overall cost of the structure.

We believe our hedging strategy will continue to enable the Company to maintain an attractive return on its agency MBS portfolio in order to produce resilient and predictable non-GAAP core operating income that supports consistent dividends to our shareholders. In a falling interest rate and wider spread environment, this hedging strategy will likely result in a temporary decline in book value.  However, the Company would expect temporary declines in book value to be recovered over time either through higher future spread earnings if interest rates remain low and spreads wide, or through a reversal of temporary decline in book value if future interest rates rise and spreads narrow. During the third quarter, the Company experienced a recovery of book value as interest rates rose and spreads narrowed.  The consistent execution of our hedging strategy may also result in an increase in leverage during periods of temporary declines in book value or decreases in leverage during periods of temporary increases in book value.  

The Company constantly monitors its allocation of its available capital between agency MBS and private-label MBS in an effort to maximize returns to its shareholders. The Company continued to opportunistically sell private-label MBS and reinvest the net proceeds into agency MBS in what it believes will deliver higher risk adjusted returns. During the third quarter of 2016, the Company sold private-label MBS for gross proceeds of $67.8 million and redeployed the available capital into agency MBS. As of September 30, 2016, the Company’s available capital was allocated approximately 96% to agency MBS and 4% to private-label MBS, compared to 86% to agency MBS and 14% to private-label MBS as of June 30, 2016.

 

 

Portfolio Overview

The following table summarizes our MBS investment portfolio at fair value as of September 30, 2016 and December 31, 2015 (dollars in thousands):

 

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Our specified agency MBS consisted of the following as of September 30, 2016 (dollars in thousands):

 

 

 

The actual CPR for the Company’s agency MBS was 12.64% for the three months ended September 30, 2016. As of September 30, 2016, the Company’s agency MBS was comprised of securities specifically selected for their relatively lower propensity for prepayment, which includes approximately 85% in specified pools of low balance loans while the remainder includes specified pools of loans originated in certain geographical areas, loans refinanced through the U.S. Government sponsored Home Affordable Refinance Program (“HARP”), loans with low FICO scores or with other characteristics selected for their relatively lower propensity for prepayment.

 

Our agency MBS investment portfolio also includes net long TBA positions, which are primarily the result of executing sequential series of “dollar roll” transactions that are settled on a net basis. In accordance with GAAP, we account for our net long TBA positions as derivative instruments.  Information about the Company’s net long TBA positions as of September 30, 2016 is as follows (dollars in thousands):

 

 

Our private-label MBS, excluding our interest-only MBS, consisted of the following as of September 30, 2016 (dollars in thousands):

 

 

As of September 30, 2016, the private-label MBS portfolio consists primarily of “re-REMIC” securities. The Company’s investments in re-REMIC securities represent “mezzanine” interests in underlying, re-securitized senior class MBS issued by private-label Real Estate Mortgage Investment Conduit (“REMIC”) securitization trusts. The senior class REMIC securities that serve as

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collateral to the Company’s investments in re-REMIC securities represent beneficial interests in pools of prime or Alt-A residential mortgage loan collateral that hold the first right to cash flows and absorb credit losses only after their respective subordinate REMIC classes have been fully extinguished. The majority of the trusts that issued the Company’s investments in re-REMIC securities employ a “sequential” principal repayment structure, while a minority of the issuing trusts employ a “pro-rata” principal repayment structure. Accordingly, the majority of the Company’s mezzanine class re-REMIC securities are not entitled to receive principal repayments until the principal balance of the senior interest in the respective collateral group has been reduced to zero. Principal shortfalls are allocated on a “reverse sequential” basis. Accordingly, any principal shortfalls on the underlying senior class REMIC securities are first absorbed by the Company’s mezzanine class re-REMIC securities, to the extent of their respective principal balance, prior to being allocated to the senior interest in the respective collateral pool. Periodic interest accrues on each re-REMIC security’s outstanding principal balance at its contractual coupon rate.

As of September 30, 2016, we had $6.0 million of outstanding repurchase agreement financing secured by $13.4 million of private-label MBS with a weighted-average cost of funding of 2.38%. During the three and nine months ended September 30, 2016, we received proceeds of $67.8 million and $106.1 million, respectively, from the sales of our private-label MBS, realizing $2.4 million and $1.7 million, respectively, in net gains. During the nine months ended September 30, 2016, we purchased private-label MBS for $5.4 million with a face amount of $5.2 million.

The Company attempts to hedge a portion of its exposure to interest rate fluctuations associated with its agency MBS primarily through the use of interest rate derivatives. Specifically, these interest rate derivatives are intended to economically hedge changes, attributable to changes in benchmark interest rates, in agency MBS fair values and future interest cash flows on the Company’s short-term financing arrangements. As of September 30, 2016, the interest rate derivative instruments used by the Company were centrally cleared interest rate swap agreements and exchange-traded put and call options on 10-year U.S. Treasury note futures.

The Company’s interest rate swap agreements represent agreements to make semiannual interest payments based upon a fixed interest rate and receive quarterly variable interest payments based upon the prevailing three-month LIBOR on the date of reset. Information about the Company’s outstanding centrally cleared interest rate swap agreements in effect as of September 30, 2016 is as follows (dollars in thousands):

 

During the third quarter, the Company also entered into forward-starting interest rate swap agreements which have effective dates in late September 2017 and early October 2017 and mature two years from their respective effective dates. The effective dates of these forward-starting interest rate swap agreements were set to occur within reasonable proximity to the maturity dates of certain of the Company’s existing interest rate swap agreements, economically extending the life of the maturing instruments. Information about the Company’s forward-starting interest rate swap agreements as of September 30, 2016 is as follows (dollars in thousands):

 

 

In addition to interest rate swap agreements, the Company had also purchased and sold exchange-traded options on U.S. Treasury note futures contracts as of September 30, 2016 with the objective of hedging a portion of the interest rate sensitivity of the Company’s agency MBS portfolio.  As of September 30, 2016, the Company holds put options which provide the Company with the right to sell 10-year U.S. Treasury note futures to a counterparty with an equivalent notional amount of $600 million that were struck at a weighted average strike price that equates to a 10-year U.S. Treasury rate of approximately 1.71%.  In addition, the Company has sold, or written, call options that provide a counterparty with the option to buy 10-year U.S. Treasury note futures from the Company with an equivalent notional amount of $600 million that were struck at a weighted average strike price per contract that equates to a 10-year U.S. Treasury rate of approximately 1.39%.  In order to limit its exposure on the sold call options from a significant decline in long-term interest rates, the Company also purchased contracts that provide the Company with the option to buy 10-year U.S. Treasury note futures from a counterparty with an equivalent notional amount of $300 million as of September 30, 2016 that were

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struck at a weighted average strike price per contract that equates to a 10-year U.S. Treasury rate of approximately 1.07%.  The options may be exercised at any time prior to their expiry, which occurs in the fourth quarter of 2016, and, if exercised, will be net settled in cash.  Information about the Company’s outstanding put and call options on 10-year U.S. Treasury note futures contracts as of September 30, 2016 is as follows (dollars in thousands):

 

 

 

 

Results of Operations

Net Interest Income

Net interest income determined in accordance with GAAP primarily represents the interest income recognized from our investments in specified agency MBS and private-label MBS (including the amortization of purchase premiums and accretion of purchase discounts), net of the interest expense incurred from repurchase agreement financing arrangements or other short- and long-term borrowing transactions. In the first quarter of 2016, we implemented a change in our accounting policy for recognizing interest income on our investments in agency MBS classified as trading securities by amortizing purchase premiums (or accreting purchase discounts) as an adjustment to interest income in accordance with the “interest method” permitted by GAAP. Prior to January 1, 2016, interest income from trading agency MBS was reported based upon each security’s stated coupon rate. Refer to “Note 2. Summary of Significant Accounting Policies” within the notes to the consolidated financial statements for further information about our accounting policies for recognizing interest income for our investments in MBS.

Net interest income determined in accordance with GAAP does not include TBA agency MBS dollar roll income, which represents the economic equivalent of net interest income generated from our investments in non-specified fixed-rate agency MBS, nor does it include the implied net interest income or expense of our interest rate swap agreements, which are not designated as hedging instruments for financial reporting purposes. In our consolidated statements of comprehensive income prepared in accordance with GAAP, TBA agency MBS dollar roll income and the implied net interest income or expense incurred from our interest rate swap agreements are reported as a component of the overall periodic change in the fair value of derivative instruments within the line item “gain (loss) from derivative instruments, net” of the “investment gain (loss), net” section.

Investment Gain (Loss), Net

“Investment gain (loss), net” primarily consists of periodic changes in the fair value (whether realized or unrealized) of investments in MBS classified as trading securities, periodic changes in the fair value (whether realized or unrealized) of derivative instruments, gains (losses) realized upon the sale of investments in MBS classified as available-for-sale, and other-than-temporary impairment charges for investments in MBS classified as available-for-sale.

We evaluate available-for-sale securities for other-than-temporary impairment on a quarterly basis. 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. When evaluating whether an impairment is other-than-temporary, consideration is given to (1) the length of time and the extent to which the fair value has been lower than amortized cost, (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 the security, and (5) whether it is more-likely-than-not we would be required to sell the security before anticipated recovery of our amortized cost basis.

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For private-label MBS, on a quarterly basis, we re-estimate the amount and timing of cash flows expected to be collected based upon current information and events. For available-for-sale private-label MBS that are impaired, we compare the present value of our revised estimate of the amount and timing of expected cash flows, discounted at the security’s existing effective interest rate used for interest income recognition, to the security’s amortized cost basis. Any shortfall between the present value of cash flows expected to be collected and the security’s amortized cost basis is recognized as an other-than-temporary impairment charge in net income as a component of “investment gain (loss), net.”

General and Administrative Expenses

“Compensation and benefits expense” includes base salaries, annual incentive cash compensation, and non-cash stock-based compensation. Annual cash incentive compensation is based on meeting estimated annual performance measures and discretionary components. Non-cash stock-based compensation includes expenses associated with all stock-based awards granted to employees, including the Company’s performance share units to named executive officers.

“Other general and administrative expenses” primarily consists of the following:

Three and nine months ended September 30, 2016 compared to the three and nine months ended September 30, 2015

The following table presents the net income (loss) reported for the three and nine months ended September 30, 2016 and 2015, respectively (dollars in thousands, except per share amounts):

 

 

Net Interest Income

Net interest income determined in accordance with GAAP (“GAAP net interest income”) decreased $7.8 million, or 29.9%, from $26.1 million for the three months ended September 30, 2015 to $18.3 million for the three months ended September 30, 2016, and $16.6 million, or 21.7%, from $76.6 million for the nine months ended September 30, 2015 to $60.0 million for the nine months ended September 30, 2016. The decrease in each comparative period is primarily attributable to (i) a meaningful increase in the proportion of our agency MBS portfolio represented by net long positions in non-specified TBA securities (which are accounted for as derivative instruments) with a corresponding reduction in the proportion represented by specified agency MBS, (ii) lower asset yields on the Company’s agency MBS driven by higher relative prepayments in the current year periods, and (iii) 27 basis point increases in the average interest costs of our short-term financing arrangements for the three and nine month periods ended September 30, 2016,

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relative to the comparative periods from the prior year due primarily to an increase in prevailing benchmark short-term interest rates. As previously noted, TBA dollar roll income is not included in net interest income determined in accordance with GAAP.

The components of GAAP net interest income from our MBS investments portfolio, excluding interest expense on unsecured long-term debt, are summarized in the following tables (dollars in thousands):

 

 

 

 

The effects of changes in the composition of our investments on our GAAP net interest income from our MBS investment activities are summarized below (dollars in thousands):

 

 

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During the three months ended September 30, 2016, the percentage allocation of our total agency MBS portfolio to net long positions in non-specified TBA securities and specified agency MBS was 19% and 81%, respectively, as compared to 6% and 94%, respectively, for the three months ended September 30, 2015. During the nine months ended September 30, 2016, the percentage allocation of our total agency MBS portfolio to net long positions in non-specified TBA securities and specified agency MBS was 16% and 84%, respectively, as compared to 5% and 95%, respectively, for the nine months ended September 30, 2015 as illustrated by the following table (dollars in thousands):

 

 

As a result of the substantial increase in our TBA portfolio, TBA dollar roll income increased $3.4 million to $5.3 million for the three months ended September 30, 2016 from $1.9 million for the comparative period of 2015, and increased $8.4 million to $12.8 million for the nine months ended September 30, 2016 from $4.4 million for the comparative period of 2015. When adjusting our net interest income determined in accordance with GAAP to include TBA dollar roll income (which is net of implied financing costs), the total spread income earned from our aggregate MBS investment portfolio for the three months and nine months ended September 30, 2016 decreased by $4.4 million (or 15.0%) and $7.6 million (or 9.0%), respectively, relative to the comparative periods from the prior year.  The reduction in total spread income in the current year periods relative to the prior year periods is due primarily to (i) a reduction in asset revenues driven by relatively higher prepayments on our specified agency MBS resulting a lower weighted average yield on those assets as well as (ii) an increase in the costs of our short-term financing arrangements and the implied financing costs of our TBA dollar rolls driven primarily by an increase in prevailing short-term interest rates. The following tables provide a comparison of GAAP interest income, GAAP net interest income (excluding interest expense from long-term debt), and TBA dollar roll income for periods indicated (dollars in thousands):

 

 

 

 

Interest expense related to long-term debt was $1.2 million for the three months ended September 30, 2016 and 2015. Interest expense related to long-term debt was $3.6 million and $3.0 million for the nine months ended September 30, 2016 and 2015, respectively. The increase in interest expense on long-term debt for the nine months ended September 30, 2016 relative to the comparative period from the prior year is primarily attributable to the issuance in March 2015 of $35.3 million of Senior Notes due 2025.

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Investment Gain (Loss), Net

“Total investment gain (loss), net” increased $80.5 million from a loss of $59.8 million for the three months ended September 30, 2015 to a gain of $20.7 million for the three months ended September 30, 2016. In the third quarter of 2016, we recognized fair value gains on our agency MBS portfolio driven by a meaningful narrowing of agency MBS spreads while we also recognized fair value gains on our interest rate derivative instruments (intended to economically hedge our interest rate risk) driven by an increase in prevailing interest rates, resulting in the outperformance of interest rate derivative instruments relative to our agency MBS portfolio.  In the third quarter of 2015, a reduction in prevailing longer-term interest rates drove the recognition of fair value gains on our agency MBS portfolio and the recognition of fair value losses on our interest rate derivative instruments. The widening of agency MBS spreads during the third quarter of 2015 resulted in the underperformance of our agency MBS portfolio relative to our interest rate derivative instruments, resulting in a net investment loss on our hedged agency MBS portfolio.  “Total investment loss, net” decreased $82.0 million from a loss of $120.1 million for the nine months ended September 30, 2015 to a loss of $38.1 million for the nine months ended September 30, 2016. Within each of these comparative periods, declines in prevailing longer-term interest rates drove the recognition of fair value losses on our interest rate derivative instruments that were not fully offset by fair value gains recognized on our agency MBS investments.

Further detail about the gains and losses recognized due to the changes in the fair value of our agency MBS, TBA transactions, and interest rate derivative instruments for the periods indicated is as follows (dollars in thousands):

 

 

Available-for-sale investments substantially consist of our private-label MBS acquired prior to 2015. The realized gains on the sale of available-for-sale investments, net, recognized for the three months ended September 30, 2016 and 2015 were the result of $67.8 million and $14.2 million, respectively, of proceeds received from the sales of private-label MBS resulting in net realized gains of $2.4 million and $1.0 million, respectively. The realized gains on the sale of available-for-sale investments, net, recognized for the nine months ended September 30, 2016 and 2015 were the result of $96.2 million and $124.6 million, respectively, of proceeds received from the sales of private-label MBS resulting in realized gains of $1.8 million and $17.4 million, respectively.

We recorded credit related other-than-temporary impairment charges of $1.7 million for the nine months ended September 30, 2016 on available-for-sale, private-label MBS. We recorded no other-than-temporary impairment charges for the three months ended September 30, 2016 and the three and nine months ended September 30, 2015. Credit related other-than-temporary impairment charges represent the excess of the amortized cost basis over the present value of expected future cash flows discounted at the security’s existing effective interest rate used for interest income recognition.

Investments classified as trading securities primarily consist of agency MBS. The $2.5 million of net gains recognized for the third quarter of 2016 were primarily driven by meaningful agency MBS spread narrowing which more than offset the effect of the increase in longer-term interest rates that occurred during the period.  The $81.1 million of net gains recognized for the nine months ended 2016 were primarily driven by the decrease in prevailing longer-term interest rates during the period combined with agency MBS spread narrowing. The $36.9 million and $5.2 million of net gains on trading investments recognized for the three and nine months ended September 30, 2015, respectively, were primarily the result of a decrease in prevailing longer-term interest rates.

Commitments to purchase and sell MBS consist primarily of forward-settling purchases of TBA agency MBS that are generally settled on a net basis through the execution of dollar roll transactions and, to a lesser extent, certain commitments to purchase specified agency MBS that will be settled by the physical delivery of the securities. We recognized net gains of $6.8 million and $30.6 million for the three and nine months ended September 30, 2016, respectively and net gains of $6.4 million and $3.2 million for the three and nine months ended September 30, 2015, respectively, from forward-settling commitments to purchase and sell agency MBS, which consists of both TBA dollar roll income as well as other fair value gains and losses stemming from these forward-settling commitments.

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Our interest rate derivative instruments currently consist of centrally-cleared interest rate swaps and exchange-traded put and call options on U.S. Treasury note futures, and have historically also included U.S. Treasury note futures, Eurodollar futures, and interest rate swap futures. While we use interest rate derivatives to economically hedge a portion of our interest rate risk, we have not designated such contracts as hedging instruments for financial reporting purposes. As a result, the implied economic financing costs of our interest rate derivatives are included in the change in fair value of the instruments recognized in “investment gain (loss), net” rather than in net interest income. During periods of falling interest rates, we will generally experience losses on our interest rate derivative instruments and during periods of rising interest rates, we will generally experience gains on our interest rate derivative instruments. The $8.4 million of net gains recognized for interest rate derivative instruments for the third quarter of 2016 were primarily attributable to the increase in prevailing longer-term interest rates that occurred during the period, partially offset by the implied net economic financing costs of our interest rate swap agreements. The $104.0 million of net losses recognized for interest rate derivative instruments during the third quarter of 2015 as well as the $150.5 million and $146.4 million of net losses recognized for the nine month periods ended September 30, 2015 and 2016, respectively, were primarily driven by a decrease in prevailing longer-term interest rates during each respective period, coupled with the implied net economic financing costs of certain of the interest rate derivatives.

The fair value of our hedging instruments is expected to fluctuate inversely relative to the change in fair value of the agency MBS portfolio. However, the degree of correlation between the price movements of our hedging instruments and those of our agency MBS portfolio may vary. While our hedging instruments are designed to protect our agency 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 MBS and the benchmark yield on U.S. Treasury securities or interest rate swaps.

General and Administrative Expenses

General and administrative expenses increased by $1.1 million, or 31.4%, from $3.5 million for the three months ended September 30, 2015 to $4.6 million for the three months ended September 30, 2016, and increased by $5.8 million, or 53.7%, from $10.8 million for the nine months ended September 30, 2015 to $16.6 million for the nine months ended September 30, 2016.

Compensation and benefits expensed increased by $1.3 million, or 61.9%, from $2.1 million for the three months ended September 30, 2015 to $3.4 million for the three months ended September 30, 2016, and increased by $1.6 million, or 22.2%, from $7.2 million for the nine months ended September 30, 2015 to $8.8 million for the nine months ended September 30, 2016. The increase in compensation and benefits expense is attributable primarily to an increase in long-term performance oriented stock-based compensation. Employee stock-based compensation increased by $1.2 million from $(0.3) million for the three months ended September 30, 2015 to $0.9 million for the three months ended September 30, 2016, and increased by $1.9 million from $(0.1) million for the nine months ended September 30, 2015 to $1.8 million for the nine months ended September 30, 2016. During the three and nine months ended September 30, 2015, the Company did not achieve certain performance measures for certain of the Company’s performance share units granted to executive officers, which resulted in the reversal of stock-based compensation expense that had been recognized in prior periods.  

Other general and administrative expenses decreased by $0.2 million, or 14.3%, from $1.4 million for the three months ended September 30, 2015 to $1.2 million for the three months ended September 30, 2016. Other general and administrative expenses increased by $4.2 million, or 113.5%, from $3.7 million for the nine months ended September 30, 2015 to $7.9 million for the nine months ended September 30, 2016, primarily due to non-recurring proxy contest related expenses. During the nine months ended September 30, 2016, we incurred $4.0 million in expenses stemming from the 2016 proxy contest that are in excess of the level of expenses normally incurred for an annual meeting of shareholders. In March 2016, Imation Corp., an IT data storage and data security company, acting in concert with the Clinton Group, Inc. (together, “Imation Group”) nominated a controlling slate of five candidates to stand for election to our eight-member board of directors at the 2016 annual meeting of shareholders. As of the record date for the 2016 meeting, the Imation Group owned collectively 11,000 shares of our Class A common stock, representing less than 0.05% of our outstanding common stock. At our annual shareholder meeting on June 9, 2016, our shareholders overwhelmingly voted to elect all of our eight director nominees. In connection with the proxy contest, we incurred non-recurring legal fees, financial advisory fees, proxy solicitor fees, mailing and printing costs of proxy solicitation materials, and other costs in excess of the level of expenses normally incurred for an annual meeting of shareholders.

Income Tax Provision

We recognized an income tax provision of $15.5 million for the three months ended September 30, 2016 and 2015, and an income tax provision of $5.1 million and $33.9 million for the nine months ended September 30, 2016 and 2015, respectively. The income tax provision for the three months ended September 30, 2016 and 2015 is net of an increase in the valuation allowance against the deferred tax assets of $2.7 million and $28.6 million, respectively, and the income tax provision recognized for the nine months ended September 30, 2016 and 2015 is net of increases in the valuation allowance against the deferred tax assets of $3.6 million and $59.2 million, respectively. The increase in the valuation allowance against the deferred tax assets for three and nine months ended

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September 30, 2015 is due mostly to net capital losses generated during the periods primarily as a result of realized and unrealized losses on certain of our economic interest rate hedging instruments. The valuation allowance represents the portion of our net capital loss carryforward that is more-likely-than-not to expire unutilized.

Other Comprehensive Loss

Other comprehensive income (loss) represents periodic unrealized holding gains and losses related to our investments in MBS classified as available-for-sale. Accumulated unrealized holding gains and losses for available-for-sale MBS are reclassified into net income as a component of “investment gain (loss), net” upon (i) sale and realization, or (ii) the occurrence of an other-than-temporary impairment. Other comprehensive loss was $2.5 million and $3.6 million for the three months ended September 30, 2016 and 2015, respectively. For the three months ended September 30, 2016, other comprehensive income included net unrealized holding losses of $0.4 million on the available-for-sale MBS portfolio, net of a tax benefit of $0.1 million, and $3.0 million of reversal of prior period net unrealized gains upon the sale of available-for-sale MBS, net of a tax benefit of $0.6 million. For the three months ended September 30, 2015, other comprehensive loss included net unrealized holding losses of $4.0 million on the available-for-sale MBS portfolio, net of a tax benefit of $1.6 million, and $1.4 million of reversal of prior period net unrealized gains upon the sale of available-for-sale MBS, net of a tax benefit of $0.3 million.

Other comprehensive loss was $7.7 million and $24.5 million for the nine months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016, other comprehensive loss included net unrealized holding losses of $10.1 million on the available-for-sale MBS portfolio, net of a tax benefit of $3.9 million, $3.3 million of reversal of prior period net unrealized gains upon the sale of available-for-sale MBS, net of a tax benefit of $0.8 million, and $1.7 million of other-than-temporary impairment charges on available-for-sale securities, net of a tax provision of $0.7 million. For the nine months ended September 30, 2015, other comprehensive loss included net unrealized holding losses of $10.9 million on the available-for-sale MBS portfolio, net of a tax benefit of $4.1 million and $22.7 million of reversal of prior period net unrealized gains upon the sale of available-for-sale MBS, net of a tax benefit of $5.0 million.

 

 

Non-GAAP Core Operating Income

 

In addition to the results of operations determined in accordance with generally accepted accounting principles as consistently applied in the United States (“GAAP”), we reported “non-GAAP core operating income”.  Beginning in the first quarter of 2016, we define core operating income as “economic net interest income” less “core general and administrative expenses.”

 

Economic Net Interest Income

 

Economic net interest income is comprised of the following: periodic (i) net interest income determined in accordance with GAAP, (ii) TBA agency MBS “dollar roll” income, and (iii) net interest income or expense incurred from interest rate swap agreements.

 

 

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Core General and Administrative Expenses

 

Core general and administrative expenses are non-interest expenses reported within the line item “total other expenses” of the consolidated statements of comprehensive income less stock-based compensation expense. For the nine months ended September 30, 2016, core general and administrative expenses also exclude non-recurring expenses related to the 2016 proxy contest that are in excess of those normally incurred for an annual meeting of shareholders.

 

Non-GAAP Core Operating Income for 2016

 

The following table presents our computation of non-GAAP core operating income for the three and nine months ended September 30, 2016 (amounts in thousands, except per share amounts):

 

 

 

The following table provides a reconciliation of GAAP pre-tax net income to non-GAAP core operating income for the three and nine months ended September 30, 2016 (amounts in thousands):

 

 

Non-GAAP core operating income is used by management to evaluate the financial performance of the Company’s long-term-focused, net interest spread-based investment strategy and core business activities over periods of time as well as assist with the determination of the appropriate level of periodic dividends to stockholders. In addition, we believe that non-GAAP core operating income assists investors in understanding and evaluating the financial performance of the Company’s long-term-focused, net interest spread-based investment strategy and core business activities over periods of time as well as its earnings capacity.

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Other than MBS interest income, TBA dollar roll income, and interest rate swap net interest income or expense, periodic fair value gains and losses recognized with respect to our investments in MBS and our economic hedging instruments, which are reported in line item “total investment gain (loss), net” of our consolidated statements of comprehensive income, are excluded from the computation of non-GAAP core operating income as such gains on losses are not reflective of the economic interest income earned or interest expense incurred from our interest-bearing financial assets and liabilities during the indicated reporting period.  Because our long-term-focused investment strategy for our agency MBS investment portfolio is to generate a net interest spread on the leveraged assets while prudently hedging periodic changes in the fair value of those assets attributable to changes in benchmark interest rates, we generally expect the fluctuations in the fair value of our agency MBS investments and our economic hedging instruments to largely offset one another over time.

 

A limitation of utilizing this non-GAAP financial measure is that the effect of accounting for “non-core” events or transactions in accordance with GAAP does, in fact, reflect the financial results of our business and these effects should not be ignored when evaluating and analyzing our financial results. For example, the economic cost or benefit of hedging instruments other than interest rate swap agreements, such as U.S. Treasury note futures or options on U.S. Treasury note futures, do not affect the computation of non-GAAP core operating income. Therefore, we believe that non-GAAP core operating income should be considered as a supplement to, and in conjunction with, net income and comprehensive income determined in accordance with GAAP.

 

Non-GAAP Core Operating Income for Fiscal Year 2015

 

We retrospectively applied our revised definition of core operating income to the quarterly and annual periods of fiscal year 2015. We note, however, that the non-GAAP core operating income measures computed for prior year periods are not directly comparable to the results computed for the three and nine months ended September 30, 2016, as we solely utilized hedging instruments other than interest rate swap agreements prior to November 2015. The economic costs or benefits of hedging instruments other than interest rate swap agreements do not affect the computation of non-GAAP core operating income.

 

The results of the retrospective application of our revised definition of non-GAAP core operating income to fiscal year 2015 are presented in the following table (amounts in thousands, except per share amounts):

 

 

 

The following table provides a reconciliation of GAAP pre-tax net income to non-GAAP core operating income for fiscal year 2015 (amounts in thousands):

 

 

 

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Liquidity and Capital Resources

Liquidity is a measurement of our ability to meet potential cash requirements including ongoing commitments to repay borrowings, fund investments, meet margin calls on our short-term borrowings and hedging instruments, and for other general business purposes. Our primary sources of funds for liquidity consist of existing cash balances, short-term borrowings (for example, repurchase agreements), principal and interest payments from our investments in MBS, and proceeds from sales of MBS. Other sources of liquidity include proceeds from the offering of common stock, preferred stock, debt securities, or other securities registered pursuant to our effective shelf registration statement filed with the Securities and Exchange Commission (“SEC”).

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

As of September 30, 2016, our debt-to-equity leverage ratio was 7.9 to 1. As of September 30, 2016, our “at risk” leverage ratio was 10.2 to 1.  Our “at risk” leverage is measured as the ratio of the sum of our total debt (excluding any unamortized issuance costs) and net payable for unsettled securities compared to our tangible stockholders’ equity. Tangible stockholders’ equity is measured as our stockholders’ equity less our net deferred tax asset.

Cash Flows

As of September 30, 2016, our cash and cash equivalents totaled $42.8 million, representing a net increase of $5.8 million from $37.0 million as of December 31, 2015. Cash provided by operating activities of $64.3 million during the nine months ended September 30, 2016 was attributable primarily to net interest income less our general and administrative expenses. Cash provided by investing activities of $229.8 million during the nine months ended September 30, 2016 was primarily generated by sales of MBS and the receipt of principal payments from agency MBS, partially offset by purchases of new agency MBS and funding of settlements and deposits for margin calls on our interest rate derivative instruments. Cash used in financing activities of $288.4 million during the nine months ended September 30, 2016 relates primarily to net repayments of FHLBC advances and dividend payments to common stockholders, partially offset by net proceeds obtained from repurchase agreements used to finance a portion of our MBS investment portfolio.

Sources of Funding

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

As of September 30, 2016, liquid assets consisted primarily of cash and cash equivalents of $42.8 million and net investments in MBS of $316.4 million. Cash equivalents consist primarily of money market funds invested in debt obligations of the U.S. government. The Company’s net investments in MBS is calculated as the sum of the Company’s total MBS investments at fair value and receivable for sold MBS, less the sum of the repurchase agreements outstanding and payable for purchased MBS.

Long-Term Debt

As of September 30, 2016, we had $73.6 million of total long-term unsecured debt, net of unamortized debt issuance costs of $1.7 million. Our trust preferred debt obligations with an aggregate principal amount of $15.0 million outstanding as of September 30, 2016 accrue and require the payment of interest quarterly at three-month LIBOR plus 2.25% to 3.00% and mature between 2033 and 2035. Our 6.625% Senior Notes due 2023 with a principal amount of $25.0 million outstanding as of September 30, 2016 accrue and require payment of interest quarterly at an annual rate of 6.625% and mature on May 1, 2023. Our 6.75% Senior Notes due 2025 with a principal amount of $35.3 million outstanding as of September 30, 2016 accrue and require payment of interest quarterly at an annual rate of 6.75% and mature on March 15, 2025.

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Repurchase Agreements

We have short-term financing facilities that are structured as repurchase agreements with various financial institutions to fund our investments in MBS. We have obtained, and believe we will be able to continue to obtain, short-term financing in amounts and at interest rates consistent with our financing objectives. Funding for MBS through repurchase agreements continues to be available to us at rates we consider to be attractive from multiple counterparties.

Our repurchase agreements include provisions contained in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association and may be amended and supplemented in accordance with industry standards for repurchase facilities. Our repurchase agreements include financial covenants, with which the failure to comply would constitute an event of default under the applicable repurchase agreement. Similarly, each repurchase agreement includes events of insolvency and events of default on other indebtedness as similar financial covenants. As provided in the standard master repurchase agreement as typically amended, upon the occurrence of an event of default or termination, the applicable counterparty has the option to terminate all repurchase transactions under such counterparty’s repurchase agreement and to demand immediate payment of any amount due from us to the counterparty.

Under our repurchase agreements, we may be required to pledge additional assets to our repurchase agreement counterparties in the event the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral (commonly referred to as a “margin call”), which may take the form of additional securities or cash. Margin calls on repurchase agreements collateralized by our MBS investments primarily result from events such as declines in the value of the underlying mortgage collateral caused by factors such as rising interest rates or prepayments. Our repurchase agreements generally provide that valuations for MBS securing our repurchase agreements are to be obtained from a generally recognized source agreed to by both parties.  However, in certain circumstances and under certain of our repurchase agreements, our lenders have the sole discretion to determine the value of the MBS securing our repurchase agreements. In such instances, our lenders are required to act in good faith in making determinations of value. Our repurchase agreements generally provide that in the event of a margin call, we must provide additional securities or cash on the same business day that the margin call is made if the lender provides us notice prior to the margin notice deadline on such day.

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

Our repurchase agreements generally mature within 30 to 90 days, but may have maturities as short as one day and as long as one year. In the event that market conditions are such that we are unable to continue to obtain repurchase agreement financing for our investments in MBS in amounts and at interest rates consistent with our financing objectives, we may liquidate such investments and may incur significant losses on any such sales of MBS.

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

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

 

 

To limit our exposure to counterparty risk, we diversify our repurchase agreement funding across multiple counterparties and by counterparty region. As of September 30, 2016, we had outstanding repurchase agreement balances with 16 counterparties. We currently have master repurchase agreements in place with a total of 18 counterparties located throughout North America, Europe and Asia. As of September 30, 2016, less than 5% of our stockholders’ equity was at risk with any one counterparty, with the top five counterparties representing approximately 20% of our stockholders’ equity. The table below includes a summary of our repurchase agreement funding by number of counterparties and counterparty region as of September 30, 2016 (dollars in thousands):

 

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Derivative Instruments

In the normal course of our operations, we are a party to financial instruments that are accounted for as derivative financial instruments including interest rate swaps, Eurodollar futures, interest rate swap futures, U.S. Treasury note futures, put and call options, and certain forward-settling MBS purchase and sale commitments.

We exchange collateral with the counterparties to our interest rate derivative instruments at least on a daily basis based upon daily changes in fair value (also known as “variation margin”) as measured by the central clearinghouse through which those derivatives are cleared. In addition, the central clearinghouse requires market participants to deposit and maintain an “initial margin” amount which is determined by the clearinghouse and is generally intended to be set at a level sufficient to protect the clearinghouse from the maximum estimated single-day price movement in that market participant’s contracts. The clearing exchanges have the sole discretion to determine the value of derivative instruments.  In the event of a margin call, we must generally provide additional collateral on the same business day. To date, we have not had any margin calls on our derivative agreements that we were not able to satisfy. However, if we encounter significant decreases in long-term interest rates, margin calls on our derivative agreements could result in a material adverse change in our liquidity position

As of September 30, 2016, we had outstanding centrally cleared interest rate swaps and exchange traded options on 10-year U.S. Treasury note futures with the following aggregate notional amount, net fair value and corresponding margin held in collateral deposit with the custodian (in thousands):

 

Share Repurchase Program

In October 2015, the Board of Directors authorized an increase in our share repurchase program pursuant to which the Company may repurchase up to 2.0 million shares of its Class A common stock. As of September 30, 2016, 1.95 million shares of Class A common stock remained available for repurchase under the repurchase program.  

Dividends

Pursuant to our variable dividend policy, our Board of Directors evaluates dividends on a quarterly basis and, in its sole discretion, approves the payment of dividends. Our dividend payments, if any, may vary significantly quarter to quarter. The Board of Directors has approved and the Company has declared and paid the following dividends to date in 2016:

 

 

The Board of Directors approved and the Company declared and paid the following dividends for 2015:

 

 

Off-Balance Sheet Arrangements

As of September 30, 2016 and December 31, 2015, we did not maintain any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, or special purpose or variable interest entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, as of September 30, 2016 and December 31, 2015, we had not guaranteed any obligations of unconsolidated entities or entered into any commitment or intent to provide funding to any such entities.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk is the exposure to loss resulting from changes in market factors such as interest rates, foreign currency exchange rates, commodity prices, equity prices, and other market changes that affect market risk sensitive instruments. The primary market risks that we are exposed to are interest rate risk (including prepayment risk and extension risk), credit risk, spread risk, liquidity risk, and regulatory risk. See “Item 1 — Business” in our Annual Report on Form 10-K for the year ended December 31, 2015 for a description of our risk management strategies.

Inflation

Virtually all of our assets and liabilities are interest rate sensitive in nature. As a result, interest rates and other factors influence our financial position and performance far more than inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our financial statements are prepared in accordance with GAAP and our distributions are determined by our Board of Directors in its sole discretion pursuant to our variable dividend policy; in each case, our activities and balance sheet are measured with reference to fair value without considering inflation.

Credit Risk

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

Our private-label MBS are generally purchased at a discount to par value. Prior to acquisition and on an on-going basis subsequent to acquisition, we estimate the amount and timing of the cash flows expected to be collected from each private-label MBS. In preparing our future cash flow estimates, we develop a number of assumptions about the future performance of the pool of mortgage loans that serve as collateral for our investment, including assumptions about the timing and amount of prepayments and credit losses. In developing these estimates, we consider economic conditions and security-level characteristics including, but not limited to, the following:

 

Developing estimates of the amount and timing of the future cash flows from our investments in private-label MBS requires us to exercise significant subjective judgment about matters that are inherently uncertain. Actual results may differ from our estimates, which could have a significant and potentially adverse effect on our financial condition, results of operations, and cash flows.

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The following table presents certain characteristics of our investments in private-label MBS as well as the residential mortgage loans that ultimately serve as their collateral as of and for the three months ended September 30, 2016:

 

 

 

The table that follows illustrates the estimated change in fair value of our current private-label MBS under several hypothetical credit loss scenarios. Our private-label MBS are classified as Level 3 within the fair value hierarchy as private-label MBS trade infrequently and, therefore, the measurement of their fair value requires the use of significant unobservable inputs. In determining fair value, we primarily use present value techniques based on the estimated cash flows of the instrument taking into consideration various assumptions that are based on our observations of assumptions used by market participants. The primary credit-related assumptions that are incorporated into the fair value measurement are the default rate, which represents the annual rate of expected defaulted loan liquidation events (such as foreclosure sales or short sales), and loss severity rates (or “loss-given-default”). The table below illustrates the effect that a 10% increase and decrease, respectively, in the default rate and loss severity rate assumptions from those used in our fair value measurements as of September 30, 2016 would have on total assets and stockholders’ equity as of September 30, 2016. Each 10% increase (decrease) in the default rate and loss severity rate assumptions was implemented in isolation (dollars in thousands, except per share amounts):

 

Interest Rate Risk

We are also exposed to interest rate risk in our MBS portfolio. Our investments in MBS are financed with short-term borrowing facilities such as repurchase agreements, which are interest rate sensitive financial instruments. Our exposure to interest rate risk fluctuates based upon changes in the level and volatility of interest rates, mortgage prepayments, and in the shape and slope of the yield curve, among other factors. Through the use of interest rate derivative instruments, we attempt to economically hedge a portion of our exposure to changes, attributable to changes in benchmark interest rates, in certain MBS fair values and future interest cash flows on our short-term financing arrangements. Our primary interest rate derivatives include centrally cleared interest rate swaps as well as exchange-traded instruments, such as U.S. Treasury note futures, and options on U.S. Treasury note futures. Historically, we have also utilized exchange-traded Eurodollar futures and interest rate swap futures.

Changes in both short- and long-term interest rates affect us in several ways, including our financial position. As interest rates increase, the fair value of fixed-rate agency MBS may be expected to decline, prepayment rates may be expected to decrease and duration may be expected to extend. However, an increase in interest rates results in an increase in the fair value of our interest rate derivative instruments. Conversely, if interest rates decline, the fair value of fixed-rate agency MBS is generally expected to increase while the fair value of our interest rate derivatives is expected to decline.

The tables that follow illustrate the expected change in fair value for our current investments in agency MBS and derivative instruments under several hypothetical scenarios of interest rate movements. For the purposes of this illustration, interest rates are defined by the U.S. Treasury yield curve. Changes in fair value are measured as percentage changes from their respective fair values

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presented in the column labeled “Value.” Our estimate of the change in the fair value of agency MBS is based upon the same assumptions we use to manage the impact of interest rates on the portfolio. The interest rate sensitivity of our agency MBS and TBA commitments is derived from The Yield Book, a third-party model. Actual results could differ significantly from these estimates. The effective durations are based on observed fair value changes, as well as our own estimate of the effect of interest rate changes on the fair value of the investments, including assumptions regarding prepayments based, in part, on age and interest rate of the mortgages underlying the MBS, prior exposure to refinancing opportunities, and an overall analysis of historical prepayment patterns under a variety of historical interest rate conditions.

The interest rate sensitivity analyses illustrated by the tables that follow have certain limitations, most notably the following:

These analyses are not intended to provide a precise forecast. Actual results could differ materially from these estimates (dollars in thousands, except per share amounts):

 

 

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Cautionary Statement About Forward-Looking Information

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

Forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking into account information currently in our possession. These beliefs, assumptions and expectations may change as a result of many possible events or factors, not all of which are known to us or are within our control. If a change occurs, the performance of our portfolio and our business, financial condition, liquidity and results of operations may vary materially from those expressed, anticipated or contemplated in our forward-looking statements. You should carefully consider these risks, along with the following factors that could cause actual results to vary from our forward-looking statements, before making an investment in our securities:

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These and other risks, uncertainties and factors, including those described elsewhere in this Quarterly Report on Form 10-Q, could cause our actual results to differ materially from those projected in any forward-looking statements we make. All forward-looking statements speak only as of the date on which they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

 

 

Item 4. Controls and Procedures

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

As of the end of the period covered by this Quarterly Report on Form 10-Q, our management, with the participation of our Chief Executive Officer, J. Rock Tonkel, Jr., and our Chief Financial Officer, Richard E. Konzmann, carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined under Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) pursuant to Rule 13a-15(b) of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding disclosure.

Changes in Internal Control Over Financial Reporting

There have been no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

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PART II

OTHER INFORMATION

Item 1. Legal Proceedings

We are from time to time involved in civil lawsuits, legal proceedings and arbitration matters relating to our business that we consider to be in the ordinary course. There can be no assurance that these matters individually or in aggregate will not have a material adverse effect on our financial condition or results of operations in a future period. We are also subject to the risk of litigation, including litigation that may be without merit. As we intend to actively defend such litigation, significant legal expenses could be incurred. An adverse resolution of any future litigation against us could materially affect our financial condition, results of operations and liquidity. Furthermore, we operate in highly-regulated markets that currently are under intense regulatory scrutiny, and we have received, and we expect in the future that we may receive, inquiries and requests for documents and information from various federal, state and foreign regulators. In addition, one or more of our subsidiaries have received requests to repurchase loans from various parties in connection with the former securitization business conducted by a subsidiary. We believe that the continued scrutiny of MBS, structured financed and derivative market participants increases the risk of additional inquiries and requests from regulatory or enforcement agencies and other parties. We cannot provide any assurance that these inquiries and requests will not result in further investigation of or the initiation of a proceeding against us or that, if any such investigation or proceeding were to arise, it would not materially adversely affect our Company.

Item 1A. Risk Factors

None.

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

Purchases of Equity Securities by the Issuer

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information

None.

Item 6. Exhibits

 

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