MFA FINANCIAL, INC. - Quarter Report: 2010 September (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2010

 

OR

 

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

 

For the transition period from                              to                            

 

Commission File Number: 1-13991

 

MFA FINANCIAL, INC.

(Exact name of registrant as specified in its charter)

 

 

 

(212) 207-6400

(Registrant’s telephone number, including area code)

 

 

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

 

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

 

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

 

 

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

 

280,930,004 shares of the registrant’s common stock, $0.01 par value, were outstanding as of November 1, 2010.

 

 

Table of Contents

 

TABLE OF CONTENTS

 

		Page
PART I
FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets as of September 30, 2010 (Unaudited) and December 31, 2009	1
	Consolidated Statements of Operations (Unaudited) for the Three and Nine Months Ended September 30, 2010 and September 30, 2009	2
	Consolidated Statements of Comprehensive Income (Unaudited) for the Three and Nine Months Ended September 30, 2010 and September 30, 2009	3
	Consolidated Statement of Changes in Stockholders’ Equity (Unaudited) for the Nine Months Ended September 30, 2010	4
	Consolidated Statements of Cash Flows (Unaudited) for the Nine Months Ended September 30, 2010 and September 30, 2009	5
	Notes to the Consolidated Financial Statements (Unaudited)	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	32
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	46
Item 4.	Controls and Procedures	52
PART II OTHER INFORMATION
Item 1.	Legal Proceedings	53
Item 1A.	Risk Factors	53
Item 6.	Exhibits	53
Signatures		56

 

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MFA FINANCIAL, INC.

CONSOLIDATED BALANCE SHEETS

 

		September 30,			December 31,
(In Thousands, Except Per Share Amounts)		2010			2009
		(Unaudited)
Assets:
Agency mortgage-backed securities (“MBS”), at fair value ($5,721,900 and $7,597,136 pledged as collateral, respectively)		$	6,180,753		$	7,664,851
Non-Agency MBS, at fair value ($1,102,820 and $240,694 pledged as collateral, respectively)		1,804,776			1,093,103
Cash and cash equivalents		270,925			653,460
Restricted cash		41,213			67,504
Forward contracts to repurchase MBS (“MBS Forwards”), at fair value		125,744			86,014
Interest receivable		34,297			41,775
Real estate, net		10,802			10,998
Goodwill		7,189			7,189
Prepaid and other assets		2,305			2,315
Total Assets		$	8,478,004		$	9,627,209
Liabilities:
Repurchase agreements		$	5,995,447		$	7,195,827
Accrued interest payable		7,397			13,274
Mortgage payable on real estate		—			9,143
Interest rate swap agreements (“Swaps”), at fair value		175,303			152,463
Dividends and dividend equivalents rights (“DERs”) payable		538			76,286
Accrued expenses and other liabilities		8,361			11,954
Total Liabilities		$	6,187,046		$	7,458,947
Commitments and contingencies (Note 9)
Stockholders’ Equity:
Preferred stock, $.01 par value; series A 8.50% cumulative redeemable; 5,000 shares authorized; 3,840 shares issued and outstanding ($96,000 aggregate liquidation preference)		$	38		$	38
Common stock, $.01 par value; 370,000 shares authorized; 280,335 and 280,078 issued and outstanding, respectively		2,803			2,801
Additional paid-in capital, in excess of par		2,183,163			2,180,605
Accumulated deficit		(121,261		)	(202,189		)
Accumulated other comprehensive income		226,215			187,007
Total Stockholders’ Equity		$	2,290,958		$	2,168,262
Total Liabilities and Stockholders’ Equity		$	8,478,004		$	9,627,209

 

The accompanying notes are an integral part of the consolidated financial statements.

 

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MFA FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

 

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
(In Thousands, Except Per Share Amounts)		2010			2009			2010			2009
		(Unaudited)
Interest Income:
MBS		$	97,296		$	124,399		$	293,455		$	383,029
Cash and cash equivalent investments		121			149			286			1,020
Interest Income		97,417			124,548			293,741			384,049
Interest Expense		35,464			52,976			109,656			183,119
Net Interest Income		61,953			71,572			184,085			200,930
Other-Than-Temporary Impairments:
Total other-than-temporary impairment losses		—			—			(184		)	(78,135		)
Portion of loss (reclassified from)/recognized in other comprehensive income		—			—			(5,228		)	69,126
Net Impairment Losses Recognized in Earnings		—			—			(5,412		)	(9,009		)
Other Income, Net:
Gains on MBS Forwards, net		21,307			754			41,304			754
Gains on sale of MBS, net		—			—			33,739			13,495
Revenue from operations of real estate		369			378			1,100			1,145
Loss on termination of repurchase agreements		—			—			(26,815		)	—
Miscellaneous other income, net		—			—			—			43
Other Income, Net		21,676			1,132			49,328			15,437
Operating and Other Expense:
Compensation and benefits		4,106			3,710			12,527			10,824
Other general and administrative expense		2,003			1,713			5,995			5,559
Real estate operating expense, mortgage interest and prepayment penalty		306			444			1,298			1,359
Operating and Other Expense		6,415			5,867			19,820			17,742
Net Income		77,214			66,837			208,181			189,616
Less: Preferred Stock Dividends		2,040			2,040			6,120			6,120
Net Income Available to Common Stock and Participating Securities		$	75,174		$	64,797		$	202,061		$	183,496
Earnings Per Share - Basic and Diluted		$	0.27		$	0.25		$	0.72		$	0.78
Dividends Declared Per Share of Common Stock		$	0.19		$	0.25		$	0.43		$	0.47

 

The accompanying notes are an integral part of the consolidated financial statements.

 

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MFA FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
(In Thousands)		2010			2009			2010			2009
		(Unaudited)
Net Income		$	77,214		$	66,837		$	208,181		$	189,616
Other Comprehensive Income:
Unrealized gain on MBS, net		48,061			173,536			98,095			410,397
Reclassification adjustment for MBS sales		—			—			(41,459		)	(3,033		)
Reclassification adjustment for net losses included in net income for other-than-temporary impairments		—			—			5,412			8,865
Unrealized (loss)/gain on Swaps, net		(7,624		)	(4,943		)	(22,840		)	58,938
Comprehensive Income		$	117,651		$	235,430		$	247,389		$	664,783
Dividends declared on preferred stock		(2,040		)	(2,040		)	(6,120		)	(6,120		)
Comprehensive Income Available to Common Stock and Participating Securities		$	115,611		$	233,390		$	241,269		$	658,663

 

The accompanying notes are an integral part of the consolidated financial statements.

 

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MFA FINANCIAL, INC.

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

 

		Nine Months
		Ended
		September 30,
(In Thousands, Except Per Share Amounts)		2010
		(Unaudited)
Preferred Stock, Par Value $.01; Series A 8.50% Cumulative Redeemable — Liquidation Preference $25.00 per Share:
Balance at September 30, 2010 and December 31, 2009 (3,840 shares)		$	38
Common Stock, Par Value $.01:
Balance at December 31, 2009 (280,078 shares)		2,801
Issuance of common stock (257 shares)		2
Balance at September 30, 2010 (280,335 shares)		2,803
Additional Paid-in Capital, in excess of Par:
Balance at December 31, 2009		2,180,605
Issuance of common stock, net of expenses		368
Equity-based compensation expense		2,190
Balance at September 30, 2010		2,183,163
Accumulated Deficit:
Balance at December 31, 2009		(202,189		)
Net income		208,181
Dividends declared on common stock		(120,774		)
Dividends declared on preferred stock		(6,120		)
Dividends attributable to DERs		(359		)
Balance at September 30, 2010		(121,261		)
Accumulated Other Comprehensive Income:
Balance at December 31, 2009		187,007
Change in unrealized gains on MBS, net		62,048
Change in unrealized losses on Swaps		(22,840		)
Balance at September 30, 2010		226,215
Total Stockholders’ Equity at September 30, 2010		$	2,290,958

 

The accompanying notes are an integral part of the consolidated financial statements.

 

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MFA FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

		Nine Months Ended
		September 30,
(In Thousands)		2010			2009
		(Unaudited)
Cash Flows From Operating Activities:
Net income		$	208,181		$	189,616
Adjustments to reconcile net income to net cash provided by operating activities:
Gain on sales of MBS		(33,739		)	(13,495		)
Losses on termination of repurchase agreements		26,815			—
Other-than-temporary impairment charges		5,412			9,009
Net amortization of purchase premiums and discounts on MBS		5,404			8,468
Decrease in interest receivable		7,478			5,078
Depreciation and amortization on real estate		483			353
Unrealized gain and other on MBS Forwards		(25,909		)	(90		)
Increase in prepaid and other assets and other		(53		)	(931		)
(Decrease)/increase in accrued expenses and other liabilities		(3,593		)	1,948
Decrease in accrued interest payable		(5,877		)	(11,145		)
Equity-based compensation expense		2,190			1,316
Negative amortization and principal accretion on MBS		—			(12		)
Net cash provided by operating activities		$	186,792		$	190,115
Cash Flows From Investing Activities:
Principal payments on MBS		$	2,524,021		$	1,413,711
Proceeds from sale of MBS		939,119			438,507
Purchases of MBS		(2,492,909		)	(666,428		)
Net additions to leasehold improvements, furniture, fixtures and real estate investment		(276		)	(549		)
Net cash provided by investing activities		$	969,955		$	1,185,241
Cash Flows From Financing Activities:
Principal payments on repurchase agreements		$	(39,524,402	)	$	(50,186,109	)
Proceeds from borrowings under repurchase agreements		38,324,022			48,722,560
Payments to terminate repurchase agreements		(26,815		)	—
Principal payments on MBS Forwards		(1,088,668		)	(219,916		)
Proceeds from MBS Forwards		962,012			166,547
Payments made for margin calls on repurchase agreements and Swaps		(435,507		)	(114,570		)
Proceeds from reverse margin calls on repurchase agreements and Swaps		461,850			135,868
Proceeds from issuances of common stock		370			403,298
Dividends paid on preferred stock		(6,120		)	(6,120		)
Dividends paid on common stock and DERs		(196,881		)	(151,261		)
Principal amortization and prepayment on mortgage loan		(9,143		)	(125		)
Net cash used in financing activities		$	(1,539,282	)	$	(1,249,828	)
Net (decrease)/increase in cash and cash equivalents		$	(382,535	)	$	125,528
Cash and cash equivalents at beginning of period		$	653,460		$	361,167
Cash and cash equivalents at end of period		$	270,925		$	486,695

 

The accompanying notes are an integral part of the consolidated financial statements.

 

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MFA FINANCIAL, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

1.      Organization

 

MFA Financial, Inc. (the “Company”) was incorporated in Maryland on July 24, 1997 and began operations on April 10, 1998.  The Company has elected to be treated as a real estate investment trust (“REIT”) for federal income tax purposes.  In order to maintain its qualification as a REIT, the Company must comply with a number of requirements under federal tax law, including that it must distribute at least 90% of its annual REIT taxable income to its stockholders.  (See Note 10(b))

 

2.      Summary of Significant Accounting Policies

 

(a)  Basis of Presentation and Consolidation

The interim unaudited financial statements of the Company have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted according to these SEC rules and regulations.  Management believes that the disclosures included in these interim financial statements are adequate to make the information presented not misleading.  The accompanying financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.  In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at September 30, 2010 and results of operations for all periods presented have been made.  The results of operations for the nine months ended September 30, 2010 should not be construed as indicative of the results to be expected for the full year.

 

The consolidated financial statements of the Company have been prepared on the accrual basis of accounting in accordance with GAAP.  The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  The consolidated financial statements of the Company include the accounts of all subsidiaries; significant intercompany accounts and transactions have been eliminated.

 

Effective July 1, 2009, the Company adopted the provisions of the Financial Accounting Standards Board (“FASB”), Accounting Standards Codification (the “Codification”), which is now the source of authoritative GAAP.  While the Codification did not change GAAP, all existing authoritative accounting literature, with certain exceptions, was superseded and incorporated into the Codification.  As a result, pre-Codification references to GAAP have been eliminated.

 

(b)  Agency and Non-Agency MBS

The Company has investments in residential MBS that are issued or guaranteed as to principal and/or interest by a federally chartered corporation, such as Fannie Mae or Freddie Mac, or any agency of the U.S. Government, such as Ginnie Mae (collectively, “Agency MBS”), and residential MBS not guaranteed by any U.S. Government agency or any federally chartered corporation (“Non-Agency MBS”), as described in Note 3.

 

Designation

The Company generally intends to hold its MBS until maturity; however, from time to time, it may sell any of its securities as part of the overall management of its business.  As a result, all of the Company’s MBS are designated as “available-for-sale” and, accordingly, are carried at their fair value with unrealized gains and losses excluded from earnings (except when an other-than-temporary impairment is recognized, as discussed below) and reported in accumulated other comprehensive income, a component of stockholders’ equity.

 

Upon the sale of an investment security, any unrealized gain or loss is reclassified out of accumulated other comprehensive income to earnings as a realized gain or loss using the specific identification method.

 

Revenue Recognition, Premium Amortization and Discount Accretion

Interest income on securities is accrued based on the outstanding principal balance and their contractual terms.  Premiums and discounts associated with Agency MBS and Non-Agency MBS rated AA and higher at the time of purchase are amortized into interest income over the life of such securities using the effective yield method.  Adjustments to premium amortization are made for actual prepayment activity.

 

Interest income on the Non-Agency MBS that were purchased at a discount to par value and/or were rated below AA at the time of purchase is recognized based on the security’s effective interest rate.  The effective interest

 

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MFA FINANCIAL, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

rate on these securities is based on the projected cash flows from each security, which are estimated based on the Company’s observation of current information and events and include assumptions related to interest rates, prepayment speeds and the timing and amount of credit losses.  On at least a quarterly basis, the Company reviews and, if appropriate, makes adjustments to its cash flow projections based on input and analysis received from external sources, internal models, and its judgment about prepayment rates, the timing and amount of credit losses, and other factors.  Changes in cash flows from those originally projected, or from those estimated at the last evaluation, may result in a prospective change in the yield/interest income recognized on these securities.  (See Note 3)

 

Based on the projected cash flows from the Company’s Non-Agency MBS purchased at a discount to par value, a portion of the purchase discount may be designated as credit protection against future credit losses and, therefore, may not be accreted into interest income.  The amount designated as credit discount may be adjusted over time, based on the actual performance of the security, its underlying collateral, actual and projected cash flow from such collateral, economic conditions and other factors.  If the performance of a security with a credit discount is more favorable than forecasted, a portion of the amount designated as credit discount may be accreted into interest income over time.  Conversely, if the performance of a security with a credit discount is less favorable than forecasted, additional amounts of the purchase discount may be designated as credit discount, or impairment charges and write-downs of such securities to a new cost basis could result.

 

Determination of MBS Fair Value

The Company determines the fair value of its Agency MBS based upon prices obtained from a third-party pricing service, which are indicative of market activity.  In determining the fair value of its Non-Agency MBS, management considers a number of observable market data points including prices obtained from third-party pricing services and brokers as well as dialogue with market participants.  (See Note 13)

 

Impairments

When the fair value of an investment security is less than its amortized cost at the balance sheet date, the security is considered impaired.  The Company assesses its impaired securities on at least a quarterly basis and designates such impairments as either “temporary” or “other-than-temporary.”  If the Company intends to sell an impaired security, or it is more likely than not that it will be required to sell the impaired security before its anticipated recovery, then the Company must recognize an other-than-temporary impairment through charges to earnings equal to the entire difference between the investment’s amortized cost and its fair value at the balance sheet date.  If the Company does not expect to sell an other-than-temporarily impaired security, only the portion of the other-than-temporary impairment related to credit losses is recognized through charges to earnings with the remainder recognized through other accumulated comprehensive income on the consolidated balance sheet.  Impairments recognized through other comprehensive income do not impact earnings.  Following the recognition of an other-than-temporary impairment through earnings, a new cost basis is established for the security and may not be adjusted for subsequent recoveries in fair value through earnings.  However, other-than-temporary impairments recognized through charges to earnings may be accreted back to the amortized cost basis of the security on a prospective basis through interest income.  The determination as to whether an other-than-temporary impairment exists and, if so, the amount considered other-than-temporarily impaired is subjective, as such determinations are based on both factual and subjective information available at the time of assessment.  As a result, the timing and amount of other-than-temporary impairments constitute material estimates that are susceptible to significant change.  (See Note 3)

 

Non-Agency MBS on which impairments are recognized have experienced, or are expected to experience, credit-related adverse cash flow changes.  The Company’s estimate of cash flows expected for its Non-Agency MBS is based on its review of the underlying mortgage loans securing the MBS.  The Company considers information available about the performance of underlying mortgage loans, including prepayment rates, default rates, loss severities, delinquency rates, percentage of non-performing, Fair Isaac Corporation (“FICO”) scores at loan origination, year of origination, loan-to-value ratios, geographic concentrations, as well as reports by credit rating agencies, such as Moody’s Investors Services, Inc. (“Moody’s”), Standard & Poor’s Corporation (“S&P”), or Fitch, Inc. (collectively, “Rating Agencies”), general market assessments, and dialogue with market participants.  As a result, significant judgment is used in the Company’s analysis to determine the expected cash flows for its Non-Agency MBS.  In determining the other-than-temporary impairment related to credit losses, the Company compares the present value of the remaining cash flows expected to be collected at the purchase date (or last date previously revised) against the present value of the cash flows expected to be collected at the current financial reporting date.

 

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MFA FINANCIAL, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

Balance Sheet Presentation

The Company’s MBS pledged as collateral against repurchase agreements and Swaps are included in MBS on the consolidated balance sheets with the fair value of the MBS pledged disclosed parenthetically.  Purchases and sales of securities are recorded on the trade date or when all significant uncertainties regarding the securities are removed.  However, if a repurchase agreement is determined to be linked to the purchase of an MBS, then the MBS and linked repurchase borrowing will be reported net, as an MBS Forward.  (See Notes 2(l) and 4)

 

(c)  Cash and Cash Equivalents

Cash and cash equivalents include cash on deposit with financial institutions and investments in money market funds, all of which have original maturities of three months or less.  Cash and cash equivalents may also include cash pledged as collateral to the Company by its repurchase agreement and/or Swap counterparties as a result of reverse margin calls (i.e., margin calls made by the Company).  The Company did not hold any cash pledged by its counterparties at September 30, 2010 or December 31, 2009.  At September 30, 2010 and December 31, 2009, all of the Company’s cash investments were comprised of overnight money market funds, which are not bank deposits and are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.  (See Notes 8 and 13)

 

(d)  Restricted Cash

Restricted cash represents the Company’s cash held by its counterparties as collateral against the Company’s Swaps and/or repurchase agreements.  Restricted cash, which earns interest, is not available to the Company for general corporate purposes, but may be applied against amounts due to counterparties to the Company’s repurchase agreements and/or Swaps, or returned to the Company when the collateral requirements are exceeded or at the maturity of the Swap or repurchase agreement.  The Company had aggregate restricted cash held as collateral against its Swaps and repurchase agreements of $41.2 million and $67.5 million at September 30, 2010 and December 31, 2009, respectively.  (See Notes 4, 7, 8 and 13)

 

(e)  Goodwill

At September 30, 2010 and December 31, 2009, the Company had goodwill of $7.2 million, which represents the unamortized portion of the excess of the fair value of its common stock issued over the fair value of net assets acquired in connection with its formation in 1998.  Goodwill is tested for impairment at least annually, or more frequently under certain circumstances, at the entity level.  Through September 30, 2010, the Company had not recognized any impairment against its goodwill.

 

(f)  Real Estate

The Company has 100% of the ownership interest in Lealand Place, a 191-unit apartment property located in Lawrenceville, Georgia, through Lealand Place, LLC (“Lealand”), an indirect, wholly-owned subsidiary.  This property was acquired through a tax-deferred exchange under Section 1031 of the Internal Revenue Code of 1986, as amended (the “Code”).  (See Note 6)

 

The property, capital improvements and other assets held in connection with this investment are carried at cost, net of accumulated depreciation and amortization.  Maintenance, repairs and minor improvements are expensed in the period incurred, while real estate assets, except land, and capital improvements are depreciated over their useful life using the straight-line method.

 

(g)  Repurchase Agreements

The Company finances the acquisition of a significant portion of its MBS with repurchase agreements.  Under repurchase agreements, the Company sells securities to a lender and agrees to repurchase the same securities in the future for a price that is higher than the original sale price.  The difference between the sale price that the Company receives and the repurchase price that the Company pays represents interest paid to the lender.  Although legally structured as a sale and repurchase, the Company accounts for its repurchase agreements as secured borrowings, with the exception of those repurchase agreements accounted for as components of linked transactions.  (See Note 2(l) below).  Under its repurchase agreements, the Company pledges its securities as collateral to secure the borrowing, which is equal in value to a specified percentage of the fair value of the pledged collateral, while the Company retains beneficial ownership of the pledged collateral.  At the maturity of a repurchase financing, the Company is required to repay the loan and concurrently receives back its pledged collateral from the lender.  With the consent of the lender, the Company may renew a repurchase financing at the then prevailing financing terms.  Margin calls, whereby a lender requires that the Company pledge additional securities or cash as collateral to secure borrowings under its repurchase financing with such lender, are routinely experienced by the Company when the value of the MBS pledged as collateral declines as a result of principal amortization or due to changes in market interest rates, spreads or other market conditions.  To date, the Company has satisfied all of its margin calls and has

 

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MFA FINANCIAL, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

never sold assets in response to a margin call.

 

The Company’s borrowings under repurchase agreements typically have terms ranging from one month to six months at inception, with some having longer terms.  Should a counterparty decide not to renew a repurchase financing at maturity, the Company must either refinance elsewhere or be in a position to satisfy the obligation.  If, during the term of a repurchase agreement borrowing, a lender should file for bankruptcy, the Company might experience difficulty recovering its pledged assets which could result in an unsecured claim against the lender for the difference between the amount loaned to the Company plus interest due to the counterparty and the fair value of the collateral pledged to such lender.  The Company enters into repurchase agreements with multiple counterparties with a maximum loan from any lender of no more than three times the Company’s stockholders’ equity.  (See Notes 2(l), 4, 7, 8 and 13)

 

(h)  Equity-Based Compensation

Compensation expense for equity-based awards is recognized over the vesting period of such awards, based upon the fair value of such awards at the grant date.  Payments pursuant to DERs, which are attached to certain equity-based awards, are charged to stockholders’ equity when declared.  The Company has applied a zero forfeiture rate for its equity-based awards, as such awards have been granted to a limited number of employees and historical forfeitures have been minimal.  Forfeitures, or an indication that forfeitures may occur, would result in a revised forfeiture rate and would be accounted for prospectively as a change in estimate.

 

Forfeiture provisions for dividends and DERs on unvested equity instruments on the Company’s equity-based awards vary by award.  To the extent that equity awards do not vest and grantees are not required to return payments of dividends or DERs to the Company, additional compensation expense is recorded at the time an award is forfeited.  (See Notes 2(i) and 12)

 

(i)  Earnings per Common Share (“EPS”)

Basic earnings per common share is computed using the two-class method, which includes the weighted-average number of shares of common stock outstanding during the period and other securities that participate in dividends, such as the Company’s unvested restricted stock and restricted stock units (“RSUs”) that have non-forfeitable rights to dividends and DERs attached to vested stock options to arrive at total common equivalent shares.  In applying the two-class method, earnings are allocated to both common stock shares and securities that participate in dividends based on their respective weighted-average shares outstanding for the period. For the diluted EPS calculation, common equivalent shares are further adjusted for the effect of dilutive unexercised stock options and RSUs outstanding that are unvested and have dividends that are subject to forfeiture using the treasury stock method.  Under the treasury stock method, common equivalent shares are calculated assuming that all dilutive common stock equivalents are exercised and the proceeds, along with future compensation expenses associated with such instruments, are used to repurchase shares of the Company’s outstanding common stock at the average market price during the reported period.  (See Note 11)

 

(j)  Comprehensive Income

The Company’s comprehensive income includes net income, the change in net unrealized gains/(losses) on its MBS and hedging instruments, adjusted by realized net gains/(losses) reclassified out of accumulated other comprehensive income for MBS and is reduced by dividends declared on the Company’s preferred stock.

 

(k)  U.S. Federal Income Taxes

The Company has elected to be taxed as a REIT under the provisions of the Code and the corresponding provisions of state law.  The Company expects to operate in a manner that will enable it to continue to be taxed as a REIT.  A REIT is not subject to tax on its earnings to the extent that it distributes at least 90% of its annual REIT taxable income to its stockholders.  As such, no provision for current or deferred income taxes has been made in the accompanying consolidated financial statements.

 

(l)  Derivative Financial Instruments

Hedging Activity

As part of the Company’s interest rate risk management, it periodically hedges a portion of its interest rate risk using derivative financial instruments and does not enter into derivative transactions for speculative or trading purposes and, accordingly, accounts for its Swaps as cash flow hedges.  The Company’s Swaps have the effect of modifying the interest rate repricing characteristics of the Company’s repurchase agreements and cash flows for such liabilities.  No cost is incurred at the inception of a Swap, pursuant to which the Company agrees to pay a fixed rate of interest and receive a variable interest rate, generally based on one-month or three-month London Interbank Offered Rate (“LIBOR”), on the notional amount of the Swap.  The Company documents its risk-management policies, including objectives and strategies, as they relate to its hedging activities and the relationship between the

 

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MFA FINANCIAL, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

hedging instrument and the hedged liability.  The Company assesses, both at inception of a hedge and on a quarterly basis thereafter, whether or not the hedge is “highly effective.”

 

The Company discontinues hedge accounting on a prospective basis and recognizes changes in the fair value through earnings when:  (i) it is determined that the derivative is no longer effective in offsetting cash flows of a hedged item (including forecasted transactions), (ii) it is no longer probable that the forecasted transaction will occur or (iii) it is determined that designating the derivative as a hedge is no longer appropriate.

 

Swaps are carried on the Company’s balance sheet at fair value, as assets, if their fair value is positive, or as liabilities, if their fair value is negative.  Changes in the fair value of the Company’s Swaps are recorded in other comprehensive income provided that the hedge remains effective.  A change in fair value for any ineffective amount of a Swap would be recognized in earnings.  The Company has not recognized any change in the value of its existing Swaps through earnings as a result of hedge ineffectiveness, except that all gains and losses realized on Swaps that were terminated early were recognized, as the borrowings that such Swaps hedged were repaid.

 

Although permitted under certain circumstances, the Company does not offset cash collateral receivables or payables against its net derivative positions.  (See Notes 4, 8 and 13)

 

Non-Hedging Activity/MBS Forwards

On January 1, 2009, the Company adopted new accounting guidance required for certain transfers of financial assets and repurchase financings.  Given that this guidance was prospective, the initial adoption had no impact on the Company’s historical consolidated financial statements.  Under this accounting guidance, it is presumed that the initial transfer of a financial asset (i.e., the purchase of an MBS by the Company) and repurchase financing of this MBS with the same counterparty are considered part of the same arrangement, or a “linked transaction.”  The two components of a linked transaction (MBS purchase and repurchase financing) are not reported separately but are evaluated on a combined basis and reported as a forward (derivative) contract and are presented as “MBS Forwards” on the Company’s consolidated balance sheet.  In addition, changes in the fair value of MBS Forwards are reported as gains or losses on the Company’s consolidated statements of operations and are not included in other comprehensive income.  However, if certain criteria are met, the initial transfer (i.e., the purchase of a security by the Company) and repurchase financing will not be treated as a linked transaction and will be evaluated and reported separately, as an MBS purchase and repurchase financing.  (See Note 2(b))  When or if a transaction is no longer considered to be linked, the MBS and repurchase financing will be reported on a gross basis.  In this case, the fair value of the MBS at the time the transactions are no longer considered linked will become the cost basis of the MBS.  (See Notes 4, 8 and 13)

 

(m)  Fair Value Measurements and the Fair Value Option for Financial Assets and Financial Liabilities

The Company’s presentation of fair value for its financial assets and liabilities is determined within a framework that stipulates that the fair value of a financial asset or liability is an exchange price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability.  The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability.  This definition of fair value is based on a consistent definition of fair value which focuses on exit price and prioritizes the use of market-based inputs over entity-specific inputs when determining fair value.  In addition, the framework for measuring fair value establishes a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date.  (See Note 13)

 

Although permitted under GAAP to measure many financial instruments and certain other items at fair value, the Company has not elected the fair value option for any of its assets or liabilities.  If the fair value option is elected, unrealized gains and losses on such items for which fair value is elected would be recognized in earnings at each subsequent reporting date.  A decision to elect the fair value option for an eligible financial instrument, which may be made on an instrument by instrument basis, is irrevocable.

 

(n)  New Accounting Standards and Interpretations

Accounting Standards Codification

See Note 2(a).

 

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MFA FINANCIAL, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

Accounting for Transfers of Financial Assets/Consolidation

On June 12, 2009, the FASB issued new accounting guidance for transfers of financial assets which: (i) eliminates the concept of a qualified special purpose entity (“QSPE”) and eliminates its exemption as a variable interest entity (“VIE”); (ii) clarifies that the objective of determining whether a transferor has surrendered control over transferred financial assets must consider the transferor’s continuing involvements in the transferred financial asset, including all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer, even if they were not entered into at the time of the transfer; (iii) modifies the financial-components approach and limits the circumstances in which a financial asset, or portion of a financial asset, should be derecognized when the transferor has not transferred the entire original financial asset to an entity that is not consolidated with the transferor in the financial statements being presented and/or when the transferor has continuing involvement with the transferred financial asset; and (iv) defines the term “participating interest” to establish specific conditions for reporting a transfer of a portion of a financial asset as a sale.  Under this new accounting, when the transfer of financial assets is accounted for as a sale, the transferor must recognize and initially measure at fair value all assets obtained and liabilities incurred as a result of the transfer, including any retained beneficial interest.  This new accounting eliminated off-balance sheet transactions when an entity retains any interest in or control over assets transferred in this process.  The implementation of the new accounting for transfers of financial assets on January 1, 2010 did not have any impact on the Company’s consolidated financial statements, as it has no off-balance sheet transactions, no QSPEs, nor had it transferred assets through a securitization.

 

In conjunction with new accounting guidance for transfers of financial assets, the FASB issued new guidance that requires an enterprise to perform an analysis to determine whether an enterprise’s variable interest or interests give it a controlling financial interest in a VIE.  The analysis identifies the primary beneficiary of a VIE as the enterprise that has both the power to direct the activities that most significantly impact the entity’s economic performance and the obligation to absorb losses of the entity or the right to receive benefits from the entity which could potentially be significant to the VIE.  With the removal of the QSPE exemption, established QSPEs must be evaluated for consolidation under this statement.  In addition, enhanced disclosures are required to provide users of financial statements with more transparent information about and an enterprise’s involvement in a VIE and also requires ongoing assessments of whether an enterprise is the primary beneficiary of a VIE.  The Company’s adoption of this new accounting on January 1, 2010 did not have any impact on the Company, as it was not the primary beneficiary of any VIE.  At September 30, 2010, the Company did not have any interest in a VIE.

 

Derivatives and Hedging

In February 2010, the FASB issued an Accounting Standards Update (“ASU”) with respect to Derivatives and Hedging which provides a four-step analysis to determine whether call or put options that can accelerate the settlement of debt instruments should be considered clearly and closely related to the debt host contract.  If it is determined that such option is closely related to the host contract, bifurcation of the host contract from the derivative instrument is not necessary.  If an existing hybrid instrument requires bifurcation under this update, a one-time election can be made to utilize the Fair Value Option for the entire contract.  This update became effective for the Company as of January 1, 2010.  The update had no material impact on the Company’s consolidated financial statements.

 

In March 2010, the FASB issued an ASU clarifying previous guidance that exempts certain credit related features from analysis as potential embedded derivatives subject to bifurcation and separate fair value accounting.  This ASU specifies that an embedded credit derivative feature related to the transfer of credit risk that is only in the form of subordination of one financial instrument to another is not subject to bifurcation from a host contract.  All other embedded credit derivative features should be analyzed to determine whether their economic characteristics and risks are “clearly and closely related” to the economic characteristics and risks of the host contract and whether bifurcation and separate fair value accounting is required.  The adoption of this guidance by the Company on July 1, 2010, had no material effect on the Company’s consolidated financial statements.

 

Proposed Accounting Standards

The FASB has recently issued or discussed a number of proposed standards on such topics as consolidation, financial statement presentation, revenue recognition, leases, financial instruments, hedging, contingencies and fair value.  Some of the proposed changes are potentially significant and could have a material impact on the Company’s reporting.  The Company has not yet fully evaluated the potential impact of these proposals but will make such an evaluation as the standards are finalized.

 

(o)  Reclassifications

Certain prior period amounts have been reclassified to conform to the current period presentation.

 

3.      MBS

 

The Company’s MBS are primarily comprised of Agency MBS and, to a lesser extent, Non-Agency MBS.  These MBS are primarily secured by hybrid mortgages (which have a fixed interest rate for a specified period, typically three to ten years at origination, and, thereafter, generally reset annually (“Hybrids”)), by adjustable-rate mortgages (“ARMs”), by mortgages that have interest rates that reset more frequently (“Floaters”) (collectively,

 

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MFA FINANCIAL, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

“ARM-MBS”) and, to a lesser extent, by 15- and 30-year fixed rate mortgages.  MBS do not have a single maturity date and further, the mortgage loans underlying ARM-MBS do not all reset at the same time.

 

At September 30, 2010, $834.2 million, or 10.4%, of the MBS portfolio was comprised of fixed-rate MBS, of which $449.3 million were secured by 15-year fixed-rate mortgages and $384.9 million were secured by 30-year fixed-rate mortgages.

 

The Company pledges a significant portion of its MBS as collateral against its borrowings under repurchase agreements and Swaps.  Non-Agency MBS that are accounted for as components of MBS Forwards are not reflected in the tables set forth in this note.  (See Notes 4 and 8)

 

Agency MBS:  Agency MBS are guaranteed as to principal and/or interest by a federally chartered corporation, such as Fannie Mae or Freddie Mac, or an agency of the U.S. Government, such as Ginnie Mae, and, as such, carry an implied AAA rating.  The payment of principal and/or interest on Ginnie Mae MBS is backed by the full faith and credit of the U.S. Government.  Since the third quarter of 2008, Fannie Mae and Freddie Mac have been under the conservatorship of the Federal Housing Finance Agency, which significantly strengthened the backing for these government-sponsored entities.

 

Non-Agency MBS:  The Company’s Non-Agency MBS are secured by pools of residential mortgages, which are not guaranteed by an agency of U.S. Government or any federally chartered corporation.  Non-Agency MBS may be rated by one or more Rating Agencies or may be unrated (i.e., not assigned a rating by any Rating Agency).  The rating indicates the opinion of the Rating Agency as to the creditworthiness of the investment, indicating the obligor’s ability to meet its full financial commitment on the obligation.  A rating of “D” is assigned when a security has defaulted on any of its contractual terms.  The Company’s Non-Agency MBS are primarily comprised of the senior most tranches from the MBS structure.  Within the Company’s Non-Agency MBS portfolio are securities that were purchased beginning in late 2008 at discounts to par value through the Company’s wholly-owned subsidiary MFResidential Assets I, LLC (“MFR”) and “Legacy Non-Agency MBS” that were purchased at or near par by the Company prior to July 2007.

 

The following tables present certain information about the Company’s MBS at September 30, 2010 and December 31, 2009:

 

September 30, 2010
		Principal/						Accretable									Carrying			Gross			Gross			Net
		Current			Purchase			Purchase			Credit			Amortized			Value/			Unrealized			Unrealized			Unrealized
(In Thousands)		Face			Premiums			Discounts			Discounts (1)			Cost (2)			Fair Value			Gains			Losses			Gain/(Loss)
Agency MBS:
Fannie Mae		$	5,346,673		$	85,853		$	(243	)	$	—		$	5,432,283		$	5,635,842		$	207,089		$	(3,530	)	$	203,559
Freddie Mac		489,635			10,636			—			—			509,251			525,693			16,518			(76		)	16,442
Ginnie Mae		18,493			323			—			—			18,816			19,218			402			—			402
Total Agency MBS		5,854,801			96,812			(243		)	—			5,960,350			6,180,753			224,009			(3,606		)	220,403
Non-Agency MBS (3)
Rated AAA		2,274			54			—			—			2,328			2,078			—			(250		)	(250		)
Rated AA		34,400			937			(466		)	—			34,871			29,646			366			(5,591		)	(5,225		)
Rated A		27,165			45			(6,605		)	(1,721		)	18,884			22,650			4,410			(644		)	3,766
Rated BBB		45,491			28			(2,413		)	(895		)	42,211			39,134			248			(3,325		)	(3,077		)
Rated BB		46,788			—			(3,747		)	(2,250		)	40,791			43,611			2,820			—			2,820
Rated B		87,524			—			(17,432		)	(6,530		)	63,562			74,883			11,607			(286		)	11,321
Rated CCC		646,985			—			(55,094		)	(176,245		)	412,919			463,678			56,252			(5,493		)	50,759
Rated CC		567,030			—			(55,082		)	(180,176		)	331,772			381,212			56,166			(6,726		)	49,440
Rated C		884,402			—			(57,901		)	(239,492		)	572,663			639,799			77,056			(9,920		)	67,136
Unrated and D-rated (4)		184,527			—			(16,441		)	(59,912		)	103,660			108,085			10,103			(5,678		)	4,425
Total Non-Agency MBS		2,526,586			1,064			(215,181		)	(667,221		)	1,623,661			1,804,776			219,028			(37,913		)	181,115
Total MBS		$	8,381,387		$	97,876		$	(215,424	)	$	(667,221	)	$	7,584,011		$	7,985,529		$	443,037		$	(41,519	)	$	401,518

 

table continued

 

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MFA FINANCIAL, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

continued

 

December 31, 2009
		Principal/						Accretable									Carrying			Gross			Gross			Net
		Current			Purchase			Purchase			Credit			Amortized			Value/			Unrealized			Unrealized			Unrealized
(In Thousands)		Face			Premiums			Discounts			Discounts (1)			Cost (2)			Fair Value			Gains			Losses			Gain/(Loss)
Agency MBS:
Fannie Mae		$	6,723,557		$	88,712		$	(544	)	$	—		$	6,811,725		$	7,056,211		$	247,964		$	(3,478	)	$	244,486
Freddie Mac		545,787			8,327			—			—			567,049			585,462			18,589			(176		)	18,413
Ginnie Mae		22,353			397			—			—			22,750			23,178			428			—			428
Total Agency MBS		7,291,697			97,436			(544		)	—			7,401,524			7,664,851			266,981			(3,654		)	263,327
Non-Agency MBS (3)
Rated AAA		38,125			1,084			—			—			39,209			29,971			—			(9,238		)	(9,238		)
Rated AA		23,594			29			(5,797		)	(2,640		)	15,186			18,300			3,477			(363		)	3,114
Rated A		32,849			54			(6,873		)	(61		)	25,969			26,416			2,613			(2,166		)	447
Rated BBB		97,412			23			(6,239		)	(8,074		)	82,441			80,556			3,755			(5,640		)	(1,885		)
Rated BB		53,184			—			(7,401		)	(12,026		)	33,533			38,676			6,228			(1,085		)	5,143
Rated B		73,343			—			(15,574		)	(15,537		)	42,232			53,853			11,621			—			11,621
Rated CCC		575,112			53			(47,178		)	(216,391		)	310,249			350,495			49,024			(8,778		)	40,246
Rated CC		601,050			—			(48,057		)	(159,680		)	383,146			406,709			48,908			(25,345		)	23,563
Rated C		101,820			—			(9,667		)	(38,695		)	53,458			63,560			10,149			(47		)	10,102
Unrated and D-rated (4)		41,257			—			(2,533		)	(1,900		)	31,537			24,567			78			(7,048		)	(6,970		)
Total Non-Agency MBS		1,637,746			1,243			(149,319		)	(455,004		)	1,016,960			1,093,103			135,853			(59,710		)	76,143
Total MBS		$	8,929,443		$	98,679		$	(149,863	)	$	(455,004	)	$	8,418,484		$	8,757,954		$	402,834		$	(63,364	)	$	339,470

 

(1)  Purchase discounts designated as credit discounts are not expected to be accreted into interest income.

(2) Includes principal payments receivable of $9.0 million and $12.9 million at September 30, 2010 and December 31, 2009, respectively, which are not included in the Principal/Current Face.  Amortized cost is reduced by cumulative other-than-temporary impairments recognized through earnings of $21.6 million and $17.7 million at September 30, 2010 and December 31, 2009, respectively.

(3)  Non-Agency MBS are reported based on the lowest rating issued by a Rating Agency, if more than one rating is issued on the security, at the date presented.

(4)  Includes 11 MBS, which were D-rated and had an aggregate amortized cost and fair value of $96.3 million and $99.3 million, respectively, at September 30, 2010 and two MBS, which were D-rated and had an aggregate amortized cost and fair value of $29.9 million and $22.8 million, respectively, at December 31, 2009.

 

Unrealized Losses on MBS and Impairments

The following table presents information about the Company’s MBS that were in an unrealized loss position at September 30, 2010:

 

 

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