Arlington Asset Investment Corp. - Quarter Report: 2017 March (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		☐  (Do not check if a small reporting company)		Small reporting company		☐
Emerging growth company		☐

Title		Outstanding
Class A Common Stock		23,628,167 shares

						Page
PART I — FINANCIAL INFORMATION
		Item 1.		Consolidated Financial Statements and Notes		1
				Consolidated Balance Sheets — March 31, 2017 (unaudited) and December 31, 2016 (audited)		1
				Consolidated Statements of Comprehensive Income — Three Months Ended March 31, 2017 and 2016 (unaudited)		2
				Consolidated Statements of Changes in Equity — Three Months Ended March 31, 2017 (unaudited) and Year Ended December 31, 2016 (audited)		3
				Consolidated Statements of Cash Flows — Three Months Ended March 31, 2017 and 2016 (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		45
		Item 4.		Controls and Procedures		49
PART II — OTHER INFORMATION
		Item 1.		Legal Proceedings		50
		Item 1A.		Risk Factors		50
		Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds		50
		Item 3.		Defaults Upon Senior Securities		50
		Item 4.		Mine Safety Disclosures		50
		Item 5.		Other Information		50
		Item 6.		Exhibits		50
				Signatures		53

		March 31, 2017				December 31, 2016
		(unaudited)				(audited)
ASSETS
Cash and cash equivalents		$	15,775			$	54,794
Interest receivable			13,723				11,646
Sold securities receivable			160,431				—
Mortgage-backed securities, at fair value
Private-label			1,292				1,266
Agency			4,391,274				3,911,375
Derivative assets, at fair value			5,546				74,889
Deferred tax assets, net			65,149				73,432
Deposits, net			63,782				11,149
Other assets			3,520				3,003
Total assets		$	4,720,492			$	4,141,554
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Repurchase agreements		$	4,241,855			$	3,649,102
Interest payable			2,415				3,434
Accrued compensation and benefits			1,589				5,406
Dividend payable			15,964				15,739
Derivative liabilities, at fair value			6,096				9,554
Other liabilities			4,380				1,247
Long-term unsecured debt			73,712				73,656
Total liabilities			4,346,011				3,758,138
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, 23,628,167    and 23,607,111 shares issued and outstanding, respectively			236				236
Class B common stock, $0.01 par value, 100,000,000 shares authorized, -0- and    20,256 shares issued and outstanding, respectively			—				—
Additional paid-in capital			1,911,194				1,910,284
Accumulated deficit			(1,536,949	)			(1,527,104	)
Total stockholders’ equity			374,481				383,416
Total liabilities and stockholders’ equity		$	4,720,492			$	4,141,554

		Three Months Ended March 31,
		2017				2016
Interest income
Agency mortgage-backed securities		$	30,286			$	25,655
Private-label mortgage-backed securities			37				2,974
Other			20				125
Total interest income			30,343				28,754
Interest expense
Short-term secured debt			8,859				5,500
Long-term unsecured debt			1,207				1,193
Total interest expense			10,066				6,693
Net interest income			20,277				22,061
Investment loss, net
Other-than-temporary impairment charges			—				(99	)
(Loss) gain on trading investments, net			(4,219	)			50,950
Gain (loss) from derivative instruments, net			2,305				(100,760	)
Other, net			152				19
Total investment loss, net			(1,762	)			(49,890	)
General and administrative expenses
Compensation and benefits			3,445				2,564
Other general and administrative expenses			1,480				1,771
Total general and administrative expenses			4,925				4,335
Income (loss) before income taxes			13,590				(32,164	)
Income tax provision (benefit)			8,336				(546	)
Net income (loss)		$	5,254			$	(31,618	)
Basic earnings (loss) per share		$	0.22			$	(1.38	)
Diluted earnings (loss) per share		$	0.22			$	(1.38	)
Weighted-average shares outstanding (in thousands)
Basic			23,652				22,994
Diluted			23,897				22,994
Other comprehensive income (loss), net of taxes
Unrealized losses on available-for-sale securities    (net of taxes of $-0- and $(3,164), respectively)		$	—			$	(4,970	)
Reclassification
Included in investment loss, net, related to other-than-    temporary impairment charges on available-for-sale    securities (net of taxes of $-0- and $39, respectively)			—				60
Comprehensive income (loss)		$	5,254			$	(36,528	)

		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, 2015			22,874,819			$	229				102,216			$	1			$	1,898,085			$	12,371			$	(1,426,655	)		$	484,031
Net loss			—				—				—				—				—				—				(41,347	)			(41,347	)
Conversion of Class B common stock to    Class A common stock			81,960				1				(81,960	)			(1	)			—				—				—				—
Issuance of Class A common stock			595,342				6				—				—				9,669				—				—				9,675
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			—				—				—				—				2,974				—				—				2,974
Income tax provision from stock-based    compensation			—				—				—				—				(175	)			—				—				(175	)
Other comprehensive loss			—				—				—				—				—				(12,371	)			—				(12,371	)
Dividends declared			—				—				—				—				—				—				(59,102	)			(59,102	)
Balances, December 31, 2016			23,607,111				236				20,256				—				1,910,284				—				(1,527,104	)			383,416
Net income			—				—				—				—				—				—				5,254				5,254
Conversion of Class B common stock to    Class A common stock			20,256				—				(20,256	)			—				—				—				—				—
Issuance of Class A common stock			800				—				—				—				12				—				—				12
Stock-based compensation			—				—				—				—				898				—				—				898
Dividends declared			—				—				—				—				—				—				(15,099	)			(15,099	)
Balances, March 31, 2017			23,628,167			$	236			$	—			$	—			$	1,911,194			$	—			$	(1,536,949	)		$	374,481

		Three Months Ended March 31,
		2017				2016
Cash flows from operating activities:
Net income (loss)		$	5,254			$	(31,618	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities
Investment loss, net			1,762				49,890
Net premium amortization on mortgage-backed securities			7,411				5,328
Deferred tax provision (benefit)			8,283				(824	)
Other			900				517
Changes in operating assets
Interest receivable			(2,077	)			2,128
Other assets			(380	)			2,051
Changes in operating liabilities
Interest payable and other liabilities			(1,410	)			(2,510	)
Accrued compensation and benefits			(3,817	)			(3,747	)
Net cash provided by operating activities			15,926				21,215
Cash flows from investing activities:
Purchases of private-label mortgage-backed securities			—				(5,357	)
Purchases of agency mortgage-backed securities			(874,306	)			(377,604	)
Proceeds from sales of agency mortgage-backed securities			116,915				933,927
Receipt of principal payments on private-label mortgage-backed securities			4				—
Receipt of principal payments on agency mortgage-backed securities			105,401				93,459
Proceeds from (payments for) derivatives and deposits, net			19,140				(101,528	)
Other			13				15,764
Net cash (used in) provided by investing activities			(632,833	)			558,661
Cash flows from financing activities:
Proceeds from repurchase agreements, net			592,753				227,601
Repayments of Federal Home Loan Bank advances			—				(786,900	)
Proceeds from issuance of common stock			12				—
Excess tax benefits associated with stock-based awards			—				68
Dividends paid			(14,877	)			(14,448	)
Net cash provided by (used in) financing activities			577,888				(573,679	)
Net (decrease) increase in cash and cash equivalents			(39,019	)			6,197
Cash and cash equivalents, beginning of period			54,794				36,987
Cash and cash equivalents, end of period		$	15,775			$	43,184
Supplemental cash flow information:
Cash payments for interest		$	11,029			$	7,708
Cash payments for taxes		$	—			$	—

		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. 2016-07, Simplifying the Transition to the Equity Method of Accounting (Topic 323)	This amendment eliminates the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held.	January 1, 2017	The adoption of ASU No. 2016-07 did not impact the Company’s consolidated financial statements.
ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting (Topic 718)	This amendment was issued with the objective of simplifying several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. Some of the areas for simplification apply only to nonpublic entities.	January 1, 2017	The adoption of ASU No. 2016-07 did not have a material impact on the Company’s consolidated financial statements.
Recently Issued Accounting Guidance Not Yet Adopted

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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. As of March 31, 2017 and December 31, 2016, the Company had $4,391,274 and $3,911,375, respectively, of fair value in agency MBS classified as trading securities.  

 

As of March 31, 2017, 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 December 31, 2016, the Company’s portfolio of investments in agency MBS also included investments in inverse interest-only agency MBS with an aggregate fair value of $1,923. The Company’s investments in inverse interest-only agency MBS represented beneficial interests 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 loss, net” in the

9

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

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 were classified as available-for-sale, all of which had been sold as of December 31, 2016. The Company has elected to classify its investments in private-label MBS acquired in 2015 or later as trading securities. As of March 31, 2017 and December 31, 2016, the Company held investments in private-label MBS with a fair value of $1,292 and $1,266, respectively, all of which were classified as trading securities.

 

As of March 31, 2017, 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 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 trusts that issued the Company’s investments in re-REMIC securities employ a “sequential” principal repayment structure. Accordingly, 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.

 

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. As of March 31, 2017 and December 31, 2016, the Company had no available-for-sale private-label MBS.

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. There were no sales of available-for-sale private-label MBS during the three months ended March 31, 2017 and 2016.

 

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

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

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.”

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

For the three months ended March 31, 2016, the Company recorded credit related other-than-temporary impairment charges of $99 as a component of “investment gain (loss), net” on the consolidated statements 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 months ended March 31, 2017. 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 net gains recognized as a component of “investment 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 March 31, 2017 and December 31, 2016, 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 months ended March 31, 2017 and 2016:

 

Long-Term Unsecured Debt

As of March 31, 2017 and December 31, 2016, the Company had $73,712 and $73,656, respectively, of outstanding long-term unsecured debentures, net of unamortized debt issuance costs of $1,588 and $1,644, respectively. The Company’s long-term debentures consisted of the following as of the dates indicated:

 

 

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 balance sheets, with all periodic changes in fair value reflected as a component of “investment gain (loss), net” in the consolidated

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

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 cash “variation margin” with the counterparties to its interest rate derivative instruments at least on a daily basis based upon daily changes in fair value as measured by the Chicago Mercantile Exchange (“CME”), the central clearinghouse through which those derivatives are cleared. In addition, the CME requires market participants to deposit and maintain an “initial margin” amount which is determined by the CME and is generally intended to be set at a level sufficient to protect the CME from the maximum estimated single-day price movement in that market participant’s contracts.

Receivables recognized for the right to reclaim cash initial margin posted in respect of interest rate derivative instruments are included in the line item “deposits, net” in the accompanying consolidated balance sheets. Prior to the first quarter of 2017, the daily exchange of variation margin associated with centrally cleared derivative instruments was considered a pledge of collateral. For these prior periods, receivables recognized for the right to reclaim cash variation margin posted in respect of interest rate derivative instruments are included in the line item “deposits, net” in the accompanying consolidated balance sheets. The Company elected to offset any payables recognized for the obligation to return cash variation margin received from an interest rate derivative instrument counterparty against receivables recognized for the right to reclaim cash initial margin posted by the Company to that same counterparty.

Beginning in the first quarter of 2017, as a result of a CME amendment to their rule book which governs their central clearing activities, the daily exchange of variation margin associated with a centrally cleared derivative instrument is legally characterized as the daily settlement of the derivative instrument itself, as opposed to a pledge of collateral. Accordingly, beginning in 2017, the Company accounts for the daily receipt or payment of variation margin associated with its centrally cleared interest rate swaps as a direct reduction to the carrying value of the interest rate swap derivative asset or liability, respectively. Beginning in 2017, the carrying amount of centrally cleared interest rate swaps reflected in the Company’s consolidated balance sheets is equal to the unsettled fair value of such instruments; because variation margin is exchanged on a one-day lag, the unsettled fair value of such instruments represents the change in fair value that occurred on the last day of the reporting period.

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 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 for settlement 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 for a forward settlement month are generally priced at a

14

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

discount relative to TBA securities sold 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 gain (loss), net” along with all other periodic changes in the fair value of TBA commitments.

In addition to transacting in net long positions in TBA securities for investment purposes, the Company may also, from time to time, transact in net sale (or “net short”) positions in TBA securities for the purpose of economically hedging a portion of the sensitivity of the fair value of the Company’s investments in agency MBS to changes in interest rates.

Cash collateral posted by the Company in respect of TBA transactions is included in the line item “deposits, net” in the accompanying consolidated balance sheets. Cash collateral received by the Company in respect of TBA transactions is included in the line item “other liabilities” 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.

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 March 31, 2017:

 

 

15

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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 information about the Company’s forward-starting interest rate swap agreements that had yet to take effect as of March 31, 2017:

 

 

The following table presents information about the Company’s interest rate swap agreements that were in effect as of December 31, 2016:

 

 

The following table presents information about the Company’s forward-starting interest rate swap agreements that had yet to take effect as of December 31, 2016:

 

 

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 March 31, 2017 with the objective of hedging a portion of the interest rate sensitivity of the Company’s agency MBS portfolio.  As of March 31, 2017, the Company held 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 $700,000 that were struck at a weighted average strike price that equates to a 10-year U.S. Treasury rate of approximately 2.63%.  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 $350,000 that were struck at a weighted average strike price per contract that equates to a 10-year U.S. Treasury rate of approximately 2.35%.  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 $350,000 as of March 31, 2017 that were struck at a weighted average strike price per contract that equates to a 10-year U.S. Treasury rate of approximately 2.10%.  The options may be exercised at any time prior to their expiry, which occurs in the second quarter of 2017, and, if exercised, may be net settled in cash or through physical receipt or delivery of the underlying futures contracts.  Information about the Company’s outstanding put and call options on 10-year U.S. Treasury note futures contracts as of March 31, 2017 is as follows:

 

16

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

 

 

Information about the Company’s outstanding put and call options on 10-year U.S. Treasury note futures contracts as of December 31, 2016 is as follows:

 

 

17

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

 

TBA Commitments

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

 

 

 

 

Derivative Instrument Gains and Losses

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

 

18

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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:

  

 

 

 

 

Cash Collateral Posted and Received for Derivative Instruments

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

 

 

19

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ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

 

As of March 31, 2017, the Company had received $2,280 of cash collateral in respect of its forward-settling TBA commitments. The Company recognized a corresponding obligation to return this cash collateral to its counterparties, which is included in the line item “other liabilities” in the accompanying consolidated balance sheets.

 

 

Note 7. Offsetting of Financial Assets and Liabilities

The agreements that govern certain of the Company’s derivative instruments and collateralized 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 assets and liabilities as well as collateralized short-term financing arrangements on a gross basis.

Receivables recognized for the right to reclaim cash initial margin posted in respect of interest rate derivative instruments are included in the line item “deposits, net” in the accompanying consolidated balance sheets. Prior to the first quarter of 2017, the daily exchange of variation margin associated with centrally cleared derivative instruments was considered a pledge of collateral. For these prior periods, receivables recognized for the right to reclaim cash variation margin posted in respect of interest rate derivative instruments are included in the line item “deposits, net” in the accompanying consolidated balance sheets. The Company elected to offset any payables recognized for the obligation to return cash variation margin received from an interest rate derivative instrument counterparty against receivables recognized for the right to reclaim cash initial margin posted by the Company to that same counterparty.

 

Beginning in the first quarter of 2017, as a result of a CME amendment to their rule book which governs their central clearing activities, the daily exchange of variation margin associated with a centrally cleared derivative instrument is legally characterized as the daily settlement of the derivative instrument itself, as opposed to a pledge of collateral. Accordingly, beginning in 2017, the Company accounts for the daily receipt or payment of variation margin associated with its centrally cleared interest rate swaps as a direct reduction to the carrying value of the interest rate swap derivative asset or liability, respectively. Beginning in 2017, the carrying amount of centrally cleared interest rate swaps reflected in the Company’s consolidated balance sheets is equal to the unsettled fair value of such instruments; because variation margin is exchanged on a one-day lag, the unsettled fair value of such instruments represents the change in fair value that occurred on the last day of the reporting period.

20

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

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

 

 

21

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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. In determining fair value, third-party pricing services use a market approach.  The inputs used in the fair value measurements performed by the third-party pricing services are based upon readily 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.

22

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

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.

Other

Long-term unsecured debt - As of March 31, 2017 and December 31, 2016, the carrying value of the Company’s long-term debt was $73,712 and $73,656, 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 $68,401 and $66,489 as of March 31, 2017 and December 31, 2016, 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.

Investments in equity securities of non-public companies and investment funds - As of March 31, 2017 and December 31, 2016, the Company had investments in equity securities and investment funds with a carrying amount of $2,058 and $1,918, respectively, which are included in the line item “other assets” in the accompanying consolidated balance sheets.  As of March 31, 2017 and December 31, 2016, $684 and $533, respectively, 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 $1,374 and $1,385 in investments in equity securities of non-public companies and investment funds as of March 31, 2017 and December 31, 2016, respectively, were measured at cost, net of impairments. The Company’s estimate of the fair value of investments in equity securities and investment funds is $5,971 and $6,034 as of March 31, 2017 and December 31, 2016, 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 the consideration of 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.

23

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

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

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 March 31, 2017 and December 31, 2016. 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 months ended March 31, 2017 or the year ended December 31, 2016.

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:

 

24

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

 

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”).  As of March 31, 2017, the Company had estimated net operating loss (“NOL”) carry-forwards of $85,050 that can be used to offset future taxable ordinary income.  The Company’s NOL carry-forwards begin to expire in 2027.  As of March 31, 2017, the Company had estimated net capital loss (“NCL”) carry-forwards of $319,975 that can be used to offset future net capital gains.  The scheduled expirations of the Company’s NCL carry-forwards are $136,840 in 2019, $102,927 in 2020, $71,131 in 2021 and $9,077 in 2022.  The Company is subject to federal alternative minimum tax (“AMT”) and state and local taxes on its taxable income and gains that are not offset by its NOL and NCL carry-forwards.

As of March 31, 2017 and December 31, 2016, the Company had a net deferred tax asset of $65,149 and $73,432, respectively, net of a valuation allowance on NCL carry-forwards of $119,428 and $116,300, respectively. A valuation allowance is provided against the deferred tax asset if, based on the Company’s evaluation, it is more-likely-than-not that some or all of the deferred tax assets will not be realized.  All available evidence, both positive and negative, is considered to determine whether a valuation allowance for deferred tax assets is needed.  Items considered in determining the Company’s valuation allowance include expectations of future earnings of the appropriate tax character, recent historical financial results, tax planning strategies, the length of statutory carry-forward periods and the expected timing of the reversal of temporary differences.  As of March 31, 2017, 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. Forming a conclusion that an additional valuation allowance is not needed is difficult when negative evidence exists, such as cumulative losses in recent years, which is generally measured as pre-tax earnings determined in accordance with GAAP over a historical three-year period.  As of March 31, 2017, the Company had cumulative pre-tax net income of $12,675 over the preceding three-year period; however, if the Company were to have a three-year cumulative pre-tax net loss as of a future reporting date, the Company may determine that an additional valuation allowance against its deferred tax assets that are capital in nature is warranted.  As of March 31, 2017, the Company’s deferred tax assets that are capital in nature for which a valuation allowance had not been provided had an aggregate carrying value of $47,458. The Company will continue to assess the need for a valuation allowance at each reporting date.

As of March 31, 2017, the Company has assessed the need for recording a provision for any uncertain tax position and has made the determination that such provision is not necessary.

The Company is subject to examination by the U.S. Internal Revenue Service (“IRS”) and state and local taxing jurisdictions where the Company has significant business operations. As of March 31, 2017, there are no on-going examinations.

 

25

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

 

Note 10. Earnings (Loss) 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 months ended March 31, 2016 did not include the antidilutive effect of 46,156 shares of unvested shares of performance share units and restricted stock.

 

 

Note 11. Stockholders’ Equity

The Company has authorized share capital of 450,000,000 shares of Class A common stock, par value $0.01 per share; 100,000,000 shares of Class B common stock, par value $0.01 per share; and 25,000,000 shares of undesignated preferred stock. Holders of the Class A and Class B common stock are entitled to one vote and three votes per share, respectively, on all matters voted upon by the shareholders. Shares of Class B common stock are convertible into shares of Class A common stock on a one-for-one basis at the option of the Company in certain circumstances including either (i) upon sale or other transfer, or (ii) at the time the holder of such shares of Class B common stock ceases to be employed by the Company.  The Company’s Board of Directors has the authority, without further action by the shareholders, to issue preferred stock in one or more series and to fix the terms and rights of the preferred stock.

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 2017:

 

 

The Board of Directors approved and the Company declared and paid the following dividends for 2016:

 

 

Conversion of Class B Common Stock to Class A Common Stock

On October 28, 2016, the Company entered into exchange agreements with each of the Company’s Executive Chairman and Chief Executive Officer to exchange all of their shares of Class B common stock for shares of the Company’s Class A common stock.

26

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

During the three months ended March 31, 2017 and during the year ended December 31, 2016, holders of the Company's Class B common stock converted an aggregate of 20,256 and 81,960 shares of Class B common stock into 20,256 and 81,960 shares of Class A common stock, respectively.

As of March 31, 2017, all remaining shares of Class B common stock had been exchanged for shares of the Company’s Class A common stock.

Share Repurchase Program

 

The Company’s Board of Directors authorized a 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 March 31, 2017, there remain available for repurchase 1,951,305 shares of Class A common stock under the Repurchase Program.

 

Equity Distribution Agreements

 

On May 24, 2013, the Company entered into separate equity distribution agreements (the “Prior Equity Distribution Agreements”) with each of RBC Capital Markets, LLC, JMP Securities LLC, Ladenburg Thalmann & Co. Inc. and MLV & Co. LLC (the “Prior Equity Sales Agents”), pursuant to which the Company may offer and sell, from time to time, up to 1,750,000 shares of the Company’s Class A common stock. Pursuant to the Prior Equity Distribution Agreements, shares of the Company’s common stock may be offered and sold through the Prior Equity Sales Agents in transactions that are deemed to be “at the market” offerings as defined in Rule 415 under the Securities Act of 1933, including sales made directly on the NYSE or sales made to or through a market maker other than on an exchange or, subject to the terms of a written notice from the Company, in privately negotiated transactions.  

During the three months ended March 31, 2017, the Company issued 800 shares of Class A common stock at a weighted average public offering price of $15.16 per share for proceeds net of underwriting discounts and commissions of $12 under the Prior Equity Distribution Agreements.  On February 23, 2017, the Company terminated the Prior Equity Distribution Agreements.

On February 22, 2017, the Company entered into new separate equity distribution agreements (the “New Equity Distribution Agreements”) with each of JMP Securities LLC, FBR Capital Markets & Co., JonesTrading Institutional Services LLC and Ladenburg Thalmann & Co. Inc. (the “New Equity Sales Agents”), pursuant to which the Company may offer and sell, from time to time, up to 6,000,000 shares of the Company’s Class A common stock. Pursuant to the New Equity Distribution Agreements, shares of the Company’s common stock may be offered and sold through the New Equity Sales Agents in transactions that are deemed to be “at the market” offerings as defined in Rule 415 under the Securities Act of 1933, including sales made directly on the NYSE or sales made to or through a market maker other than on an exchange or, subject to the terms of a written notice from the Company, in privately negotiated transactions.

As of March 31, 2017, the Company had 6,000,000 shares of Class A common stock available for sale under the New Equity Distribution Agreements.

 

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

27

---

ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

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, 2016.

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, 2016.

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. As of March 31, 2017, nearly all of our investment capital was allocated to agency MBS. 

 

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

 

Following the November 2016 surprising election victory by Republican Donald Trump, together with the Republican party securing control of both houses of Congress, a major repricing was triggered in nearly every financial market.  The new administration’s expected pro-growth economic policies, including potential income tax reform, infrastructure spending and deregulation, raised expectations for faster economic growth and higher inflation.  In turn, this led to increased demand for U.S. equity assets and a sell-off in U.S. Treasuries driving the 10-year U.S. Treasury rate up to a high of 2.60% in the fourth quarter, a 72 basis point increase post the election.  In response, the dramatic increase in rates and volatility led to meaningful widening in agency MBS spreads relative to swap and U.S. Treasury rates during the fourth quarter.  In the first quarter of 2017, the markets generally continued to price in optimism of the pro-economic growth policies of the new administration.  However, these growth expectations became more tempered as it became clear that any proposed new policies would be a challenge to enact.

 

During the first quarter of 2017, the 10-year U.S. Treasury rate traded in a range of 31 basis points and ended the quarter at 2.40%, down only five basis points from year-end.  However, the spread between 10-year U.S. Treasury rates and interest rate swaps widened almost eleven basis points during the first quarter of 2017 with the 10-year swap rate ending at 2.38% on March 31, 2017.

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The treasury rate curve flattened during the first quarter as the spread between the 2-year and 10-year U.S. Treasury rate narrowed twelve basis points.  With the decreased overall volatility, agency MBS spreads relative to swap and U.S. Treasury rates remained relatively unchanged during the quarter.  

 

On March 15, 2017, the Federal Open Market Committee (“FOMC”) announced that it was raising the target federal funds rate range by 25 basis points to 0.75% to 1.00%, which followed its 25 basis point increase announced in December 2016.  In its March 15, 2017 statement, the FOMC commented that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will rise to 2% over the medium term.  The FOMC commented further that it expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate, and will likely remain, for some time, below levels that are expected to prevail in the longer run.  Based on federal fund futures prices, most market participants currently believe that it is likely that the FOMC will raise its target federal funds rate up to two more times during 2017.  In the minutes of the March 2017 meeting, the FOMC signaled to the market that a change to the Federal Reserve’s reinvestment policy of its U.S. Treasury securities and agency MBS would likely be appropriate later this year.  A change in the reinvestment policy could entail either phasing out or ceasing all reinvestments; however, any change to the reinvestment policy would be communicated to the public well in advance.

 

Beginning in February 2017, prepayment speeds in the residential mortgage environment declined significantly due to both seasonal factors and the sharp increase in long-term rates post the U.S. presidential election.  Looking forward, near term prepayment speeds are expected to remain moderate, subject to normal seasonal variations.  However, continued wage growth, home price appreciation and the recent downward movement in long-term interest rates in April 2017 may accelerate prepayment speeds from current levels.  

 

Housing prices continue to improve as evidenced by the S&P CoreLogic Case-Shiller U.S. National Home Price NSA index reporting a 5.9% annual gain in January 2017, the highest annual gain in 31 months, and the overall index reaching a historical high.  However, housing prices may begin to level off as tight housing supplies and higher mortgage rates may lead to housing price pressures.

 

Recent Government Activity

 

Uncertainty over the new administration’s policies, together with questions regarding the administration’s ability to work with Congress in order to implement such policies, are likely to increase market and credit volatility over the remainder of 2017.  We expect vigorous debate and discussion in a number of areas, including residential housing and mortgage reform, taxation, fiscal policy and monetary policy, to continue over the next few years; however, we cannot be certain if or when any specific proposal or policy might be announced, emerge from committee or be approved by Congress, and if so, what the effects on us may be.

 

 

Executive Summary

As of March 31, 2017, the Company’s book value was $15.83 per share, a decrease of 2.3% from $16.21 per share as of December 31, 2016. The Company’s tangible book value, which is calculated as shareholders’ equity less the Company’s net deferred tax asset, was $13.08 per share as of March 31, 2017, a decrease of 0.2% from $13.11 per share as of December 31, 2016.  For the quarter ended March 31, 2017, the Company declared a dividend of $0.625 per share, resulting in an annualized economic return of 18.2% measured as the change in tangible book value plus dividends declared during the quarter.

For the first quarter of 2017, the Company had net income of $0.22 per diluted share compared to a net loss of $1.79 per diluted share in the prior quarter. The Company had non-GAAP core operating income of $0.60 per diluted share for the first quarter of 2017 compared to $0.64 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 first quarter 2017 earnings benefited from lower prepayments speeds resulting in higher agency MBS yields, however the benefit was more than offset by higher cost of funding, lower investment volumes at the beginning of the quarter, an increase in the average interest rate hedge position, and higher general and administrative expenses as compared to the fourth quarter of 2016.

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 decreased to 8.17% for the first quarter of 2017 from 12.90% in the prior quarter, resulting in an increase in the average asset yield to 2.85% during the first quarter compared to 2.55% in the prior quarter.

The Company’s average cost of short-term funding during the quarter ended March 31, 2017 was 0.90%, an increase of 10 basis points from the prior quarter attributable primarily to the increase in benchmark short-term rates driven by the Federal Reserve rate

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increases.  However, the impact on earnings of the rise in LIBOR during the first quarter of 2017 was mitigated by a narrowing of the spread between LIBOR and repurchase agreement funding rates.   

As of March 31, 2017, the Company’s agency investment portfolio totaled $4,864 million, comprised of $4,391 million of specified agency MBS and $473 million of net long TBA agency MBS. Beginning at the end 2016 and into the beginning 2017, the Company reduced its TBA agency MBS position and therefore its overall agency investment portfolio given the extended period of elevated prepayment speeds and lower expected TBA returns available at that time.  However, stabilization in interest rates and a sharp decline in prepayment speeds starting in February of 2017 supported an improvement in the attractiveness of TBA dollar rolls enabling the Company to increase its overall agency portfolio balance by quarter end to prior levels.  

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 March 31, 2017, 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.  The Company purchases and sells put and call options on U.S. Treasury note futures with the objective of protecting the Company’s capital against a significant rise in interest rates while limiting its exposure to a significant fall in interest rates. The Company increased the notional amount of its interest rate swap position towards the end of 2016, while also increasing the duration of its interest rate portfolio through the beginning 2017 in response to higher expected duration of its agency MBS portfolio associated with the rise in rates post the U.S Presidential election.

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 attractive dividends to our shareholders. In a volatile 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 spreads remain wide, or through a reversal of temporary declines in book value if future interest rate volatility is low and spreads narrow.  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 continues to utilize its tax benefits afforded to it as a C-corporation that allow it to shield substantially all of its income from the payment of cash taxes.  As of March 31, 2017, the Company had NOL carry-forwards of $85.1 million and NCL carry-forwards of $320.0 million.  From a GAAP accounting perspective, the Company had a net deferred tax asset of $65.1 million, or $2.75 per share, as of March 31, 2017.  The Company continues to record a valuation allowance against a portion of the deferred tax asset attributable to NCL carry-forwards that the Company believes will likely expire prior to utilization.  

 

 

Portfolio Overview

The following table summarizes our MBS investment portfolio at fair value as of March 31, 2017 and December 31, 2016 (dollars in thousands):

 

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Agency MBS Investment Portfolio

Our specified agency MBS consisted of the following as of March 31, 2017 (dollars in thousands):

 

 

 

The actual CPR for the Company’s agency MBS was 8.17% for the three months ended March 31, 2017. As of March 31, 2017, the Company’s agency MBS was comprised of securities specifically selected for their relatively lower propensity for prepayment, which includes approximately 95% 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”) 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 March 31, 2017 is as follows (dollars in thousands):

 

 

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Private-Label MBS Investment Portfolio

Our private-label MBS, excluding our interest-only MBS, consisted of the following as of March 31, 2017 (dollars in thousands):

 

 

As of March 31, 2017, the private-label MBS portfolio consists 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 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 trusts that issued the Company’s investments in re-REMIC securities employ a “sequential” principal repayment structure. Accordingly, 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.

Economic Hedging Instruments

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 March 31, 2017, 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 interest rate swap agreements in effect as of March 31, 2017 is as follows (dollars in thousands):

 

The Company also has forward-starting interest rate swap agreements as of March 31, 2017 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 March 31, 2017 is as follows (dollars in thousands):

 

 

In addition to interest rate swap agreements, the Company had also purchased and sold options on U.S. Treasury note futures contracts as of March 31, 2017 with the objective of hedging a portion of the interest rate sensitivity of the Company’s agency MBS

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portfolio.  As of March 31, 2017, the Company held 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 $700 million that were struck at a weighted average strike price that equates to a 10-year U.S. Treasury rate of approximately 2.63%.  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 $350 million as of March 31, 2017, that were struck at a weighted average strike price per contract that equates to a 10-year U.S. Treasury rate of approximately 2.35%.  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 $350 million as of March 31, 2017 that were struck at a weighted average strike price per contract that equates to a 10-year U.S. Treasury rate of approximately 2.10%.  The options may be exercised at any time prior to their expiry, which occurs in the second quarter of 2017, and, if exercised, are expected to be settled in cash.  

Information about the Company’s outstanding put and call options on 10-year U.S. Treasury note futures contracts as of March 31, 2017 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. 

Net interest income determined in accordance with GAAP does not include TBA agency MBS dollar roll income, which we believe 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.

General and Administrative Expenses

“Compensation and benefits expense” includes base salaries, annual cash incentive compensation, and non-cash stock-based compensation. Annual cash incentive compensation is based on meeting estimated annual performance measures and discretionary

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components. Non-cash stock-based compensation includes expenses associated with 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 months ended March 31, 2017 compared to the three months ended March 31, 2016

The following table presents the net income (loss) reported for the three months ended March 31, 2017 and 2016, respectively (dollars in thousands, except per share amounts):

 

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Net Interest Income

Net interest income determined in accordance with GAAP (“GAAP net interest income”) decreased $1.8 million, or 8.1%, from $22.1 million for the three months ended March 31, 2016 to $20.3 million for the three months ended March 31, 2017. The decrease from the comparative period is primarily attributable to a 25 basis point increase in the average interest costs of our short-term financing arrangements due primarily to an increase in prevailing benchmark short-term interest rates, partially offset by an increase in the average balance of our specified agency MBS. 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 portfolio, excluding interest expense on unsecured long-term debt, are summarized in the following table (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):

 

 

During the three months ended March 31, 2017, the percentage allocation of our total agency MBS portfolio to net long positions in non-specified TBA securities and specified agency MBS was 12% and 88%, respectively, as compared to 15% and 85%, respectively, for the three months ended March 31, 2016 as illustrated by the following table (dollars in thousands):

 

 

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TBA dollar roll income decreased $0.4 million to $3.4 million for the three months ended March 31, 2017 from $3.8 million for the comparative period of 2016. 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 ended March 31, 2017 decreased by $2.2 million (or 8.0%) relative to the comparative period from the prior year.  The reduction in total spread income in the current year period relative to the prior year period is due primarily to 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):

 

 

 

Investment Loss, Net

“Total investment loss, net” decreased $48.1 million from a loss of $49.9 million for the three months ended March 31, 2016 to a loss of $1.8 million for the three months ended March 31, 2017. In the first quarter of 2016, a reduction in prevailing longer-term interest rates coupled with MBS spread widening drove the recognition of fair value gains on our agency MBS portfolio which fell short of the fair value losses recognized on our interest rate derivative instruments.

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):

 

 

We recorded credit related other-than-temporary impairment charges of $0.1 million for the three months ended March 31, 2016, on available-for-sale, private-label MBS. We recorded no other-than-temporary impairment charges for the three months ended March 31, 2017. 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.

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Investments classified as trading securities primarily consist of agency MBS. The $4.2 million of net losses recognized for the three months ended March 31, 2017 were primarily driven by modest agency MBS spread widening which more than offset the effect of a decrease in longer-term interest rates that occurred during the period.  The $51.0 million of net gains on trading investments recognized for the three months ended March 31, 2016, were primarily the result of a decrease in prevailing longer-term interest rates, partially offset by MBS spread widening.

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 $3.2 million and $11.3 million for the three months ended March 31, 2017 and 2016, 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.

Our interest rate derivative instruments currently consist of interest rate swaps and 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 $0.9 million of net losses recognized for interest rate derivative instruments for the three months ended March 31, 2017 were primarily attributable to implied net economic financing costs of our interest rate swap agreements. The $112.1 million of net losses recognized for interest rate derivative instruments during the three months ended March 31, 2016 were primarily driven by a decline in prevailing long-term interest rates during the 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 $0.6 million, or 14.0%, from $4.3 million for the three months ended March 31, 2016 to $4.9 million for the three months ended March 31, 2017.

Compensation and benefits expensed increased by $0.8 million, or 30.8%, from $2.6 million for the three months ended March 31, 2016 to $3.4 million for the three months ended March 31, 2017. The increase in compensation and benefits expense is attributable primarily to an increase in long-term performance based stock-based compensation. Total employee stock-based compensation increased by $0.4 million from $0.4 million for the three months ended March 31, 2016 to $0.8 million for the three months ended March 31, 2017. The increase in employee stock-based compensation is attributable primarily to an improvement in the achievement of performance measures in certain of the Company’s long-term performance based stock-based compensation awards.

Other general and administrative expenses decreased by $0.3 million, or 16.7%, from $1.8 million for the three months ended March 31, 2016 to $1.5 million for the three months ended March 31, 2017. The decrease in other general and administrative expenses is attributable primarily to $0.4 million of non-recurring expenses during the three months ended March 31, 2016 stemming from the 2016 proxy contest that were 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 $8.3 million and an income tax benefit of $0.5 million for the three months ended March 31, 2017 and 2016, respectively. The income tax provision for the three months ended March 31, 2017 and 2016 includes the effect of an increase in the valuation allowance against the deferred tax assets of $3.1 million and $12.0 million, respectively. The increase in the valuation allowance against the deferred tax assets for the three months ended March 31, 2017 and 2016 is due mostly to an increase in our net capital loss carry-forward from net capital losses generated during the periods primarily from losses on certain of our economic interest rate hedging instruments.

A valuation allowance is provided against the deferred tax asset if, based on our evaluation, it is more-likely-than-not that some or all of the deferred tax assets will not be realized. All available evidence, both positive and negative, is considered in our determination for whether a valuation allowance for deferred tax assets is needed. Items considered in determining our valuation

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allowance include expectations of future earnings of the appropriate tax character, recent historical financial results, tax planning strategies, the length of statutory carry-forward periods and the expected timing of the reversal of temporary differences. As of March 31, 2017, we continue to provide a valuation allowance against the portion of net capital loss carry-forwards for which we believe is more likely than not that the benefits will not be realized prior to expiration. Forming a conclusion that an additional valuation allowance is not needed is difficult when negative evidence exists, such as cumulative losses in recent years, which is generally measured as pre-tax earnings determined in accordance with GAAP over a historical three-year period. As of March 31, 2017, we had cumulative pre-tax net income of $12,675 over the preceding three-year period; however, if we were to have a three-year cumulative pre-tax net loss as of a future reporting date, we may determine that an additional significant valuation allowance against our deferred tax assets that are capital in nature is warranted. As of March 31, 2017, our deferred tax assets that are capital in nature for which a valuation allowance had not been provided had an aggregate carrying value of $47,458. We will continue to assess the need for a valuation allowance at each reporting date.

Other Comprehensive Loss

Other comprehensive income (loss) was $0 million and ($4.9) million for the three months ended March 31, 2017 and 2016, respectively. For the three months ended March 31, 2016, other comprehensive loss included net unrealized holding losses of $8.1 million on the available-for-sale MBS portfolio, net of a tax benefit of $3.2 million, and $99.2 thousand other-than-temporary impairment charges on available-for-sale securities, net of a tax provision of $38.6 thousand.

 

 

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.” We define core operating income as “economic net interest income” less “core general and administrative expenses.”

 

Economic Net Interest Income

 

Economic net interest income, a non-GAAP financial measure, represents the interest income earned net of the interest expense incurred from all of our interest bearing financial instruments as well as the agency MBS which underlie, and are implicitly financed through, our TBA dollar roll transactions. 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.

 

We believe that economic net interest income assists investors in understanding and evaluating the financial performance of the Company’s long-term-focused, net interest spread-based investment strategy, prior to the deduction of core general and administrative expenses.

 

 

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Core General and Administrative Expenses

 

Core general and administrative expenses are non-interest expenses reported within the line item “total general and administrative expenses” of the consolidated statements of comprehensive income less stock-based compensation expense. For the three months ended March 31, 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

 

The following table presents our computation of non-GAAP core operating income for the three months ended March 31, 2017 and 2016 (amounts in thousands, except per share amounts):

 

 

 

The following table provides a reconciliation of GAAP pre-tax net income (loss) to non-GAAP core operating income for the three months ended March 31, 2017 and 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 shareholders. 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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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.

 

 

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 March 31, 2017, our debt-to-equity leverage ratio was 11.5 to 1 measured as the ratio of the sum of our total debt to our shareholders’ equity as reported on our consolidated balance sheet. In evaluating our liquidity and leverage ratios, we also monitor our “at risk” short-term financing to investable capital ratio.  Our “at risk” short-term financing to investable capital ratio is measured as the ratio of the sum of our short-term financing (i.e. repurchase agreement financing), net payable or receivable for unsettled securities and net contractual forward price of our TBA commitments compared to our investable capital.  Our investable capital is calculated as the sum of our tangible stockholders’ equity and long-term unsecured debt. Tangible stockholders’ equity is measured as our stockholders’ equity less our net deferred tax asset, and our long-term unsecured debt is measured as our long-term unsecured debt excluding any unamortized issuance costs.  As of March 31, 2017, our “at risk” short-term financing to investable capital ratio was 11.8 to 1.  

Cash Flows

As of March 31, 2017, our cash and cash equivalents totaled $15.8 million, representing a net decrease of $39.0 million from $54.8 million as of December 31, 2016. Cash provided by operating activities of $15.9 million during the three months ended March 31, 2017 was attributable primarily to net interest income less our general and administrative expenses. Cash used in investing activities of $632.8 million during the three months ended March 31, 2017 was primarily generated by purchases of new agency MBS, partially offset by sales of agency MBS, the receipt of principal payments from agency MBS and proceeds received from settlements and deposits for margin calls on our interest rate derivative instruments. Cash provided by financing activities of $577.9 million during the three months ended March 31, 2017 relates primarily to net proceeds obtained from repurchase agreements used to finance a portion of our MBS investment portfolio partially offset by dividend payments to common stockholders.

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

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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 March 31, 2017, liquid assets consisted primarily of cash and cash equivalents of $15.8 million and net investments in MBS of $311.1 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.

Debt Capital

Long-Term Unsecured Debt

As of March 31, 2017, we had $73.7 million of total long-term unsecured debt, net of unamortized debt issuance costs of $1.6 million. Our trust preferred debt obligations with an aggregate principal amount of $15.0 million outstanding as of March 31, 2017 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 March 31, 2017 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 March 31, 2017 accrue and require payment of interest quarterly at an annual rate of 6.75% and mature on March 15, 2025.

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 (“SIFMA”) 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.

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

The following table provides information regarding our outstanding repurchase agreement borrowings as of 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 March 31, 2017, we had outstanding repurchase agreement balances with 16 counterparties and have master repurchase agreements in place with a total of 19 counterparties located throughout North America, Europe and Asia. As of March 31, 2017, no more than 7.1% of our stockholders’ equity was at risk with any one counterparty, with the top five counterparties representing approximately 31.2% of our stockholders’ equity. The table below includes a summary of our repurchase agreement funding by number of counterparties and counterparty region as of March 31, 2017 (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 (i) interest rate derivative instruments such as interest rate swaps, Eurodollar futures, interest rate swap futures, U.S. Treasury note futures, and put and call options on U.S. Treasury note futures, and (ii) derivative instruments that economically serve as investments such as TBA contracts.

Interest Rate Derivative Instruments

We exchange cash variation margin with the counterparties to our interest rate derivative instruments at least on a daily basis based upon daily changes in fair value 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 March 31, 2017, we had outstanding interest rate swaps and 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):

 

 

TBA Dollar Roll Transactions

TBA dollar roll transactions represent a form of off-balance sheet financing accounted for as derivative instruments.  In a TBA dollar roll transaction, we do not intend to take physical delivery of the underlying agency MBS and will generally enter into an offsetting position and net settle the paired off position in cash.  However, under certain market conditions, it may be uneconomical for us to roll our TBA contracts into future months and we may need to take or make physical delivery of the underlying securities. If we were required to take physical delivery to settle a long TBA contract, we would have to fund our total purchase commitment with cash or other financing sources and our liquidity position could be negatively impacted.

Our TBA contracts are subject to master securities forward transaction agreements published by SIFMA as well as supplemental terms and conditions with each counterparty.  Under the terms of these agreements, we may be required to pledge collateral to our counterparty in the event the fair value of our TBA contracts declines and such counterparty demands collateral through a margin call.  Margin calls on TBA contracts are generally caused by such factors as rising interest rates or prepayments.  Our TBA contracts generally provide that valuations for our TBA commitments and any pledged collateral are to be obtained from a generally recognized source agreed to by both parties.  However, in certain circumstances, our counterparties have the sole discretion to determine the value of the TBA commitment and any pledged collateral. In such instances, our counterparties are required to act in good faith in making determinations of value. In the event of a margin call, we must generally provide additional collateral on the same business day.

Equity Capital

Equity Distribution Agreements

On May 24, 2013, we entered into separate equity distribution agreements (the “Prior Equity Distribution Agreements”) with each of RBC Capital Markets, LLC, JMP Securities LLC, Ladenburg Thalmann & Co. Inc. and MLV & Co. LLC (the “Prior Equity Sales Agents”), pursuant to which we may offer and sell, from time to time, up to 1,750,000 shares of our Class A common stock. Pursuant to the Prior Equity Distribution Agreements, shares of our common stock may be offered and sold through the Prior Equity

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Sales Agents in transactions that are deemed to be “at the market” offerings as defined in Rule 415 under the Securities Act of 1933 as amended (the “Securities Act”), including sales made directly on the NYSE or sales made to or through a market maker other than on an exchange or, subject to the terms of a written notice from us, in privately negotiated transactions.  

During the three months ended March 31, 2017, we issued 800 shares of Class A common stock at a weighted average public offering price of $15.16 per share for proceeds net of underwriting discounts and commissions of $12 thousand under the Prior Equity Distribution Agreements.  On February 23, 2017, we terminated the Prior Equity Distribution Agreements.

On February 22, 2017, we entered into new separate equity distribution agreements (the “New Equity Distribution Agreements”) with each of JMP Securities LLC, FBR Capital Markets & Co., JonesTrading Institutional Services LLC and Ladenburg Thalmann & Co. Inc. (the “New Equity Sales Agents”), pursuant to which we may offer and sell, from time to time, up to 6,000,000 shares of our Class A common stock. Pursuant to the New Equity Distribution Agreements, shares of our common stock may be offered and sold through the New Equity Sales Agents in transactions that are deemed to be “at the market” offerings as defined in Rule 415 under the Securities Act, including sales made directly on the NYSE or sales made to or through a market maker other than on an exchange or, subject to the terms of a written notice from us, in privately negotiated transactions.

As of March 31, 2017, we had 6,000,000 shares of Class A common stock available for sale under the New Equity Distribution Agreements.

Share Repurchase Program

The Company’s Board of Directors authorized a share repurchase program pursuant to which the Company may repurchase up to 2.0 million shares of its Class A common stock. As of March 31, 2017, 1,951,305 shares of Class A common stock remained available for repurchase under the repurchase program.  

 

Off-Balance Sheet Arrangements

As of March 31, 2017 and December 31, 2016, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, or special purpose or variable interest entities (“VIEs”), established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Our economic interests held in unconsolidated VIEs are limited in nature to those of a passive holder of MBS issued by a securitization trust. As of March 31, 2017 and December 31, 2016, we had not consolidated for financial reporting purposes any securitization trusts as we do not have the power to direct the activities that most significantly impact the economic performance of such entities. Further, as of March 31, 2017 and December 31, 2016, we had not guaranteed any obligations of unconsolidated entities or entered into any commitment or intent to provide funding to any such entities.

 

 

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, prepayment risk, 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, 2016 for a description of our risk management strategies.

Interest Rate Risk

We are 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 interest rate swaps as well as U.S. Treasury note futures and options on U.S. Treasury note futures. Historically, we have also utilized 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.

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The tables that follow illustrate the estimated 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 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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Spread Risk

Our investments in MBS expose us to “spread risk.”  Spread risk, also known as “basis risk,” is the risk of an increase in the spread between market participants’ required rate of return (or “market yield”) on our MBS and prevailing benchmark interest rates, such as the U.S. Treasury or interest rate swap rates.

The spread risk inherent to our investments in agency MBS and the resulting fluctuations in fair value of these securities can occur independent of changes in prevailing benchmark interest rates and may relate to other factors impacting the mortgage and fixed income markets, such as actual or anticipated monetary policy actions by the U. S. Federal Reserve, liquidity, or changes in market participants’ required rates of return on different assets. While we use interest rate derivative instruments to attempt to mitigate the sensitivity of our net book value to changes in prevailing benchmark interest rates, such instruments are generally not designed to mitigate spread risk inherent to our investment in agency MBS. Consequently, the value of our agency MBS and, in turn, our net book value, could decline independent of changes in interest rates.

The tables that follow illustrate the estimated change in fair value for our investments in agency MBS and TBA commitments under several hypothetical scenarios of agency MBS spread movements. Changes in fair value are measured as percentage changes from their respective fair values presented in the column labeled “Value.” The sensitivity of our agency MBS and TBA commitments to changes in MBS spreads is derived from The Yield Book, a third-party model. The analysis to follow reflects an assumed spread duration for our investment in agency MBS of 6.0 years, which is a model-based assumption that is dependent upon the size and composition of our investment portfolio as well as economic conditions present as of March 31, 2017.

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).

 

 

 

Credit Risk

We are exposed to credit risk to the extent we invest in private-label MBS. The private-label MBS in which we invest are generally backed by a pool of single-family residential mortgage loans.  The private-label MBS in which we invest are not issued or guaranteed by a U.S. government agency or GSE and are generally non-investment grade or not rated by major rating agencies.

Private-label MBS are generally only supported by one or more forms of private credit enhancements that may provide an extra layer of loss coverage in the event that credit losses are incurred upon foreclosure sale or other liquidations of underlying mortgage properties in amounts that exceed the equity holder’s equity interest in the property.  Forms of credit enhancement include issuer guarantees, reserve funds, private mortgage guaranty pool insurance, overcollateralization and structural subordination. In addition, private-label MBS are generally purchased at a discount to par value, which may provide further protection to credit losses of the underlying residential mortgage loan collateral.

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Inflation

Virtually all of our assets and liabilities are interest rate sensitive in nature. As a result, interest rates and other factors influence our 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.

Cautionary Statement About Forward-Looking Information

When used in this Quarterly Report on Form 10-Q, in future filings with the Securities and Exchange Commission (“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 and Section 21E of the Securities Exchange Act of 1934, as amended (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 March 31, 2017 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 that we consider to be in the ordinary course of our business. There can be no assurance that these matters individually or in the 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 finance, 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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SIGNATURES

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

 

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EXHIBIT INDEX

 

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