MFA FINANCIAL, INC. - Quarter Report: 2010 June (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 June 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

 

280,897,466 shares of the registrant’s common stock, $0.01 par value, were outstanding as of July 29, 2010.

 

 

Table of Contents

 

TABLE OF CONTENTS

 

		Page
PART I
FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets as of June 30, 2010 (Unaudited) and December 31, 2009	1
	Consolidated Statements of Operations (Unaudited) for the Three and Six Months Ended June 30, 2010 and June 30, 2009	2
	Consolidated Statements of Comprehensive Income (Unaudited) for the Three and Six Months Ended June 30, 2010 and June 30, 2009	3
	Consolidated Statement of Changes in Stockholders’ Equity (Unaudited) for the Six Months Ended June 30, 2010	4
	Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended June 30, 2010 and June 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	47
Item 4.	Controls and Procedures	53
PART II
OTHER INFORMATION
Item 1.	Legal Proceedings	54
Item 1A.	Risk Factors	54
Item 6.	Exhibits	54
Signatures		57

 

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MFA FINANCIAL, INC.

CONSOLIDATED BALANCE SHEETS

 

(In Thousands, Except Per Share Amounts)		June 30, 2010			December 31, 2009
		(Unaudited)
Assets:
Agency mortgage-backed securities (“MBS”), at fair value ($6,076,860 and $7,597,136 pledged as collateral, respectively)		$	6,385,570		$	7,664,851
Non-Agency MBS, at fair value ($1,030,954 and $240,694 pledged as collateral, respectively)		1,564,021			1,093,103
Cash and cash equivalents		531,543			653,460
Restricted cash		43,393			67,504
Forward contracts to repurchase MBS (“MBS Forwards”), at fair value		104,031			86,014
Interest receivable		34,641			41,775
Real estate, net		10,883			10,998
Goodwill		7,189			7,189
Prepaid and other assets		3,063			2,315
Total Assets		$	8,684,334		$	9,627,209
Liabilities:
Repurchase agreements		$	6,274,220		$	7,195,827
Accrued interest payable		7,770			13,274
Mortgage payable on real estate		—			9,143
Interest rate swap agreements (“Swaps”), at fair value		167,679			152,463
Dividends and dividend equivalents rights (“DERs”) payable		487			76,286
Accrued expenses and other liabilities		6,021			11,954
Total Liabilities		$	6,456,177		$	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; 280,268 and 280,078 issued and outstanding, respectively		2,803			2,801
Additional paid-in capital, in excess of par		2,182,444			2,180,605
Accumulated deficit		(142,906		)	(202,189		)
Accumulated other comprehensive income		185,778			187,007
Total Stockholders’ Equity		$	2,228,157		$	2,168,262
Total Liabilities and Stockholders’ Equity		$	8,684,334		$	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						Six Months Ended
		June 30,						June 30,
(In Thousands, Except Per Share Amounts)		2010			2009			2010			2009
		(Unaudited)
Interest Income:
MBS		$	88,515		$	126,477		$	196,159		$	258,630
Cash and cash equivalent investments		112			260			165			871
Interest Income		88,627			126,737			196,324			259,501
Interest Expense		35,741			58,006			74,192			130,143
Net Interest Income		52,886			68,731			122,132			129,358
Other-Than-Temporary Impairments:
Total other-than-temporary impairment losses		(3,370		)	(76,586		)	(3,370		)	(78,135		)
Portion of loss (reclassified from)/recognized in other comprehensive income		(2,042		)	69,126			(2,042		)	69,126
Net Impairment Losses Recognized in Earnings		(5,412		)	(7,460		)	(5,412		)	(9,009		)
Other Income, Net:
Gain on MBS Forwards, net		7,197			—			19,997			—
Gains on sale of MBS, net		—			13,495			33,739			13,495
Revenue from operations of real estate		357			384			731			767
Loss on termination of repurchase agreements		—			—			(26,815		)	—
Miscellaneous other (loss)/income, net		—			(1		)	—			43
Other Income, Net		7,554			13,878			27,652			14,305
Operating and Other Expense:
Compensation and benefits		4,053			3,612			8,421			7,114
Other general and administrative expense		2,139			1,978			3,992			3,846
Real estate operating expense, mortgage interest and prepayment penalty		546			453			992			915
Operating and Other Expense		6,738			6,043			13,405			11,875
Net Income		48,290			69,106			130,967			122,779
Less: Preferred Stock Dividends		2,040			2,040			4,080			4,080
Net Income Available to Common Stock and Participating Securities		$	46,250		$	67,066		$	126,887		$	118,699
Earnings Per Share - Basic and Diluted		$	0.16		$	0.30		$	0.45		$	0.53
Dividends Declared Per Share of Common Stock		$	0.24		$	0.22		$	0.24		$	0.22

 

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						Six Months Ended
		June 30,						June 30,
(In Thousands)		2010			2009			2010			2009
		(Unaudited)
Net Income		$	48,290		$	69,106		$	130,967		$	122,779
Other Comprehensive Income:
Unrealized gain on MBS, net		11,975			124,419			50,034			236,861
Reclassification adjustment for MBS sales		—			(12,377		)	(41,459		)	(3,033		)
Reclassification adjustment for net losses included in net income for other-than-temporary impairments		5,412			7,460			5,412			8,865
Unrealized (loss)/gain on Swaps, net		(13,929		)	53,060			(15,216		)	63,881
Comprehensive Income		$	51,748		$	241,668		$	129,738		$	429,353
Dividends declared on preferred stock		(2,040		)	(2,040		)	(4,080		)	(4,080		)
Comprehensive Income Available to Common Stock and Participating Securities		$	49,708		$	239,628		$	125,658		$	425,273

 

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

 

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MFA FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

 

		Six Months
		Ended
		June 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 June 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 (190 shares)		2
Balance at June 30, 2010 (280,268 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		271
Equity-based compensation expense		1,568
Balance at June 30, 2010		2,182,444
Accumulated Deficit:
Balance at December 31, 2009		(202,189		)
Net income		130,967
Dividends declared on common stock		(67,403		)
Dividends declared on preferred stock		(4,080		)
Dividends attributable to DERs		(201		)
Balance at June 30, 2010		(142,906		)
Accumulated Other Comprehensive Income:
Balance at December 31, 2009		187,007
Change in unrealized gains on MBS, net		13,987
Change in unrealized losses on Swaps		(15,216		)
Balance at June 30, 2010		185,778
Total Stockholders’ Equity at June 30, 2010		$	2,228,157

 

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

 

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MFA FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

		Six Months Ended
		June 30,
(In Thousands)		2010			2009
		(Unaudited)
Cash Flows From Operating Activities:
Net income		$	130,967		$	122,779
Adjustments to reconcile net income to net cash provided by operating activities:
Gains on sale 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		6,208			7,729
Decrease in interest receivable		7,134			4,175
Depreciation and amortization on real estate		341			221
Unrealized gain and other on MBS Forwards		(11,191		)	—
Increase in prepaid and other assets and other		(780		)	(910		)
(Decrease)/increase in accrued expenses and other liabilities		(5,933		)	132
Decrease in accrued interest payable		(5,504		)	(9,016		)
Equity-based compensation expense		1,568			900
Negative amortization and principal accretion on MBS		—			(12		)
Net cash provided by operating activities		$	121,298		$	121,512
Cash Flows From Investing Activities:
Principal payments on MBS		$	1,850,272		$	834,085
Proceeds from sale of MBS		939,119			438,507
Purchases of MBS		(1,944,922		)	(327,588		)
Net additions to leasehold improvements, furniture, fixtures and real estate investment		(228		)	(460		)
Net cash provided by investing activities		$	844,241		$	944,544
Cash Flows From Financing Activities:
Principal payments on repurchase agreements		$	(27,181,964	)	$	(33,833,050	)
Proceeds from borrowings under repurchase agreements		26,260,357			32,746,145
Payments to terminate repurchase agreements		(26,815		)	—
Principal payments on MBS Forwards		(571,792		)	—
Proceeds from MBS Forwards		564,966			—
Payments made for margin calls on repurchase agreements and Swaps		(432,205		)	(101,800		)
Proceeds from reverse margin calls on repurchase agreements and Swaps		456,350			127,158
Proceeds from issuances of common stock		273			16,512
Dividends paid on preferred stock		(4,080		)	(4,080		)
Dividends paid on common stock and DERs		(143,403		)	(95,531		)
Principal amortization and prepayment on mortgage loan		(9,143		)	(85		)
Net cash used by financing activities		$	(1,087,456	)	$	(1,144,731	)
Net decrease in cash and cash equivalents		$	(121,917	)	$	(78,675	)
Cash and cash equivalents at beginning of period		$	653,460		$	361,167
Cash and cash equivalents at end of period		$	531,543		$	282,492

 

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 June 30, 2010 and results of operations for all periods presented have been made.  The results of operations for the six months ended June 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 prices obtained from third-party pricing services, broker quotes and other applicable market based data.  If listed prices or quotes are not available, then fair value is based upon internally developed models that are primarily based on observable market-based inputs.  (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, 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 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 amortized cost basis of each other-than-temporarily impaired Non-Agency security to the expected principal recovery on the impaired MBS.

 

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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 high quality 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 June 30, 2010 or December 31, 2009.  At June 30, 2010, all of the Company’s cash investments were in high quality overnight money market funds.  (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 $43.4 million and $67.5 million at June 30, 2010 and December 31, 2009, respectively.  (See Notes 4, 7, 8 and 13)

 

(e)  Goodwill

 

At June 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 June 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 structured as a sale and repurchase, 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 had satisfied all of its margin calls and has never sold assets in response to a margin call.

 

The Company’s repurchase financing 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

 

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MFA FINANCIAL, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

repurchase financing, 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 are 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 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

 

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MFA FINANCIAL, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

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 netted together and reported as a derivative instrument, specifically as a net forward contract on the Company’s consolidated balance sheet as MBS Forwards.  In addition, changes in the fair value of the net forward contract are reported as gains or losses on the Company’s consolidated statements of operation 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))

 

At June 30, 2010, the Company had 37 linked MBS and repurchase agreement transactions.  As such, the Company accounted for these purchase contracts and related repurchase agreements on a net basis and recorded a derivative instrument, or forward contract on the Company’s consolidated balance sheet.  Changes in the fair value of these forward contracts (i.e., MBS Forwards) are reported as a net gain or loss on the Company’s consolidated statements of operations.  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

 

On June 12, 2009, the FASB issued new accounting 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 are 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 has it transferred assets through a securitization.

 

In conjunction with new accounting 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 does not have any interests in a VIE.  The Company’s adoption of this new accounting on January 1, 2010 did not have any impact on the Company, as it is not the primary beneficiary of any VIE.

 

(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.  MBS do not have a single maturity date and, further, the mortgage loans underlying ARM-MBS have interest rates that do not all reset at the same time.  At June 30, 2010 and December 31, 2009, the Company’s MBS were primarily secured by hybrid mortgages that have a fixed interest rate for a specified period, typically three to ten years at origination, and, thereafter, generally reset annually (“Hybrids”), and adjustable-rate mortgages (“ARMs”) (collectively, “ARM-MBS”).  At June 30, 2010, $568.7 million, or 7.2%, of the Company’s MBS portfolio was comprised of $267.7 million of 15-year fixed-rate MBS and $301.0 million of 30-year fixed-rate Non-Agency MBS.

 

The Company pledges a significant portion of its MBS as collateral against its borrowings under repurchase agreements and Swaps.  The Company has Non-Agency MBS that are accounted for as components of MBS Forwards and, accordingly, 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 credit worthiness 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

 

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MFA FINANCIAL, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

senior most tranches from the MBS structure.  The Company’s Non-Agency MBS are categorized as the following:  “MFR MBS”, which are Non-Agency MBS 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,” which are Non-Agency MBS that were purchased directly by the Company prior to July 2007.

 

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

 

June 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		$	5,635,863		$	87,279		$	(263	)	$	—		$	5,722,879		$	5,921,432		$	203,354		$	(4,801	)	$	198,553
Freddie Mac		407,959			6,208			—			—			428,734			444,131			15,496			(99		)	15,397
Ginnie Mae		19,277			338			—			—			19,615			20,007			392			—			392
Total Agency MBS		6,063,099			93,825			(263		)	—			6,171,228			6,385,570			219,242			(4,900		)	214,342
Non-Agency MBS (3)
Rated AAA		2,337			56			—			—			2,393			2,105			—			(288		)	(288		)
Rated AA		36,196			987			(487		)	(13		)	36,683			30,501			383			(6,565		)	(6,182		)
Rated A		27,631			45			(6,890		)	(1,722		)	19,064			23,025			4,593			(632		)	3,961
Rated BBB		76,062			29			(4,410		)	(2,136		)	69,545			67,213			1,276			(3,608		)	(2,332		)
Rated BB		6,762			—			(386		)	(614		)	5,762			6,187			425			—			425
Rated B		89,590			—			(17,956		)	(6,744		)	64,890			75,829			11,511			(572		)	10,939
Rated CCC		801,512			—			(76,202		)	(221,195		)	501,387			560,348			67,327			(8,366		)	58,961
Rated CC		934,575			—			(80,296		)	(273,384		)	566,550			631,159			85,614			(21,005		)	64,609
Rated C		198,089			—			(15,502		)	(68,378		)	114,208			127,929			13,785			(64		)	13,721
Unrated and D-rated (4)		64,760			—			(6,809		)	(8,723		)	44,424			39,725			1,823			(6,522		)	(4,699		)
Total Non-Agency MBS		2,237,514			1,117			(208,938		)	(582,909		)	1,424,906			1,564,021			186,737			(47,622		)	139,115
Total MBS		$	8,300,613		$	94,942		$	(209,201	)	$	(582,909	)	$	7,596,134		$	7,949,591		$	405,979		$	(52,522	)	$	353,457

 

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 $14.6 million and $12.9 million at June 30, 2010 and December 31, 2009, respectively, which are not included in the Principal/Current Face.  Amortized cost is reduced by other-than-temporary impairments recognized through earnings of $21.9 million and $17.7 million at June 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 four MBS, which were D-rated and had an aggregate amortized cost and fair value of $42.8 million and $37.9 million, respectively, at June 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. 

 

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MFA FINANCIAL, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

The table below presents the Company’s unrealized gain/loss position by MBS category at June 30, 2010 and December 31, 2009:

 

		June 30, 2010						December 31, 2009
(In Thousands)		Unrealized Gains			Unrealized Losses			Unrealized Gains			Unrealized Losses
Agency MBS		$	219,242		$	4,900		$	266,981		$	3,654
MFR MBS		186,737			10,192			135,819			6,577
Legacy Non-Agency MBS		—			37,430			34			53,133
Total		$	405,979		$	52,522		$	402,834		$	63,364

 

Unrealized Losses on MBS and Impairments

 

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

 

Unrealized Loss Position For:
		Less than 12 Months								12 Months or more								Total
		Fair			Unrealized			Number of		Fair			Unrealized			Number of		Fair			Unrealized
(In Thousands)		Value			Losses			Securities		Value			Losses			Securities		Value			Losses
Agency MBS:
Fannie Mae		$	252,753		$	1,758		10		$	49,721		$	3,043		10		$	302,474		$	4,801
Freddie Mac		—			—			—		3,271			99			1		3,271			99
Total Agency MBS		252,753			1,758			10		52,992			3,142			11		305,745			4,900
Non-Agency MBS:
Rated AAA		—			—			—		2,105			288			2		2,105			288
Rated AA		—			—			—		29,144			6,565			3		29,144			6,565
Rated A		7,078			86			1		1,689			546			2		8,767			632
Rated BBB		—			—			—		21,083			3,608			2		21,083			3,608
Rated B		14,166			572			1		—			—			—		14,166			572
Rated CCC		158,008			2,709			12		24,910			5,657			4		182,918			8,366
Rated CC		8,835			6,022			2		96,048			14,983			2		104,883			21,005
Rated C		3,553			64			1		—			—			—		3,553			64
Unrated and other		10,964			811			5		23,201			5,711			1		34,165			6,522
Total Non-Agency MBS		202,604			10,264			22		198,180			37,358			16		400,784			47,622
Total MBS		$	455,357		$	12,022		32		$	251,172		$	40,500		27		$	706,529		$	52,522

 

At June 30, 2010, the Company did not intend to sell any of its MBS that were in an unrealized loss position, and it is “more likely than not” that the Company will not be required to sell these MBS before recovery of their amortized cost basis, which may be at their maturity.

 

Gross unrealized losses on the Company’s Agency MBS were $4.9 million at June 30, 2010.  Given the credit quality inherent in Agency MBS, the Company does not consider any of the current impairments on its Agency MBS to be credit related.  In assessing whether it is “more likely than not” that the Company will be required to sell any impaired security before its anticipated recovery, which may be at their maturity, it considers the significance of each investment, the amount of impairment, the projected future performance of such impaired securities, as well as the Company’s current and anticipated leverage capacity and liquidity position.  Based on these analyses, the Company determined that at June 30, 2010 any unrealized losses on its Agency MBS were temporary.

 

Unrealized losses on the Company’s Non-Agency MBS were $47.6 million at June 30, 2010. These unrealized losses, which were not designated as credit related, are primarily believed to be related to an overall widening of spreads for many types of fixed income products, reflecting, among other things, limited liquidity in the market and a general negative bias toward structured mortgage products, including Non-Agency MBS.

 

The Company recognized credit-related other-than-temporary impairment losses of $5.4 million through earnings during the six months ended June 30, 2010.  These credit-related losses were recognized in connection with six Legacy Non-Agency MBS.  During the three and six months ended June 30, 2009, the Company recognized other-than-temporary impairment losses of $7.5 million and $9.0 million, respectively, through earnings for credit-related impairments on certain of its Legacy Non-Agency MBS.

 

13