Western Asset Mortgage Capital Corp - Quarter Report: 2013 June (Form 10-Q)

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x                Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended June 30, 2013

 

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:  001-35543

 

Western Asset Mortgage Capital Corporation

(Exact name of Registrant as specified in its charter)

 

 

Western Asset Mortgage Capital Corporation

385 East Colorado Boulevard

Pasadena, California 91101

(Address of Registrant’s principal executive offices)

 

(626) 844-9400

(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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No o

 

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

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 under the Securities Exchange Act of 1934).  Yes o No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.

 

As of August 13, 2013, there were 24,304,503 shares, par value $0.01, of the registrant’s common stock issued and outstanding.

 

 

 

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TABLE OF CONTENTS

 

		Page
Part I — FINANCIAL INFORMATION
ITEM 1.	Financial Statements	2
ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	31
ITEM 3.	Quantitative and Qualitative Disclosures about Market Risk	63
ITEM 4.	Controls and Procedures	66
Part II — OTHER INFORMATION		68
ITEM 1.	Legal Proceedings	68
ITEM 1A.	Risk Factors	68
ITEM 2.	Unregistered Sales of Equity Securities and Use of Proceeds	68
ITEM 3.	Defaults Upon Senior Securities	68
ITEM 4.	Mine Safety Disclosures	68
ITEM 5.	Other Information	68
ITEM 6.	Exhibits	69
Signatures		70

 

 

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Western Asset Mortgage Capital Corporation

Balance Sheets (Unaudited)

(in thousands—except share and per share data)

 

		June 30, 2013			December 31, 2012
Assets:
Cash and cash equivalents		$	8,716		$	56,292
Residential mortgage-backed securities, at fair value ($4,146,646 and $5,043,824 pledged as collateral, at fair value, respectively)		4,186,750			5,212,581
Linked transactions, net, at fair value		1,647			—
Investment related receivables		12,360			—
Accrued interest receivable		15,108			17,361
Due from counterparties		134,409			54,142
Derivative assets, at fair value		118,332			24,344
Other assets		650			244
Total Assets		$	4,477,972		$	5,364,964
Liabilities and Stockholders’ Equity:
Liabilities:
Borrowings under repurchase agreements		$	3,961,629		$	4,794,730
Accrued interest payable		5,887			6,561
Investment related payables		22,167			—
Due to counterparties		39,000			—
Derivative liabilities, at fair value		1,484			4,771
Cash overdraft payable		—			5,666
Accounts payable and accrued expenses		1,311			988
Underwriting and offering costs payable		8			75
Payable to related party		2,016			1,924
Dividend payable		21,878			27,041
Total Liabilities		4,055,380			4,841,756
Commitments and contingencies
Stockholders’ Equity:
Common stock, $0.01 par value, 500,000,000 shares authorized, 24,304,503 and 24,143,944 shares issued and outstanding, respectively		243			241
Preferred stock, $0.01 par value, 100,000,000 shares authorized and no shares outstanding		—			—
Additional paid-in capital		505,957			505,454
Retained earnings (accumulated deficit)		(83,608		)	17,513
Total Stockholders’ Equity		422,592			523,208
Total Liabilities and Stockholders’ Equity		$	4,477,972		$	5,364,964

 

See notes to unaudited financial statements.

 

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Western Asset Mortgage Capital Corporation

Statement of Operations (Unaudited)

(in thousands—except share and per share data)

 

		For the three months ended June 30, 2013			For the six months ended June 30, 2013			For the period from May 15, 2012 (commencement of operations) through June 30, 2012, as Revised (See Note 2)
Net Interest Income:
Interest income		$	32,742		$	66,492		$	7,083
Interest expense		4,522			9,703			725
Net Interest Income		28,220			56,789			6,358
Other Income (Loss):
Interest income on cash balances and other income		12			45			—
Realized gain (loss) on sale of Residential mortgage-backed securities and other securities, net		(6,083		)	(17,743		)	1,157
Other loss on Residential mortgage-backed securities		(3,533		)	(5,801		)	(87		)
Unrealized gain (loss) on Residential mortgage-backed securities and other securities, net		(156,286		)	(211,045		)	2,983
Gain on linked transactions, net		3,909			4,505			—
Gain (loss) on derivative instruments, net		109,474			124,314			(5,159		)
Other Income (Loss), net		(52,507		)	(105,725		)	(1,106		)
Operating Expenses:
General and administrative (includes $251, $537 and $54 non-cash stock based compensation, respectively)		1,541			3,278			584
Management fee — related party		1,826			3,939			407
Total Operating Expenses		3,367			7,217			991
Net income (loss) to Common Stock and participating securities		$	(27,654	)	$	(56,153	)	$	4,261
Net income (loss) per Common Share — Basic		$	(1.14	)	$	(2.32	)	$	0.41
Net income (loss) per Common Share - Diluted		$	(1.14	)	$	(2.32	)	$	0.41
Dividends Declared per Share of Common Stock		$	1.85		$	1.85		$	—

 

See notes to unaudited financial statements.

 

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Western Asset Mortgage Capital Corporation

Statement of Changes in Stockholders’ Equity (Unaudited)

(in thousands—except shares and share data)

 

		Common Stock					Additional Paid-			Retained Earnings (Accumulated
		Shares		Par			In Capital			Deficit)			Total
Balance at December 31, 2012		24,143,944		$	241		$	505,454		$	17,513		$	523,208
Grants of restricted stock		160,559		2			(2		)	—			—
Vesting of restricted stock		—		—			505			—			505
Net income (loss)		—		—			—			(56,153		)	(56,153		)
Dividends on common stock		—		—			—			(44,968		)	(44,968		)
Balance at June 30, 2013		24,304,503		$	243		$	505,957		$	(83,608	)	$	422,592

 

See notes to unaudited financial statements.

 

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Western Asset Mortgage Capital Corporation

Statement of Cash Flows (Unaudited)

(in thousands)

 

		For the six months ended June 30, 2013			For the period from May 15, 2012 (commencement of operations) through June 30, 2012, as Revised (See Note 2)
Cash flows from operating activities:
Net income (loss)		$	(56,153	)	$	4,261
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Premium amortization and (discount accretion), net		14,199			1,567
Restricted stock amortization expense		505			54
Unrealized loss (gain) on Residential mortgage-backed securities and other securities, net		211,045			(2,983		)
Mark-to-market adjustments on linked transactions		(711		)	—
Mark-to-market adjustments on derivative instruments		(90,303		)	5,269
Other loss on Residential mortgage-backed securities		5,801			87
Realized loss (gain) on sale of Residential mortgage-backed securities and other securities, net		17,743			(1,157		)
Realized loss on sale of Agency Interest-Only Strips accounted for as derivatives, net		99			—
Realized loss on TBAs, net		2,563			—
Realized gain on sale of swaptions, net		(1,038		)	—
Realized loss on expiration of option derivatives, net		925			—
Realized gain on linked transaction, net		(3,748		)	—
Realized gain on termination of swaps		(8,895		)	—
Changes in operating assets and liabilities:
Decrease (increase) in accrued interest receivable		2,253			(7,076		)
Increase in other assets		(406		)	(552		)
Increase (decrease) in accrued interest payable		(674		)	1,000
Increase in accounts payable and accrued expenses		323			432
Increase in payable to related party		92			407
Net cash provided by operating activities		93,620			1,309
Cash flows from investing activities:
Purchase of Residential mortgage-backed securities and other securities		(1,725,304		)	(2,158,676		)
Purchase of securities underlying linked transactions		(76,408		)	—
Proceeds from sale of Residential mortgage-backed securities and other securities		2,209,607			237,390
Proceeds from sale of securities underlying linked transactions		21,733			—
Principal payments and basis recovered on Residential mortgage-backed securities		156,970			8,399
Principal payments on securities underlying linked transactions		1,043			—
Payment of premium for option derivatives		(4,675		)	—
Premium received from option derivatives		3,750			—
Proceeds from gross settlement of TBAs		208,312			—
Net settlements of TBAs		(2,058		)	—
Proceeds from sale of interest rate swaptions		16,325			—
Payment of premium for interest rate swaptions		(23,544		)	—
Net cash provided by (used in) investing activities		785,751			(1,912,887		)
Cash flows from financing activities:
Proceeds from issuance of common stock		—			160,000
Proceeds from private placements of units and common stock (concurrent with initial public offering)		—			45,557
Redemption of common stock		—			(1		)
Payment of offering costs		(67		)	—
Proceeds from repurchase agreement borrowings		20,074,104			3,192,929
Proceeds from repurchase agreements underlying linked transactions		86,245			—
Repayments of repurchase agreement borrowings		(20,907,205		)	(1,456,436		)
Repayments of repurchase agreements underlying linked transactions		(82,960		)	—
Repayment of cash overdraft		(5,666		)	—
Due from counterparties		(80,267		)	(8,000		)
Due to counterparties		39,000			4,309
Dividends on common stock		(50,131		)	—
Net cash provided by (used in) financing activities		(926,947		)	1,938,358
Net increase (decrease) in cash and cash equivalents		(47,576		)	26,780
Cash and cash equivalents beginning of period		56,292			1
Cash and cash equivalents end of period		$	8,716		$	26,781
Supplemental disclosure of operating cash flow information:
Interest paid		$	11,681		$	446
Interest rate swaps terminated, not settled		$	8,895		$	—
Mortgage-backed securities recorded upon unlinking of linked transactions		$	53,159		$	—
Supplemental disclosure of non-cash financing/investing activities:
Offering costs to be settled with related party		$	—		$	1,200
Mortgage-backed securities sold, not settled		$	3,465		$	102,336
Mortgage-backed securities purchased, not settled		$	(22,167	)	$	(106,019	)
Mortgage-backed securities used to settle TBAs		$	208,817		$	—
Dividends and distributions declared, not paid		$	21,878		$	—

 

See notes to unaudited financial statements.

 

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Western Asset Mortgage Capital Corporation

Notes to Financial Statements (Unaudited)

(in thousands - except share and per share data)

 

The following defines certain of the commonly used terms in these Notes to Financial Statements: “Agency” or “Agencies” refer to a federally chartered corporation, such as the Federal National Mortgage Association (“Fannie Mae” or “FNMA”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac” or “FHLMC”), or an agency of the U.S. Government, such as the Government National Mortgage Association (“Ginnie Mae” or “GNMA”); references to “RMBS” refer to residential mortgage-backed securities, “Agency RMBS” refer to RMBS issued or guaranteed by the Agencies while “Non-Agency RMBS “ refer to RMBS that are not issued or guaranteed by the Agencies; references to “ARMs” refers to adjustable rate mortgages; and references to “Agency Derivatives” or “Agency Interest-Only Strips” refer to interest-only (“IO”) and inverse interest-only (“IIO”) securities issued as part of or collateralized with Agency RMBS.

 

Note 1 — Organization

 

Western Asset Mortgage Capital Corporation (is referred to throughout this report as the “Company”) is a residential real estate finance company that invests in residential mortgage assets in the United States.  The Company is primarily focused on investing in, financing and managing Agency RMBS. Although the Company’s core investment strategy is focused on Agency RMBS, the Company has opportunistically supplemented its portfolio with Non-Agency RMBS and may, in the future, opportunistically invest in commercial mortgage-backed securities (“CMBS”) and asset-backed securities (“ABS”).

 

The Company is externally managed by Western Asset Management Company (“WAM”, or the “Manager”), an investment advisor registered with the Securities and Exchange Commission (“SEC”). WAM is a wholly-owned subsidiary of Legg Mason, Inc.  The Company intends to elect and qualify to be taxed as a real estate investment trust or “REIT” commencing with its taxable year ended December 31, 2012.

 

At December 31, 2011 and through May 14, 2012, the Company complied with the reporting requirements for development stage enterprises and was subject to the risks associated with development stage enterprises. The Company completed its initial public offering and began its core operation on May 15, 2012. The Company incurred organizational, accounting and offering costs in connection with the Company’s initial public offering (the “IPO”) of its common stock and concurrent private placements. In accordance with the Management Agreement (as defined herein in Note 10) between the Company and the Manager, the Company reimbursed the Manager for $1.2 million of offering and other related organization costs, which were paid by the Manager, from the proceeds of the IPO and concurrent private placements. The Manager paid all costs in excess of $1.2 million. The Company ceased reporting as a development stage company on May 15, 2012.

 

Note 2 — Revision of Previously Issued Financial Statements for Errors Affecting Certain Items Presented in the Statements of Operations and Statements of Cash Flows

 

As previously reported in the Company’s annual report on Form 10-K for 2012, during the process of preparing the Company’s 2012 financial statements, the Company discovered that the methodology that was used to accrete interest income and to amortize the cost basis of certain of the Company’s residential mortgage backed securities, which was based on a third party vendor’s system, as well as the presentation with regard to certain items in its Statement of Cash Flows were not in accordance with GAAP. The Company has evaluated the impact of these errors and has concluded that individually and in the aggregate, these errors were not material to any previously issued financial statements. However, the Company elected to revise the Statements of Operations for the period from May 15, 2012 (commencement of operations) through June 30, 2012 and the Statements of Cash Flows for the period from May 15, 2012 (commencement of operations) through June 30, 2012 in this quarterly financial statements on Form 10-Q to correct these errors. The corrections resulted in a reclassification of a portion of the Company’s previously reported net interest income to realized and unrealized gains, and certain amounts previously reflected in operating cash flows to investing cash flows (as indicated in the tables below). These revisions had no effect on net income, shareholders’ equity, net change in cash, or total assets, of the Company reported for this period.

 

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Statements of Operations for the period from May 15, 2012 (commencement of operations) through June 30, 2012:

 

Amounts in thousands,		Period from May 15, 2012 (commencement of operations) through June 30, 2012
except share and per share amounts		As Originally Reported			Adjustments			Revised
Net interest income:
Interest income		$	6,850		$	233		$	7,083
Interest expense		725			—			725
Net interest income		6,125			233			6,358
Other Income (loss):
Interest income on cash balances		—			—			—
Realized gain on sale of residential mortgage-backed securities, net		1,120			37			1,157
Other loss on residential mortgage-backed securities		(605		)	518			(87		)
Unrealized gain on residential mortgage-backed securities, net		3,925			(942		)	2,983
Loss on derivative instruments, net		(5,313		)	154			(5,159		)
Other Income, net		(873		)	(233		)	(1,106		)
Operating Expenses:
General and administrative		584			—			584
Management fee - related party		407			—			407
Total Operating Expenses		991			—			991
Net income available to Common Stock and Participating Securities		$	4,261		—			$	4,261
Earnings per share Net income attributable to common and participating shareholders (basic)		$	0.41		$	—		$	0.41
Net income attributable to shareholders (diluted)		$	0.41		$	—		$	0.41

 

Statement of Cash Flows (summarized) for the periods from May 15, 2012 (commencement of operations) through June 30, 2012:

 

		Period from May 15, 2012 (commencement of operations) through June 30, 2012
Amounts in thousands		As Originally Reported			Adjustments			Revised
Statement of Cash Flows (effect on individual line items)
Net income		$	4,261		$	—		$	4,261
Adjustments to reconcile net income to net cash provided by operating activities:
Premium amortization and (discount accretion), net		2,198			(631		)	1,567
Unrealized (gain) loss on Residential mortgage-backed securities and other securities, net		(3,925		)	942			(2,983		)
Mark-to-market adjustments on derivative instruments		5,409			(140		)	5,269
Other loss on Residential mortgage-backed securities		605			(518		)	87
Realized (gain) loss on sale of Residential mortgage-backed securities and other securities, net		(1,120		)	(37		)	(1,157		)
All other Items		(5,735		)	—			(5,735		)
Net cash provided by operating activities		1,693			(384		)	1,309
Cash flows from investing activities:
Principal payments and basis recovered on Residential mortgage-backed securities and other securities		8,015			384			8,399
All other items		(1,921,286		)	—			(1,921,286		)
Net cash used in investing activities		(1,913,271		)	384			(1,912,887		)
Cash flows from financing activities:
All items		1,938,358			—			1,938,358
Net cash provided by financing activities		1,938,358			—			1,938,358
Net increase in cash and cash equivalents		26,780			—			26,780
Cash and cash equivalents beginning of period		1			—			1
Cash and cash equivalents end of period		$	26,781		$	—		$	26,781

 

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Note 3 — Summary of Significant Accounting Policies

 

Basis of Presentation

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“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 periods.  Actual results could differ from those estimates.

 

In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary have been made to present fairly the Company’s financial position, results of operations and cash flows.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted in accordance with Article 10 of Regulation S-X and the instructions to Form 10-Q.  These financial statements should be read in conjunction with the Company’s annual report on Form 10-K for the year ended December 31, 2012, filed with the Securities and Exchange Commission (“SEC”) on April 9, 2013.  The results of operations for the period ended June 30, 2013 are not necessarily indicative of the results to be expected for the full year or any future period.

 

The Company currently operates as one business segment.

 

Cash and Cash Equivalents

 

The Company considers all highly-liquid short term investments with original maturities of 90 days or less when purchased to be cash equivalents.  Cash and cash equivalents are exposed to concentrations of credit risk. The Company places its cash and cash equivalents with what it believes to be high credit quality institutions. At times such investments may be in excess of the Federal Deposit Insurance Corporation insurance limit.

 

Classification of mortgage-backed securities and valuations of financial instruments

 

Mortgage-backed and US Treasury securities - Fair value election

 

The Company has elected the fair value option for all of its RMBS and US Treasury securities at the date of purchase, which permits the Company to measure these securities at fair value with the change in fair value included as a component of earnings. In the Manager’s view, this election more appropriately reflects the results of the Company’s operations for a particular reporting period, as financial asset fair value changes are presented in a manner consistent with the presentation and timing of the fair value changes of economic hedging instruments.

 

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Balance Sheet Presentation

 

The Company’s mortgage-backed securities purchases and sales are recorded on the trade date, which results in an investment related payable (receivable) for RMBS purchased (sold) for which settlement has not taken place as of the balance sheet date. The Company’s RMBS pledged as collateral against borrowings under repurchase agreements, and that are not accounted for as linked transactions, described below, are included in residential mortgage-backed securities on the Balance Sheets, with the fair value of such securities pledged disclosed parenthetically.

 

Valuation of financial instruments

 

The Company discloses the fair value of its financial instruments according to a fair value hierarchy (Levels I, II, and III, as defined below). In accordance with GAAP, the Company is required to provide enhanced disclosures regarding instruments in the Level III category (which require significant management judgment), including a separate reconciliation of the beginning and ending balances for each major category of assets and liabilities.  GAAP establishes a framework for measuring fair value and expands financial statement disclosure requirements for fair value measurements. GAAP further specifies a hierarchy of valuation techniques, which is based on whether the inputs into the valuation technique are observable or unobservable. The hierarchy is as follows:

 

Level I — Quoted prices in active markets for identical assets or liabilities.

 

Level II — Quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

 

Level III — Prices are determined using significant unobservable inputs. In situations where quoted prices or observable inputs are unavailable, for example, when there is little or no market activity for an investment at the end of the period, unobservable inputs may be used.

 

The level in the fair value hierarchy within which a fair measurement in its entirety falls is based on the lowest level input that is significant to the fair value measurement in its entirety.

 

When available, the Company uses quoted market prices to determine the fair value of an asset or liability. If quoted market prices are not available, the Company consults with independent pricing services or obtains third party broker quotes. If independent pricing service, or third party broker quotes are not available, the Company determines the fair value of the securities using valuation techniques that use, when possible, current market-based or independently-sourced market parameters, such as interest rates and when applicable, estimates of prepayment and credit losses.

 

Valuation techniques for RMBS may be based upon models that consider the estimated cash flows of the security. The primary inputs to the model include yields for to-be-announced, also known as TBAs, Agency RMBS, the U.S. Treasury market and floating rate indices such as LIBOR, the Constant Maturity Treasury rate and the prime rate as a benchmark yield. The model incorporates the current weighted average maturity and additional pool level information such as prepayment speeds, default frequencies and default severities, if applicable. To the extent, the inputs are observable and timely, the values are categorized in Level II of the fair value hierarchy; otherwise they would be categorized as Level III.

 

While linked transactions, described below, are treated as derivatives for GAAP, the securities underlying the Company’s linked transactions are valued using similar techniques to those used for the Company’s securities portfolio. The value of the underlying security is then netted against the carrying amount (which approximates fair value) of the repurchase agreement at the valuation date. Additionally, TBA instruments are similar in substance to the Company’s Agency RMBS portfolio, and the Company therefore estimates fair value based on similar methods.

 

The Company determines the fair value of derivative financial instruments by obtaining quotes from a third party pricing service, whose pricing is subject to review by the Manager’s pricing committee. In valuing its interest rate derivatives, such as swaps and swaptions, the Company considers the creditworthiness of both the Company and its counterparties, along with collateral provisions contained in each derivative agreement, from the perspective of both the Company and its counterparties. All of the Company’s interest rate swaps are either cleared through a central clearinghouse and subject to the clearinghouse margin requirements or subject to bilateral collateral arrangements. The Company also has netting arrangements in place with all derivative counterparties pursuant to standard documentation developed by the International Swap and Derivatives Association. Consequently, no credit valuation adjustment was made in determining the fair value of interest rate derivatives.

 

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In May 2011, the Financial Accounting Standards Board or FASB issued amendments, which were adopted by the Company, to achieve common fair value measurement and disclosure requirements in GAAP and International Financial Reporting Standards. New disclosures, with a particular focus on Level III measurement are required. All transfers between Level I and Level II are required to be disclosed. There were no transfers between hierarchy levels during operations for the six months ended June 30, 2013.  Information about when the current use of a non-financial asset measured at fair value differs from its highest and best use is to be disclosed.

 

Fair value under GAAP represents an exit price in the normal course of business, not a forced liquidation price. If the Company is forced to sell assets in a short period to meet liquidity needs, the prices it receives can be substantially less than their recorded fair values. Furthermore, the analysis of whether it is more likely than not that the Company will be required to sell securities in an unrealized loss position prior to an expected recovery in value (if any), the amount of such expected required sales, and the projected identification of which securities will be sold is also subject to significant judgment, particularly in times of market illiquidity.

 

Any changes to the valuation methodology will be reviewed by the Company and its Manager to ensure the changes are appropriate. As markets and products develop and the pricing for certain products becomes more transparent, the Company will continue to refine its valuation methodologies. The Company utilizes and follows the pricing methodology employed by its Manager, including its review and challenge process.  The methods used by the Company may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while the Company anticipates that its valuation methods will be appropriate and consistent with other market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments can result in a different estimate of fair value at the reporting date. The Company uses inputs that are current as of the measurement date, which may include periods of market dislocation, during which price transparency may be reduced.

 

Interest income recognition and Impairment

 

Agency RMBS and Non-Agency RMBS rated AA and higher at the time of purchase

 

Interest income on mortgage-backed securities is accrued based on the respective outstanding principal balances and corresponding contractual terms. Premiums and discounts associated with Agency RMBS and Non-Agency RMBS rated AA and higher at the time of purchase, are amortized into interest income over the estimated life of such securities using the effective yield method. Adjustments to premium and discount amortization are made for actual prepayment activity.  The Company estimates prepayments at least quarterly for its securities and as a result, if prepayments increase (or are expected to increase), the Company will accelerate the rate of amortization on premiums or discounts and make a retrospective adjustment to historical amortization.  Alternatively, if prepayments decrease (or are expected to decrease) the Company will reduce the rate of amortization on the premiums or discounts and make a retrospective adjustment to historical amortization.

 

The Company assesses its Agency RMBS and Non-Agency RMBS rated AA and higher at the time of purchase for other-than-temporary impairment on at least a quarterly basis. When the fair value of an investment is less than its amortized cost at the balance sheet date of the reporting period for which impairment is assessed, the impairment is designated as either “temporary” or “other-than-temporary.” In deciding on whether or not a security is other than temporarily impaired, the Company considers several factors, including the nature of the investment, communications (if any) from the trustees of securitizations regarding the credit quality of the security, the severity and duration of the impairment, the cause of the impairment, and the Company’s intent that the Company can hold the security until recovery of its cost basis.

 

The determination as to whether an other-than-temporary impairment exists is subject to management estimates based on consideration of both factual information available at the time of assessment as well as the Company’s estimates of the future performance and projected amount and timing of cash flows expected to be collected on the security. As a result, the timing and amount of an other-than-temporary impairment constitutes an accounting estimate that may change materially over time.

 

Non-Agency RMBS that are purchased at a discount to par value and are rated below AA at the time of purchase and Agency Interest-Only Strips that are not classified as derivatives

 

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Interest income on Non-Agency RMBS that are purchased at a discount to par value and are rated below AA at the time of purchase and Agency Interest-Only Strips that are not classified as derivatives are recognized based on the effective yield method.  The effective yield on these securities is based on the projected cash flows from each security, which is estimated based on the Company’s observation of the then current information and events and will include assumptions related to interest rates, prepayment rates 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 interest rates, prepayment rates, the timing and amount of credit losses (if applicable), 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 such securities. Actual maturities of the securities are affected by the contractual lives of the associated mortgage collateral, periodic payments of scheduled principal, and prepayments of principal. Therefore, actual maturities of the securities will generally be shorter than stated contractual maturities.

 

Based on the projected cash flow of the Non-Agency RMBS purchased at a discount to par value, the Company may designate a portion of such purchase discount as credit protection against future credit losses and, therefore, not accrete such amount 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 prospectively.

 

In addition, an other-than-temporary impairment is deemed to have occurred when there is an adverse change in the expected cash flows (principal or interest) to be received and the fair value of the security is less than its carrying amount. In determining whether an adverse change in cash flows occurred, the present value of the remaining cash flows, as estimated at the initial transaction date (or the last date previously revised), is compared to the present value of the expected cash flows at the current reporting date.  The estimated cash flows reflect those a “market participant” would use and are discounted at a rate equal to the current yield used to accrete interest income. These adjustments are reflected in the Company’s Statement of Operations as Other loss on Residential mortgage-backed securities.

 

The determination as to whether an other-than-temporary impairment exists is subject to management estimates based on consideration of both factual information available at the time of assessment as well as the Company’s estimates of the future performance and projected amount and timing of cash flows expected to be collected on the security. As a result, the timing and amount of an other-than-temporary impairment constitutes an accounting estimate that may change materially over time.

 

Certain of the Company’s RMBS that are in an unrealized loss position at June 30, 2013 are not considered other than temporarily impaired because the Company has no intent to sell these investments, it is more likely than not that the Company will not be required to sell the investment before recovery of its amortized cost basis and the Company is not required to sell the security for regulatory or other reasons.

 

Sales of securities

 

Sales of securities are driven by the Company’s portfolio management process. The Company seeks to mitigate risks including those associated with prepayments and will opportunistically rotate the portfolio into securities the Company’s Manager believe have more favorable attributes. Strategies may also be employed to manage net capital gains, which need to be distributed for tax purposes. Realized gains or losses on sales of securities and derivatives, inclusive of linked transactions are included in the net realized gain line item on the Statement of Operations, and are recorded at the time of disposition. The cost of positions sold is calculated using the specific identification method.

 

Due from counterparties/Due to counterparties

 

Due from counterparties represents cash posted with its counterparties as collateral for the Company’s interest rate swaps and repurchase agreements. Due to counterparties represents cash posted with the Company by its counterparties as collateral under the Company’s interest rate swaps, interest rate swaptions and repurchase agreements. In addition, Due to counterparties include non-cash collateral in which the Company has the obligation to return the collateral upon the Company either selling or pledging the non-cash collateral. Due from counterparties and Due to counterparties are carried at cost, which approximates fair value. To the extent the Company receives collateral other than cash from its counterparties such assets are not included in the Company’s balance sheet.  Notwithstanding the foregoing, if the Company either rehypothecates such assets or pledges the assets as collateral pursuant to a repurchase agreement, the cash received and the corresponding liability is reflected on the balance sheet.

 

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Derivatives and hedging activities

 

Subject to maintaining its qualification as a REIT for U.S. federal income tax purposes, the Company utilizes derivative financial instruments, including interest rate swaps, swaptions, U.S. Treasuries, to-be-announced securities (“TBAs”) and Agency Interest-Only Strips to hedge the interest rate risk associated with its portfolio and related borrowings. Derivatives are used for hedging purposes rather than speculation. The Company determines the fair value of its derivative positions and obtains quotations from a third party to facilitate the process of determining these fair values. If the Company’s hedging activities do not achieve the desired results, reported earnings may be adversely affected.

 

GAAP requires an entity to recognize all derivatives as either assets or liabilities and to measure those instruments at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives are classified as either hedges of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge) or hedges of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge).  Fair value adjustments are recorded in earnings immediately, if the Company does not elect hedge accounting for a derivative instrument.

 

The Company elected not to apply hedge accounting for its derivative instruments and records the change in fair value and net interest rate swap payments (including accrued amounts) related to interest rate swaps in Gain (loss) on derivative instruments, net in its Statement of Operations.

 

The Company also invests in Agency Interest-Only Strips, Agency Inverse Interest-Only Strips, swaptions and TBAs. The Company evaluates the terms and conditions of its holdings of Agency Interest-Only Strips, Agency Inverse Interest-Only Strips, swaptions and TBAs to determine if these instruments have the characteristics of an investment or should be considered a derivative under GAAP.  Accordingly, Agency Interest-Only Strips, Agency Inverse Interest-Only Strips, swaptions and TBAs having the characteristics of derivatives are accounted for at fair value with such changes recognized in Gain (loss) on derivative instruments, net in its Statement of Operations, along with any interest earned (including accrued amounts). The carrying value of these Agency Interest-Only Strips, Agency Inverse Interest-Only Strips, swaptions and TBAs is included in Residential mortgage-backed securities on the Balance Sheet.

 

The Company evaluates all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. See “Warrants” below. Derivative instruments are recorded at fair value and are re-valued at each reporting date, with changes in the fair value together with interest earned (including accrued amounts) reported in the Gain (loss) on derivatives, net  in the Statements of Operations.

 

Repurchase agreements

 

Mortgage-backed securities sold under repurchase agreements are treated as collateralized financing transactions, unless they meet sales treatment. Securities financed through a repurchase agreement remain on the Company’s Balance Sheet as an asset and cash received from the lender is recorded in the Company’s Balance Sheet as a liability, unless they are accounted for as linked transactions, described below. Interest paid in accordance with repurchase agreements is recorded as interest expense, unless they are accounted for as linked transactions, described below.  The Company reflects all proceeds from repurchase agreement borrowings and repayment of repurchase agreement borrowings which are not linked transactions, including transactions pertaining to collateral received with respect with certain swap transactions, on a gross basis on the Statement of Cash Flows.

 

Linked Transactions

 

In instances where the Company finances securities through repurchase agreements with the same counterparty from which the securities were purchased, the Company accounts for the purchase commitment and repurchase agreement on a net basis and records a forward commitment to purchase securities as a derivative instrument if the transaction does not comply with the criteria for gross presentation.  Such forward commitments are recorded at fair value with subsequent changes in fair value recognized in Gain on linked transactions, net on its Statement of Operations. If the transaction complies with the criteria for gross presentation, the Company records the assets and the related financing on a gross basis in its Balance Sheet and the corresponding interest income and interest expense in its Statement of Operations.

 

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Share-based compensation

 

The Company accounts for share-based compensation to its independent directors, to its employees, to its Manager and to employees of its Manager and its affiliates using the fair value based methodology prescribed by GAAP.  Compensation cost related to restricted common stock issued to the Company’s independent directors, including any such restricted stock which is subject to a deferred compensation program, and employees of the Company is measured at its fair value at the grant date, and amortized into expense over the service period on a straight-line basis. Compensation cost related to restricted common stock issued to the Manager and to employees of the Manager and its affiliates is initially measured at fair value at the grant date, and amortized into expense over the vesting period on a straight-line basis and re-measured on subsequent dates to the extent the awards are unvested.

 

Warrants

 

The Company evaluates all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the statements of operations.  Financial instruments without the features of liabilities are recorded as a component of equity.  For the Company’s warrants, the Company uses a variation of the adjusted Black-Scholes option valuation model to record the financial instruments at their relative fair values at issuance. The warrants issued with the Company’s common stock in the private placement to certain accredited institutional investors on May 15, 2012, were evaluated by the Company and were recorded at their relative fair value as a component of equity at the date of issuance.

 

Income taxes

 

The Company intends to elect and qualify to be taxed as a REIT commencing with its taxable year ended December 31, 2012. Accordingly, the Company will generally not be subject to corporate U.S. federal or state income tax to the extent that the Company makes qualifying distributions to stockholders, and provided that the Company satisfies, on a continuing basis, through actual investment and operating results, the REIT requirements including certain asset, income, distribution and stock ownership tests. If the Company fails to qualify as a REIT, and does not qualify for certain statutory relief provisions, the Company will be subject to U.S. federal, state and local income taxes and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year in which the Company lost its REIT qualification. Accordingly, the failure to qualify as a REIT could have a material adverse impact on the Company’s results of operations and amounts available for distribution to stockholders.

 

The dividends paid deduction for qualifying dividends paid to stockholders is computed using the Company’s taxable income as opposed to net income reported on the financial statements. Taxable income, generally, will differ from net income reported on the financial statements because the determination of taxable income is based on tax provisions and not GAAP.

 

The Company may create and elect to treat certain subsidiaries as Taxable REIT Subsidiaries (“TRS”). In general, a TRS may hold assets and engage in activities that the Company cannot hold or engage in directly and generally may engage in any real estate or non-real estate-related business. A TRS is subject to U.S. federal, state and local corporate income taxes, and its value may not exceed 25% of the value of the Company. While a TRS will generate net income, a TRS can declare dividends to the Company, which will be included in the Company’s taxable income and necessitate a distribution to its stockholders. Conversely, if the Company retains earnings at the TRS level, no distribution is required and it can increase book equity of the consolidated entity.  As of June 30, 2013, the Company did not have a TRS, or any other subsidiary.

 

The Company evaluates uncertain tax positions, if any, and classifies interest and penalties, if any, related to unrecognized tax benefits as a component of the provision for income taxes.

 

Offering costs

 

Offering costs borne by the Company in connection with the IPO and concurrent private placements completed on May 15, 2012 as well as its follow-on public stock offering completed on October 3, 2012 are reflected as a reduction of additional paid-in-capital.

 

Earnings per share

 

GAAP requires use of the two-class method of computing earnings per share for all periods presented for each class of common stock and participating securities as if all earnings for the period had been distributed.  Under the two-class method, during periods of net income, the net income is first reduced for dividends declared on all classes of securities to arrive at undistributed earnings.  During periods of net losses, the net loss is reduced for dividends declared on participating securities only if the security has the right to participate in the earnings of the entity and an objectively determinable contractual obligation to share in net losses of the entity.

 

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The remaining earnings are allocated to common stockholders and participating securities, to the extent that each security shares in earnings, as if all of the earnings for the period had been distributed.  Each total is then divided by the applicable number of shares to arrive at basic earnings per share.  For the diluted earnings, the denominator includes all outstanding common shares and all potential common shares assumed issued if they are dilutive.  The numerator is adjusted for any changes in income or loss that would result from the assumed conversion of these potential common shares.

 

Comprehensive Income (Loss)

 

The Company has none of the components of comprehensive income (loss) and therefore comprehensive income (loss) is not presented.

 

Accounting standards applicable to emerging growth companies

 

The JOBS Act contains provisions that relax certain requirements for “emerging growth companies”, which includes the Company. For as long as the Company is an emerging growth company, which may be up to five full fiscal years, unlike other public companies, the Company will not be required to: (i) comply with any new or revised financial accounting standards applicable to public companies until such standards are also applicable to private companies under Section 102(b)(1) of the JOBS Act; (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of the Company’s system of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act; (iii) comply with any new requirements adopted by the PCAOB requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer; or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise.

 

As noted above, under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards that have different effective dates for public and private companies until such time as those standards apply to private companies. The Company intends to take advantage of such extended transition period. Since the Company will not be required to comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies, its financial statements may not be comparable to the financial statements of companies that comply with public company effective dates. If the Company were to elect to comply with these public company effective dates, such election would be irrevocable pursuant to Section 107 of the JOBS Act.

 

Recent accounting pronouncements

 

Accounting Standards Adopted in 2013

 

In December 2011, the FASB issued guidance requiring additional disclosure information about offsetting and related arrangements.  Further in December 2012, the FASB proposed an update intended to address implementation of the December 2011 guidance. In January 2013, the FASB issued guidance to limit the scope of the new balance sheet and offsetting disclosure requirements of prior guidance related  to certain derivatives (including bifurcated embedded derivatives,) repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions. Entities will be required to disclose both gross information and net information about both instruments and transactions eligible for offset in the balance sheet as well as instruments and transactions subject to an agreement similar to a master netting arrangement. This scope would include derivatives, sale and repurchase agreements and reverse sale and repurchase agreements and securities lending arrangements. The objective of this disclosure is to facilitate comparison between those entities that prepare their financial statements on the basis of GAAP and those entities that prepare their financial statements on the basis of International Financial Reporting Standards. The guidance is effective for periods beginning on or after January 1, 2013 and interim periods within those annual periods. While this guidance did result in certain additional disclosures, it did not have a material impact on the Company’s financial statements.

 

Note 4 — Fair Value of Financial Instruments

 

Fair Value Accounting Elections

 

The Company has elected the fair value option for all of its RMBS, and as a result, all changes in the fair value of such securities are reflected in the results of operations.

 

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Financial Instruments carried at Fair Value

 

The following tables present the Company’s financial instruments, carried at fair value as of June 30, 2013 and December 31, 2012, based upon the valuation hierarchy (dollars in thousands):

 

		June 30, 2013
		Fair Value
		Level I			Level II			Level III			Total
Assets
Agency RMBS		$	—		$	3,913,602		$	—		$	3,913,602
Agency Interest-Only Strips accounted for as derivatives, included in RMBS		—			99,574			—			99,574
Non-Agency RMBS					173,574			—			173,574
Subtotal					4,186,750			—			4,186,750
Derivative assets		—			118,332			—			118,332
Non-Agency linked transactions					1,647			—			1,647
Total		$	—		$	4,306,729		$	—		$	4,306,729
Liabilities
Derivative liabilities		$	—		$	1,484		$	—		$	1,484
Total		$	—		$	1,484		$	—		$	1,484

 

		December 31, 2012
		Fair value
		Level I			Level II			Level III			Total
Assets
Agency RMBS		$	—		$	5,118,121		$	—		$	5,118,121
Agency Interest-Only Strips accounted for as derivatives, included in RMBS		—			75,387			—			75,387
Non-Agency RMBS					19,073						19,073
Subtotal					5,212,581						5,212,581
Derivative assets		—			24,344			—			24,344
Total		$	—		$	5,236,925		$	—		$	5,236,925
Liabilities
Derivative liabilities		$	—		$	4,771		$	—		$	4,771
Total		$	—		$	4,771		$	—		$	4,771

 

The Company primarily utilizes an independent third party pricing service as the primary source for valuing the Company’s assets.  All valuations received from independent pricing services are non-binding.

 

The Company generally receives one independent pricing service price for each investment in its portfolio.  The Manager has established a process to review and validate the pricing received from the independent pricing service and has a process for challenging prices received from the independent pricing service when necessary.  The Company utilizes its Manager’s policies in this regard.  The Company’s and the Manager’s review of the independent third party pricing data may consist of a review of the daily change in the prices provided by the independent pricing vendor which exceed established tolerances or comparisons to executed transaction prices.  The Manager’s pricing group, which functions independently from its portfolio management personnel, corroborates the price differences or changes in price by comparing the vendor price to alternate sources including other independent pricing services or broker quotations.  If the price change or difference cannot be corroborated, the Manager’s pricing group consults with the portfolio management team for market color in reviewing such pricing data as warranted.  To the extent that the Manager has information, typically in the form of broker quotations that would indicate that a price received from the independent pricing service is outside of a tolerance range, the Manager generally challenges the independent pricing service price.

 

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To ensure proper fair value hierarchy, the Company and the Manager review the methodology used by the third party pricing service to understand whether observable or unobservable inputs are being utilized in the vendor’s evaluation methodology.  Generally, this review is conducted annually, however ad-hoc reviews of the evaluation methodology and the assumptive data does occur.  The review of the assumptive data received from the vendor includes comparing key inputs such as weighted average life, spread, prepayment assumptions to data obtained from other third-party data providers or internal valuation models.  In addition, as part of the Company’s regular review of pricing, the Manager’s pricing group may have informal discussions with the independent pricing vendor regarding their evaluation methodology or the inputs into their method.

 

Other Fair Value Disclosures

 

Cash and cash equivalents as well as Due from counterparties and Due to counterparties on the Company’s Balance Sheets are reflected at cost which approximates fair value.

 

The fair value of the repurchase agreements is a Level II fair value measurement, based on an expected present value technique. This method discounts future estimated cash flows using rates the Company determined best estimate current market interest rates that would be offered for loans with similar characteristics and credit quality. The use of different market assumptions or estimation methodologies can have a material effect on the fair value amounts. At June 30, 2013, the Company’s borrowings under repurchase agreements had a fair value of approximately $4.0 billion and a carrying value of approximately $4.0 billion.

 

Note 5 — Residential Mortgage-Backed Securities

 

The following table presents certain information about the Company’s investment portfolio at June 30, 2013 and December 31, 2012 (dollars in thousands).  Real estate securities that are accounted for as a component of linked transactions are not reflected in the tables set forth in this note. See Note 8 for further details.

 

		June 30, 2013
		Principal Balance			Unamortized Premium (Discount), net			Non-Accretable Discount			Amortized Cost			Unrealized Gain (Loss), net			Estimated Fair Value			Net Weighted Average Coupon (1)
Agency RMBS:
20-Year Mortgage		$	772,204		$	43,489		$			$	815,693		$	(29,800	)	$	785,893		3.1	%
30-Year Mortgage		2,846,261			249,360						3,095,621			(170,926		)	2,924,695			3.7	%
Agency Interest Only- Strips		N/A			N/A						199,132			3,882			203,014			4.3	%(2)
Agency Interest-Only Strips, accounted for as derivatives (3)		N/A			N/A						N/A			N/A			99,574			5.0	%(2)
Non-Agency RMBS		272,681			(30,762		)	(68,071		)	173,848			(274		)	173,574			1.0	%
Total		$	3,891,146		$	262,087		$	(68,071	)	$	4,284,294		$	(197,118	)	$	4,186,750		3.7	%

 

		December 31, 2012
		Principal Balance			Unamortized Premium (Discount), net			Non-Accretable Discount			Amortized Cost			Unrealized Gain (Loss), net			Estimated Fair Value			Net Weighted Average Coupon (1)
Agency RMBS:
20-Year Mortgage		$	299,251		$	20,460		$			$	319,711		$	(827	)	$	318,884		3.2	%
30-Year Mortgage		4,180,104			352,378						4,532,482			17,489			4,549,971			3.7	%
CMO — Fixed rate		66,000			9,776						75,776			(1,546		)	74,230			6.5	%
Agency Interest Only- Strips		N/A			N/A						176,093			(1,057		)	175,036			4.5	%(2)
Agency Interest-Only Strips, accounted for as derivatives (3)		N/A			N/A						N/A			N/A			75,387			4.9	%(2)
Non-Agency RMBS		37,372			(5,511		)	(12,659		)	19,202			(129		)	19,073			0.5	%
Total		$	4,582,727		$	377,103		$	(12,659	)	$	5,123,264		$	13,930		$	5,212,581		3.9	%

 

(1) Net weighted average coupon as of June 30, 2013 and December 31, 2012 is presented, net of servicing and other fees.

(2) Agency Interest-Only Strips and Agency Inverse Interest-Only Strips, accounted for as derivatives have no principal balances and earn contractual interest based on a notional balance. The notional balance is used solely to determine interest distributions on interest-only class of securities.

(3) Interest on these securities is reported as a component of Gain (loss) on derivative instruments, net on the Statement of Operations.

 

As of June 30, 2013 the weighted average expected remaining term to maturity of the investment portfolio is 9.1 years.

 

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The components of the carrying value of the Company’s investment portfolio are as follows:

 

		June 30, 2013			December 31, 2012
Principal balance		$	3,891,146		$	4,582,727
Amortized cost of IOs and IIOs		199,132			176,093
Carrying value of Agency Interest-Only Strips accounted for as derivatives		99,574			75,387
Unamortized premium		292,849			382,614
Unamortized discount		(30,762		)	(5,511		)
Non-Accretable discount		(68,071		)	(12,659		)
Gross unrealized gains		11,987			25,395
Gross unrealized losses		(209,105		)	(11,465		)
Fair value		$	4,186,750		$	5,212,581

 

As of June 30, 2013, the Company held Agency RMBS with a fair value of approximately $3.8 billion in an unrealized loss position of approximately $205.7 million.  As of June 30, 2013, the Company held Non-Agency RMBS with a fair value of approximately $99.4 million in an unrealized loss position of approximately $3.4 million.  As of June 30, 2013, the Company held no investments in an unrealized loss position for greater than one year.  At June 30, 2013, the Company did not intend to sell any of its Agency RMBS that were in an unrealized loss position, and it is “more likely than not” that the Company will not be required to sell these RMBS before recovery of their amortized cost basis, which may be at their maturity.

 

The Company assesses its Agency RMBS and Non-Agency RMBS rated AA and higher at the time of purchase for other-than-temporary impairment on at least a quarterly basis. When the fair value of an investment is less than its amortized cost at the balance sheet date of the reporting period for which impairment is assessed, the impairment is designated as either “temporary” or “other-than-temporary.” In deciding on whether or not a security is other than temporarily impaired, the Company considers several factors, including the nature of the investment, communications (if any) from the trustees of securitizations regarding the credit quality of the security, the severity and duration of the impairment, the cause of the impairment, and the Company’s intent that it is more likely than not that the Company can hold the security until recovery of its cost basis.  The Company’s prepayment speed estimate is the primary assumption used to determine other-than temporary-impairments for Agency IOs and IIOs, including Agency IOs and IIOs accounted for as derivatives, for the three and six months ended June 30, 2013 and for the period from May 15, 2012 (commencement of operations) through June 30, 2012. The Company recorded other than temporary impairments for the three and six months ended June 30, 2013 of approximately $3.5 million and $5.8 million, respectively and $87 thousand for the period from May 15, 2012 (commencement of operations) through June 30, 2012 for Agency IOs, Agency IIOs and 20-year Agency RMBS which is reported as Other loss on Residential mortgage-backed securities in the Company’s Statement of Operations.

 

For Non-Agency RMBS that are purchased at a discount to par value and are rated below AA at the time of purchase and Agency Interest-Only Strips that are not classified as derivatives, an other-than-temporary impairment is deemed to have occurred when there is an adverse change in the expected cash flows (principal or interest) to be received and the fair value of the beneficial interest is less than its carrying amount. These adjustments are reflected in the Company’s Statement of Operations as Other loss on Residential mortgage-backed securities. In determining whether an adverse change in cash flows occurred, the present value of the remaining cash flows, as estimated at the initial transaction date (or the last date previously revised), is compared to the present value of the expected cash flows at the current reporting date.  The estimated cash flows reflect those a “market participant” would use and are discounted at a rate equal to the current yield used to accrete interest income. If an other-than-temporary impairment is recognized as a result of this analysis, the yield is maintained at the current accretion rate. The last revised estimated cash flows are then used for future impairment analysis purposes.  The Company recorded no other than temporary impairments for the three and six months ended June 30, 2013 and for the period from May 15, 2012 (commencement of operations) through June 30, 2012 for Non-Agency RMBS.

 

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