Edgar Filing: DYNEX CAPITAL INC

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

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

For the fiscal year ended December 31, 2009

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 1-9819

DYNEX CAPITAL, INC.

(Exact name of registrant as specified in its charter)

Virginia	52-1549373
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)

4991 Lake Brook Drive, Suite 100, Glen Allen, Virginia	23060
(Address of principal executive offices)	(Zip Code)

(804) 217-5800 (Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:
Title of each class	Name of each exchange on which registered
Common Stock, $.01 par value	New York Stock Exchange
Series D 9.50% Cumulative Convertible Preferred Stock, $.01 par value	New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes o No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.

Yes o No þ

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 þ 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 o No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.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):

Large accelerated filer	o	Accelerated filer	þ
Non-accelerated filer	o (Do not check if a smaller reporting company)	Smaller reporting company	o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes o No þ

As of June 30, 2009, the aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $90,065,635 based on the closing sales price on the New York Stock Exchange of $8.20.

Common stock outstanding as of March 1, 2010 was 14,182,912 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Definitive Proxy Statement for the registrant’s 2010 annual meeting of shareholders, expected to be filed pursuant to Regulation 14A within 120 days from December 31, 2009, are incorporated by reference into Part III.

TABLE OF CONTENTS

			Page Number
PART I.
	Item 1.	Business	1
	Item 1A.	Risk Factors	7
	Item 1B.	Unresolved Staff Comments	23
	Item 2.	Properties	23
	Item 3.	Legal Proceedings	23
	Item 4.	Reserved	24

PART II.
	Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	25
	Item 6.	Selected Financial Data	27
	Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
	Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	54
	Item 8.	Financial Statements and Supplementary Data	61
	Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	61
	Item 9A.	Controls and Procedures	61
	Item 9B.	Other Information	62

PART III.	Item 10.	Directors, Executive Officers and Corporate Governance	63
	Item 11.	Executive Compensation	63
	Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	63
	Item 13.	Certain Relationships and Related Transactions, and Director Independence	63
	Item 14.	Principal Accountant Fees and Services	64

PART IV.	Item 15.	Exhibits, Financial Statement Schedules	65

SIGNATURES			68

CAUTIONARY STATEMENT – This Annual Report on Form 10-K may contain “forward-looking” statements within the meaning of Section 27A of the Securities Act of 1933, as amended (or “1933 Act”), and Section 21E of the Securities Exchange Act of 1934, as amended. We caution that any such forward-looking statements made by us are not guarantees of future performance, and actual results may differ materially from those in such forward-looking statements. Some of the factors that could cause actual results to differ materially from estimates contained in our forward-looking statements are set forth in this Annual Report on Form 10-K for the year ended December 31, 2009. See Item 1A, “Risk Factors” as well as “Forward-Looking Statements” set forth in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10-K.

In this Annual Report on Form 10-K, we refer to Dynex Capital, Inc. and its subsidiaries as “we,” “us,” or “our,” unless we specifically state otherwise or the context indicates otherwise. The following defines certain commonly used terms in this Annual Report on Form 10-K: MBS refers to mortgage-backed securities; CMBS refers to commercial mortgage-backed securities; RMBS refers to residential mortgage-backed securities; Agency MBS refers to our MBS that are issued or guaranteed by a federally chartered corporation, such as Fannie Mae or Freddie Mac, or an agency of the U.S. government, such as Ginnie Mae; Hybrid ARMs refers to ARMs that have interest rates that are fixed for a specified period of time and, thereafter, adjust generally annually to an increment over a specified interest rate index; ARMs refers to adjustable-rate mortgage loans which typically have interest rates that adjust annually to an increment over a specified interest rate index, and includes Hybrid ARMs that are within twelve months of their initial reset date; and ARM MBS refers to MBS that are secured by ARMs. The date that the interest rate on an ARM adjusts based on the terms of that respective security is known as the reset date.

PART I

ITEM 1.

BUSINESS

We are a real estate investment trust, or REIT, which invests in mortgage securities and loans on a leveraged basis. We were incorporated in Virginia on December 18, 1987 and commenced operations in February 1988.

We invest in mortgage-backed securities (“MBS”) issued or guaranteed by a federally chartered corporation, such as Federal National Mortgage Corporation (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”), or an agency of the U.S. government, such as Government National Mortgage Association (“Ginnie Mae”). MBS issued or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae are commonly referred to as “Agency MBS”. We initiated our Agency MBS strategy during the first quarter of 2008, and it has remained our primary investment strategy throughout 2009.

We also invest in commercial mortgage-backed securities (“CMBS”) and non-Agency residential mortgage-backed securities, (collectively, “non-Agency securities”) as well as securitized residential and commercial mortgage loans. Substantially all of these securities and loans consist of, or are secured by, first lien mortgages which were originated by us from 1992 to 1998. We are no longer originating loans.

We have generally financed our investments through a combination of repurchase agreements, securitization financing, and equity capital. We employ leverage in order to increase the overall yield on our invested capital. Our primary source of income is net interest income, which is the excess of the interest income earned on our investments over the cost of financing these investments. Although our intention is generally to hold our investments on a long-term basis, we may occasionally sell investments prior to their maturity.

As a REIT, we are required to distribute to our shareholders as dividends on our preferred and common stock at least 90% of our taxable income, which is our income as calculated for income tax purposes after consideration of our tax net operating loss carryforwards (“NOLs”). We had an NOL carryforward of approximately $156.7 million as of December 31, 2008. We anticipate utilizing approximately $7.5 million of the NOL carryforward to offset our 2009 taxable income, but this amount is subject to change as we complete our 2009 tax return. These NOLs do not begin to meaningfully expire until

2019. Provided that we do not experience an ownership shift as defined under Section 382 of the Internal Revenue Code (“Code”), we may utilize the NOLs to offset portions of our distribution requirements for our REIT taxable income with certain limitations. If we do incur an ownership shift under Section 382 of the Code, then the use of the NOLs to offset REIT distribution requirements may be limited. We also have a taxable REIT subsidiary which has a NOL carryforward of approximately $4.2 million as of December 31, 2008. For further discussion, see “Federal Income Tax Considerations.”

Investment Strategy

Our investment strategy contemplates the allocation of our capital in investments that in our view have attractive risk-adjusted return profiles. Because we use leverage to enhance the returns on our invested capital, we must evaluate the attractiveness and risk of any investment based on the actual amount of the investment and the amount of equity capital (i.e., investment less leverage) allocated to each investment. Our strategy for the last several years has included the investment in short-duration, high-grade Agency MBS with less exposure to credit risk, interest rate risk, and liquidity risk (i.e., the risk that the security cannot be leveraged). In 2009, we also began investing in CMBS rated ‘AAA’ by at least one of the nationally recognized rating services. During 2009, we increased our portfolio of Agency MBS by $282.5 million and our portfolio of non-Agency securities by $102.9 million primarily related to our acquisition of ‘AAA’ rated CMBS with a fair value of $99.1 million as of December 31, 2009.

We have invested our capital primarily in Agency MBS because of the attractive risk-adjusted return profile of that strategy. We expect to continue primarily investing in shorter-duration, high grade securities such as Agency MBS and ‘AAA’-rated CMBS and RMBS for the foreseeable future depending on the nature and risks of the investment, its expected return, and future economic and market conditions.

With respect to our investment in Agency MBS, we invest in Hybrid Agency ARMs and Agency ARMs and, to a lesser extent, fixed-rate Agency MBS. Hybrid Agency ARMs are MBS collateralized by hybrid adjustable mortgage loans, which have a fixed-rate of interest for a specified period (typically three to ten years) and which then reset their interest rates at least annually to an increment over a specified interest rate index. Hybrid Agency ARMs that are within twelve months of the end of their fixed-rate periods may be classified within Agency ARMs. Agency ARMs are MBS collateralized by adjustable rate mortgage loans which have interest rates that generally will adjust at least annually to an increment over a specified interest rate index. As of December 31, 2009, our Agency MBS were collateralized by approximately $295.7 million in Hybrid Agency ARMs, $298.3 million in Agency ARMs, and $0.1 million in fixed rate MBS.

Interest rates on the ARM loans collateralizing the Hybrid Agency ARMs and Agency ARMs are based on specific index rates, such as the one-year constant maturity treasury (“CMT”) rate, the London Interbank Offered Rate (“LIBOR”), the Federal Reserve U.S. 12-month cumulative average one-year CMT (“MTA”), or the 11th District Cost of Funds Index (“COFI”). These mortgage loans will typically have interim and lifetime caps on interest rate adjustments, or interest rate caps, limiting the amount that the rates on these loans may reset in any given period.

With respect to our remaining investments, we currently have $109.1 million in non-Agency securities, $150.4 million in securitized commercial mortgage loans, $62.1 million in securitized single-family residential mortgage loans, and $2.1 million in unsecuritized mortgage loans. Of the non-Agency securities, $103.2 million are CMBS and $99.1 million of those are rated ‘AAA’. The commercial mortgage loans and non-Agency securities generally carry a fixed rate of interest. The single-family mortgage loans are predominantly variable rate based primarily on a spread to six month LIBOR.

Financing Strategy

As noted above, we use leverage to enhance the returns of our investments. Currently, we use a combination of repurchase agreements and securitizations to finance our investments. In addition, we have recently received approval to participate in the Term Asset-Backed Securities Loan Facility (“TALF”) program offered by the Federal Reserve Bank of New York. This program is discussed further in the “Non-Agency securities” section below. We may occasionally hedge our borrowing costs by entering into derivative instruments such as interest rate caps and interest rate swaps. Below is a discussion of our financing strategy for our different investments.

Agency MBS

We finance our Agency MBS by borrowing against a substantial portion of the market value of these assets utilizing repurchase agreements. Repurchase agreements are financings under which we pledge our Agency MBS as collateral to secure loans made by the repurchase agreement counterparty (i.e., the lender). The amount borrowed under a repurchase agreement is usually limited by the lender to a percentage of the estimated market value of the pledged collateral, which is normally up to 95% for Agency MBS. The difference between the market value of the pledged Agency MBS collateral and the amount of the repurchase agreement is the amount of equity we have in the position and is intended to provide the lender some protection against fluctuations of value in the collateral and/or the failure by us to repay the borrowing.

Under repurchase agreement arrangements, a lender may require that we pledge additional assets by initiating a margin call if the fair value of our pledged collateral declines below a required margin amount specified within the terms of the particular repurchase agreement. Our pledged collateral fluctuates in value primarily due to principal payments and changes in market interest rates and spreads, prevailing market yields, actual or anticipated prepayment speeds and other market conditions. Lenders may also initiate margin calls during periods of market stress. If we fail to meet any margin call, our lenders have the right to terminate the repurchase agreement and sell the collateral pledged. We will set aside securities and/or cash in order to lower our overall debt to equity ratio and to maintain financial flexibility to meet margin calls from our lenders.

With respect to financing our Agency MBS, we expect to maintain an effective debt to equity capital ratio of between five and nine times our equity capital invested in Agency MBS, although the ratio may vary from time to time depending upon market conditions and other factors.

Non-Agency Securities

We generally finance our ‘AAA’-rated non-Agency securities by borrowing against a portion of the market value of these assets utilizing repurchase agreements. We are not currently borrowing against non-Agency securities that are rated below ‘AAA’.

Like Agency MBS, the amount borrowed under a repurchase agreement for non-Agency securities is limited by the lender to a certain percentage of the estimated market value of the pledged collateral, which is normally up to 85% for non-Agency securities. Similar to Agency MBS, we are subject to margin calls by lenders, and if we fail to meet any margin call, our lenders have the right to terminate the repurchase agreement and sell the collateral pledged. We will set aside securities and/or cash in order to lower our overall debt to equity ratio and to maintain financial flexibility to meet margin calls from our lenders. With respect to financing our non-Agency securities, we expect to maintain an effective debt to equity capital ratio of between two and five times our equity capital invested in non-Agency securities, although the ratio may vary from time to time depending upon market conditions and other factors.

Repurchase agreement borrowings generally will have a term of between one and three months and carry a rate of interest based on a spread to an index, such as LIBOR. In prior years, repurchase agreement terms for certain collateral could be as long as one year, though such terms are less common in the marketplace today. Repurchase agreement financing is provided principally by major financial institutions and major broker-dealers. A significant source of liquidity for the repurchase agreement market is money market funds which provide collateral-based lending to the financial institutions and broker-dealer community that, in turn, is provided to the repurchase agreement market. In order to reduce our exposure to counterparty related risk, we generally seek to diversify our exposure by entering into repurchase agreements with multiple lenders. Together with Agency MBS, our maximum net exposure, which is defined as the difference between the amount loaned to us plus accrued interest payable and the value of the securities pledged by us as collateral plus accrued interest receivable, to any single repurchase agreement lender was $18.0 million as of December 31, 2009.

In June 2009, the New York Federal Reserve began accepting certain ‘AAA’ rated CMBS as eligible collateral for financing under its TALF program. The financing is on a non-recourse basis for periods ranging from three to five years. This program will only be offered for a limited time as the financing of existing CMBS under TALF is set to expire in March 2010 and the financing of newly issued CMBS under TALF is set to expire in June 2010. As of February 28, 2010, we have purchased $15.0 million in non-Agency CMBS of which $12.8 million is being financed under the TALF program. We anticipate using additional financing under the TALF program for certain of our future CMBS investments.

In the future, we may use other sources of funding in addition to repurchase agreements and TALF borrowings to finance our Agency MBS and non-Agency portfolios including, but not limited to, other types of collateralized borrowings such as loan agreements, lines of credit, commercial paper, or the issuance of equity or debt securities.

Securitized Mortgage Loans

We have financed our securitized mortgage loans with securitization financing issued by us to third parties. Through limited-purpose finance subsidiaries the Company has issued non-recourse bonds pursuant to indentures which are collateralized by the mortgage loans. Each series of securitization financing may consist of various classes of bonds at either fixed or variable rates of interest and having varying repayment terms. Payments received on securitized mortgage loans and reinvestment income earned thereon is used to make payments on the securitization financing bonds. As of December 31, 2009, we had approximately $119.7 million of securitization financing which carried a fixed-rate of interest and approximately $23.4 million which carried a variable-rate of interest which resets monthly based on a spread to LIBOR.

The obligations under securitization financing are payable solely from the cash flows generated by the securitized mortgage loans collateralizing the financing and are otherwise non-recourse to the Company. The stated maturity date for each class of bonds is generally calculated based on the final scheduled payment date of the underlying collateral. The actual maturity of each class will be directly affected by the rate of principal prepayments on the related collateral. Generally we will have the right to redeem the securitization financing at its outstanding principal balance plus accrued interest after a certain date or once the securitization financing is paid down to a certain percentage of its original principal balance. As a result, the actual maturity of any class of a series of securitization financing may occur earlier than its stated maturity.

Hedging Activities

We have and will continue to use derivative instruments to hedge our exposure to changes in interest rates. For example, during a period of rising interest rates, we may be exposed to reductions in our net interest income because interest rates on our investments may not reset as frequently as the interest rates on our repurchase agreement and securitization financing borrowings, or if we have financed fixed rate assets with floating rate borrowings. In an effort to protect our net interest income during a period of rising interest rates, we may enter into certain hedging transactions including entering into interest rate swap agreements and interest rate cap agreements.

An interest rate swap agreement allows us to fix the borrowing cost on a portion of our repurchase agreement or securitization financing for a specified period of time. Typically in an interest rate swap transaction, we will pay an agreed upon fixed rate of interest determined at the time of entering into the agreement for a period typically between two and five years while receiving interest based on a floating rate such as LIBOR. An interest rate cap agreement is a contract whereby we, as the purchaser, pay a fee in exchange for the right to receive payments equal to the principal (i.e., notional amount) times the difference between a specified interest rate and a future interest rate (typically LIBOR) during a defined “active” period of time. During the fourth quarter of 2009, we entered into three interest rate swap agreements which are discussed further in Item 7, “Management’s Discussion and Analysis of Financial Condition” and in Note 11 to the consolidated financial statements. As of December 31, 2009, we had $105 million in interest rate swaps with a weighted average fixed rate of interest of 1.67%. We have not entered into any interest rate cap agreements as of December 31, 2009.

In addition, in a period of rising rates we may experience a decline in the carrying value of our Agency MBS and non-Agency securities, which will impact our shareholders’ equity and common book value per share. As a result, we may also utilize derivative financial instruments such as interest rate swap and interest rate cap agreements in an effort to protect our book value.

Competition

The financial services industry is a highly competitive market in which we compete with a number of institutions with greater financial resources. In purchasing portfolio investments, we compete with other mortgage REITs, investment banking firms, savings and loan associations, commercial banks, hedge funds, mortgage bankers, insurance companies, federal agencies and other entities, many of which have much greater financial resources and a lower cost of capital than we do. Increased competition in the market may drive prices of investments to unacceptable levels for the Company and could adversely impact our ability to borrow under repurchase agreements.

Government Policy

The volatility experienced in the credit markets over the last several years resulted in extraordinary and often coordinated measures by global central banks and governments to restore liquidity to the credit markets. Some of these activities included participation in markets by central banks and governments in which they would not normally participate. For example, among other programs, the U.S. Treasury Department (“Treasury”) and the Federal Reserve initiated programs to purchase Agency MBS in the open market pursuant to a congressional authority. These programs expire as of December 31, 2009 and in March 2010, respectively. Through February 16, 2010, the Treasury and Federal Reserve have purchased a combined total of $1.4 trillion in Agency MBS, which is comprised mostly of 30-year and 15-year fixed rate mortgages. The Treasury and Federal Reserve purchases of Agency MBS have resulted in increased prices of all Agency MBS, including Hybrid ARMs and ARMs, which has resulted in an increased market value of our portfolio of Agency MBS. In addition, the New York Federal Reserve has initiated the TALF financing program for certain types of securities as discussed above. Active participation by governmental entities in the private markets has resulted in generally more liquid and less volatile markets, while causing asset prices to increase and yields to decrease correspondingly.

Over time as the credit markets function more normally, the Treasury and the Federal Reserve will likely withdraw from participating in or providing liquidity to the private markets. However, until that time, government participation in private markets will continue to impact supply, values, and the liquidity of these markets. The impact on the markets of the withdrawal of governmental entities is uncertain and market reactions to such withdrawal could be severe.

FEDERAL INCOME TAX CONSIDERATIONS

As a REIT, we are required to abide by certain requirements for qualification as a REIT under the Code. The REIT rules generally require that a REIT invest primarily in real estate-related assets, that our activities be passive rather than active and that we distribute annually to our shareholders substantially all of our taxable income, after certain deductions, including deductions for NOL carryforwards. We could be subject to income tax if we failed to satisfy those requirements. We use the calendar year for both tax and financial reporting purposes.

There may be differences between taxable income and income computed in accordance with U.S. generally accepted accounting principles (“GAAP”). These differences primarily arise from timing differences in the recognition of revenue and expense for tax and GAAP purposes. We had NOL carryforwards of approximately $156.7 million as of December 31, 2008, which expire principally between 2019 and 2020. We anticipate utilizing $7.5 million of the NOL carryforward to offset our 2009 taxable income, but this amount is subject to change as we complete our 2009 tax return.

Failure to satisfy certain Code requirements could cause us to lose our status as a REIT. If we failed to qualify as a REIT for any taxable year, we may be subject to federal income tax (including any applicable alternative minimum tax) at regular corporate rates and would not receive deductions for dividends paid to shareholders. We could, however, utilize our NOL carryforwards to offset any taxable income. In addition, given the size of our NOL carryforwards, we could pursue a business plan in the future in which we would voluntarily forego our REIT status. If we lost or otherwise surrendered our status as a REIT, we could not elect REIT status again for five years. Several of our investments in securitized mortgage loans have ownership restrictions limiting their ownership to REITs. Therefore, if we chose to forego our REIT status, we would have to sell these investments or otherwise provide for REIT ownership of these investments. In addition, many of our repurchase agreement lenders require us to maintain our REIT status. If we lost our REIT status these lenders have the right to terminate any repurchase agreement borrowings at that time.

We also have a taxable REIT subsidiary (“TRS”), which had a NOL carryforward of approximately $4.2 million as of December 31, 2008. As we have not yet completed our 2009 tax return, we do not know the balance of this NOL carryforward as of December 31, 2009. The TRS has limited operations, and, accordingly, we have established a full valuation allowance for the related deferred tax asset.

Qualification as a REIT

Qualification as a REIT requires that we satisfy a variety of tests relating to our income, assets, distributions and ownership. The significant tests are summarized below.

Sources of Income. To continue qualifying as a REIT, we must satisfy two distinct tests with respect to the sources of our income: the “75% income test” and the “95% income test.” The 75% income test requires that we derive at least 75% of our gross income (excluding gross income from prohibited transactions) from certain real estate-related sources. In order to satisfy the 95% income test, 95% of our gross income for the taxable year must consist of either income that qualifies under the 75% income test or certain other types of passive income.

If we fail to meet either the 75% income test or the 95% income test, or both, in a taxable year, we might nonetheless continue to qualify as a REIT, if our failure was due to reasonable cause and not willful neglect and the nature and amounts of our items of gross income were properly disclosed to the Internal Revenue Service. However, in such a case we would be required to pay a tax equal to 100% of any excess non-qualifying income.

Nature and Diversification of Assets. At the end of each calendar quarter, we must meet multiple asset tests. Under the “75% asset test”, at least 75% of the value of our total assets must represent cash or cash items (including receivables), government securities or real estate assets. Under the “10% asset test,” we may not own more than 10% of the outstanding voting power or value of securities of any single non-governmental issuer, provided such securities do not qualify under the 75% asset test or relate to taxable REIT subsidiaries. Under the “5% asset test,” ownership of any stocks or securities that do not qualify under the 75% asset test must be limited, in respect of any single non-governmental issuer, to an amount not greater than 5% of the value of our total assets (excluding ownership of any taxable REIT subsidiaries).

If we inadvertently fail to satisfy one or more of the asset tests at the end of a calendar quarter, such failure would not cause us to lose our REIT status, provided that (i) we satisfied all of the asset tests at the close of the preceding calendar quarter and (ii) the discrepancy between the values of our assets and the standards imposed by the asset tests either did not exist immediately after the acquisition of any particular asset or was not wholly or partially caused by such an acquisition. If the condition described in clause (ii) of the preceding sentence was not satisfied, we still could avoid disqualification by eliminating any discrepancy within 30 days after the close of the calendar quarter in which it arose.

Ownership. In order to maintain our REIT status, we must not be deemed to be closely held and must have more than 100 shareholders. The closely held prohibition requires that not more than 50% of the value of our outstanding shares be owned by five or fewer persons at anytime during the last half of our taxable year. The more than 100 shareholders rule requires that we have at least 100 shareholders for 335 days of a twelve-month taxable year. In the event that we failed to satisfy the ownership requirements we would be subject to fines and be required to take curative action to meet the ownership requirements in order to maintain our REIT status.

EMPLOYEES

As of December 31, 2009, we had 13 employees and one corporate office in Glen Allen, Virginia. We believe our relationship with our employees is good. None of our employees are covered by any collective bargaining agreements, and we are not aware of any union organizing activity relating to our employees.

Executive Officers of the Registrant

Name (Age)	Current Title	Business Experience
Thomas B. Akin (58)	Chairman of the Board and Chief Executive Officer	Chief Executive Officer since February 2008; Chairman of the Board since 2003; managing general partner of Talkot Capital, LLC since 1995.
Stephen J. Benedetti (47)	Executive Vice President, Chief Operating Officer and Chief Financial Officer	Executive Vice President and Chief Operating Officer since November 2005; Executive Vice President and Chief Financial Officer from September 2001 to November 2005 and beginning again in February 2008.
Byron L. Boston (51)	Chief Investment Officer	Chief Investment Officer since April 2008; President of Boston Consulting Group from November 2006 to April 2008; Vice Chairman and Executive Vice President of Sunset Financial Resources, Inc. from January 2004 to October 2006.

AVAILABLE INFORMATION

We are subject to the reporting requirements of the Securities Act of 1934 (“Exchange Act”), as amended, and its rules and regulations. The Exchange Act requires us to file reports, proxy statements, and other information with the SEC. Copies of these reports, proxy statements, and other information can be read and copied at:

SEC Public Reference Room

100 F Street, N.E.

Washington, D.C. 20549

Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy statements, and other information regarding issuers that file electronically with the SEC. These materials may be obtained electronically by accessing the SEC’s home page at http://www.sec.gov.

Our website can be found at www.dynexcapital.com. Our annual reports on Form 10-K, our quarterly reports on Form 10-Q and our current reports on Form 8-K, and amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, are made available free of charge through our website as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission (“SEC”).

We have adopted a Code of Business Conduct and Ethics (“Code of Conduct”) that applies to all of our employees, officers and directors. Our Code of Conduct is also available free of charge on our website, along with our Audit Committee Charter, our Nominating and Corporate Governance Committee Charter, and our Compensation Committee Charter. We will post on our website amendments to the Code of Conduct or waivers from its provisions, if any, which are applicable to any of our directors or executive officers in accordance with SEC or NYSE requirements.

ITEM 1A.

RISK FACTORS

Our business is subject to various risks, including those described below. Our business, operating results, and financial condition could be materially and adversely affected by any of these risks. Please note that additional risks not presently known to us or that we currently deem immaterial could also impair our business, operating results, and financial condition.

	Page Number
Risks Related to Access to Credit Markets	7
Risks Related to Our Business	8
Risks Related to Regulatory and Legal Requirements	19
Risks Related to Owning Our Stock	21

Risks Related to Access to Credit Markets

The success of our business is predicated on our access to the credit markets. Failure to access credit markets on reasonable terms, or at all, could adversely affect our profitability and may, in turn, negatively affect the market price of shares of our common stock.

The credit markets have in recent years experienced extreme volatility, resulting in diminished financing capacity for mortgage investments. We depend upon the availability of adequate funding for our operations. Our access to capital depends upon a number of factors, over which we have little or no control, including:

-	General market and economic conditions;

-	The actual or perceived financial condition of credit market participants including banks, broker-dealers, hedge funds, and money-market funds, among others;

-	The impact of governmental policies and/or regulations on institutions with respect to activities in the credit markets;

-	Market perception of asset quality and liquidity of securities in which we invest; and

-	Market perception of our financial strength, our growth potential and the quality of our assets.

The recent volatility in the credit markets has demonstrated that general market conditions and the perceived effect on market participants can severely restrict the flow of capital to the credit markets. In recent years, volatility in the credit markets significantly impacted many participants in these markets resulting in a meaningful reduction in the amount of liquidity available for participants. When such an event occurs, lenders may be unwilling or unable to provide financing for our investments or may be willing to provide financing only at much higher rates. This may impact our profitability by increasing our borrowing costs or by forcing us to sell assets.

In addition, the impairment of other financial institutions could negatively affect us. If one or more major market participants fails or otherwise experience a major liquidity crisis, as was the case for Lehman Brothers Holdings Inc. in September 2008, it could adversely affect the marketability of all fixed income securities and this could negatively impact the value of the securities we acquire, thus reducing our shareholders’ equity and book value. Furthermore, if any of our potential lenders or any of our lenders are unwilling or unable to provide us with financing, we could be forced to sell our securities at time when prices are depressed or when we are under duress.

In addition, there is uncertainty as to governmental policies and/or regulations with respect to participants in the credit markets. Much of the liquidity for the credit markets comes from money funds whose size and liquidity have been impacted by the recent low interest rate environment. The Treasury has terminated its purchases of Agency MBS, which totaled approximately $220 billion as of December 31, 2009. As of February 16, 2010, the Federal Reserve has purchased approximately $1.2 trillion in Agency MBS and will continue its purchases through March 2010. The Federal Reserve has also indicated that at some point in the future it will conduct reverse repurchase operations in order to remove excess liquidity from the markets. While the Federal Reserve is unlikely to conduct such operations until the markets have fully stabilized, such an event could constrain credit markets in the future.

Risks Related to Our Business

We invest in securities where the timely receipt of principal and interest is guaranteed by Fannie Mae and Freddie Mac. Both Fannie Mae and Freddie Mac are currently under federal conservatorship and the Treasury has committed to purchasing preferred stock from each of these entities in order to ensure their adequate capitalization. Efforts made to stabilize Fannie Mae and Freddie Mac may prove unsuccessful, which may impact their ability to perform under the guaranty. If Fannie Mae and Freddie Mac are unable to perform on their guaranty, we are likely to incur losses on our investments in Agency MBS.

The payments we receive on the Agency MBS in which we invest depend upon payments on the mortgages underlying the MBS which are guaranteed by Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are U.S. Government-sponsored entities, but their guarantees are not explicitly backed by the full faith and credit of the United States. Fannie Mae and Freddie Mac have reported substantial losses in recent years and a need for substantial amounts of additional capital. Such losses are due to these entities’ business model being tied extensively to the U.S. housing market which is in a severe contraction. In response to the deteriorating financial condition of Fannie Mae and Freddie Mac, Congress and the Treasury have undertaken a series of actions to stabilize these entities including the creation of the Federal Housing Finance Agency, or FHFA, to enhance regulatory oversight over Fannie Mae and Freddie Mac. FHFA has placed Fannie Mae and Freddie Mac into federal conservatorship.

In order to provide additional capital and to support the debt obligations issued by Fannie Mae and Freddie Mac, the Treasury and FHFA have entered into preferred stock purchase agreements between the Treasury and Fannie Mae and Freddie Mac, pursuant to which the Treasury will ensure that each of Fannie Mae and Freddie Mac maintains a positive net worth. Under this initiative, the Treasury has purchased or has committed to purchasing an unlimited amount of preferred stock of both Fannie Mae and Freddie Mac in order to ensure their solvency. The Treasury also has established a new secured lending credit facility available to Fannie Mae and Freddie Mac until December 2010 which is intended to serve as a liquidity backstop.

Although the federal government has committed capital to Fannie Mae and Freddie Mac, there is no explicit guaranty of the obligations of these entities by the federal government, and there can be no assurance that these credit facilities and other capital infusions will be adequate for their needs or that the Treasury will not alter its support in the future. If the financial support is inadequate, these companies could continue to suffer losses and could fail to honor their guarantees of payment on Agency MBS in which we invest. In such a case we are likely to experience losses on our Agency MBS.

The federal conservatorship of Fannie Mae and Freddie Mac may lead to structural changes in Agency MBS and/or Fannie Mae and Freddie Mac which may adversely affect our business.

As noted above, Fannie Mae and Freddie Mac are both under conservatorship and the Treasury has committed to purchasing preferred stock of each of these entities to support their capitalization. The poor financial condition of these entities and their reliance on the Treasury for capital could alter or limit their future participation in the mortgage markets. The outcome of the conservatorship of Fannie Mae and Freddie Mac is uncertain and could result in their liquidation, the combining of the two entities into one, or the consolidation of these entities with a government entity such as Ginnie Mae. Any of these events could result in a meaningful change in the nature of their guarantees and the Agency MBS market. The supply of new issue Agency MBS could be reduced or eliminated which would substantially impact a major component of our business model. While existing Agency MBS may not be impacted, it is uncertain whether such actions with respect to Fannie Mae and Freddie Mac will cause volatility in the pricing of Agency MBS. A reduction in the supply of Agency MBS could also increase the pricing of Agency securities we seek to acquire, thereby reducing the spread between the interest we earn on our investments and our cost of financing those investments.

Attempts to stabilize the housing and mortgage market have resulted in the Treasury and Federal Reserve buying fixed-rate Agency MBS in an effort to lower overall mortgage rates. During 2009, the Treasury and Federal Reserve purchased approximately $1.3 trillion in Agency MBS, or 81%, of the estimated $1.6 trillion of Agency MBS issued during 2009. When the Treasury and Federal Reserve discontinue their purchases of Agency MBS, this may result in an increase in mortgage rates and substantial volatility in Agency MBS prices.

In an effort to support the U.S. housing market, the Treasury and Federal Reserve have become substantial buyers of Agency MBS. While they have not purchased Hybrid Agency ARMs or Agency ARMs, their purchases of fixed rate Agency MBS have caused all Agency MBS to increase in price. The Treasury announced it has discontinued its purchases of Agency MBS as of December 31, 2009 while the Federal Reserve has announced it will discontinue its purchases of Agency MBS in March 2010. While the ultimate impact is unknown, the withdrawal of the Treasury and Federal Reserve from purchasing Agency MBS may cause prices of all Agency MBS to decline which would cause our shareholders’ equity to decline and may result in margin calls by our lenders for Agency MBS that are pledged as collateral for repurchase agreements. If declines in prices are substantial, this may force us to sell assets at a loss or at an otherwise inopportune time in order to meet margin calls or repay lenders.

Mortgage loan modification programs and future legislative action may adversely affect the value of and the return on the single-family loans and securities in which we invest.

The U.S. Government, through the Federal Housing Authority and the Federal Deposit Insurance Corporation, has implemented programs designed to provide homeowners who are delinquent on their mortgage loans with alternatives to a lender-initiated foreclosure on their home. These programs may involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans or the rate of interest payable on the loan or to extend the payment terms of the loans. In addition, the U.S. Congress has indicated support for additional legislative relief for homeowners at the expense of lender’s rights, including an amendment of the bankruptcy laws to permit the modification of mortgage loans in bankruptcy proceedings. Loan modifications such as these may cause the fair value of some of our investments to decline. A decrease in the fair value of our investments that are pledged as collateral for repurchase agreements may result in margin calls by our lenders, which will negatively impact our liquidity. We may be forced to sell assets at a loss or at a lower than expected return in order to meet margin calls or repay lenders.

Changes in prepayment rates on the mortgage loans underlying our investments may adversely affect our profitability and subject us to reinvestment risk.

Our investments subject us to prepayment risk to the extent that we own these investments at premiums or discounts to their par value. Prepayments by borrowers of principal on the loans underlying our investments impact the amortization of premiums and discounts under the effective yield method of accounting in accordance with GAAP. Under the effective yield method of accounting, we recognize yields on our assets based on assumptions regarding future cash flows. Variations in actual cash flows from those assumed as a result of prepayments and subsequent changes in future cash flow expectations will cause adjustments in yields on assets which could contribute to volatility in our future results. For example, if we own our investments at premiums to their par value, such as our Agency MBS and CMBS, actual prepayments experienced in excess of forecasts as well as increased future prepayments, will cause us to amortize these premiums on an accelerated basis which may adversely affect our profitability. We use a third-party prepayment modeling servicer to help us estimate future prepayments on our investments.

Prepayments occur on both a voluntary or involuntary basis. Voluntary prepayments tend to increase when interest rates are declining or, in the case of Hybrid ARMs or ARMs, based on the shape of the yield curve as discussed further below. However, the actual level of prepayments will be impacted by economic and market conditions, including loan-to-value and income documentation requirements. Involuntary prepayments tend to increase when the yield curve is steep, evidencing economic stress and increasing delinquencies on the underlying loans.

If we receive increased prepayments of our principal in a declining interest rate environment, we may earn a lower return on our new investments as compared to the MBS that prepay given the declining interest rate environment. If we reinvest our capital in lower yielding investments, we will likely have lower net interest income and reduced profitability unless the cost of financing these investments declines faster than the rate at which we may reinvest.

Fannie Mae and Freddie Mac have recently announced a change in their policy of purchasing delinquent loans included in Agency MBS pools, which could increase prepayment rates on Agency MBS we currently own.

Under current policies, Fannie Mae and Freddie Mac are obligated to buy out seriously delinquent loans from an Agency MBS pool if the loan has been seriously delinquent for 24 months, if the loan has been permanently modified, or if a foreclosure or short sale has occurred on the property. Otherwise, Fannie Mae and Freddie Mac have the right, but not the obligation, to buy out delinquent loans in Agency MBS pools before the 24 month period. Fannie Mae and Freddie Mac have an obligation to advance principal and interest on delinquent loans to the holders of the Agency MBS if such loans have not been bought out of the Agency MBS pool. In the past, despite the requirement to continue to advance principal and interest, Fannie Mae and Freddie Mac have not exercised their right to actively buy out delinquent loans from Agency MBS pools because such buy-outs required an immediate write-down in the balance of the loans in their GAAP financial statements (and therefore a capital charge). However, recent changes in GAAP which become effective as of January 1, 2010 will result in Fannie Mae and Freddie Mac having to consolidate all loans guaranteed by them in their financial statements and provide loss reserves on delinquent loans versus writing them down to liquidation value.

On February 10, 2010, primarily as a result of the change in GAAP, Fannie Mae and Freddie Mac announced their intentions to buy out delinquent loans that are currently past due 120 days or more from Agency MBS pools. Freddie Mac is expected to complete its buy-outs in February 2010 and Fannie Mae is expected to have completed its buy-outs over a three month period beginning in March 2010. Neither Freddie Mac nor Fannie Mae has provided sufficient information to determine the ultimate impact of the buy-outs on our Agency MBS. We believe, however, that some of our Agency MBS will be affected and that we will see an increase in prepayments in those pools over the next several months. Given the dollar price at which we own the Agency MBS and since we record premium amortization under GAAP based on actual and anticipated prepayment activity, we expect to see some increase in premium amortization for the first half of 2010 relative to the last two quarters of 2009 where our premium amortization has averaged approximately $0.9 million per quarter. Any increase in premium amortization could adversely affect our results of operations. We expect Fannie Mae and Freddie Mac will continue buying out any additional loans that become 120 days or more delinquent from Agency MBS pools for the foreseeable future; however, we do not anticipate that subsequent buy-outs will have as significant of an impact on our prepayments because the population of delinquent loans 120 days or more past due will not be as large as the initial population.

A flat or inverted yield curve may adversely affect prepayment rates and supply of Hybrid ARMs and ARMs.

When the differential between short-term and long-term benchmark interest rates narrows, the yield curve is said to be “flattening.” When short-term interest rates increase and exceed long-term interest rates, the yield curve is said to be “inverted”. When this flattening or inversion occurs, borrowers have an incentive to refinance into fixed rate mortgages, or Hybrid ARMs with longer initial fixed-rate periods, which could cause our investments to experience faster levels of prepayments than expected. As noted above, increases in prepayments on our investments would cause our premium amortization to accelerate, lowering the yield on such assets and decreasing our net interest income. In addition, a decrease in the supply of Hybrid ARMS and ARMs will decrease the supply of securities collateralized by these types of loans, which could force us to change our investment strategy.

A decrease or lack of liquidity in our investments may adversely affect our business, including our ability to value and sell our assets.

We invest in securities that are not publicly traded in liquid markets. Though Agency MBS are generally deemed to be a very liquid security turbulent market conditions in the past have at times significantly and negatively impacted the liquidity of these assets. Generally this has resulted in reduced pricing for the Agency MBS (with disparities in pricing depending upon the source) and lower advance rates (or conversely higher equity requirements) from our repurchase agreement lenders. In some extreme cases, financing might not be available for certain Agency MBS. Generally our lenders will value Agency MBS based on liquidation value in periods of significant market volatility.

With respect to non-Agency securities, such securities typically experience greater price volatility than Agency MBS as there is no guaranty of payment, and they generally can be more difficult to value. In addition, third-party pricing for non-Agency securities and CMBS may be more subjective than for Agency MBS. As such, non-Agency securities and CMBS are typically less liquid than Agency MBS and are subject to greater risk of repurchase agreement financing not being available, market value reductions, and/or lower advance rates and higher costs from lenders.

The illiquidity of our investment securities may make it difficult for us to sell any such investments if the need or desire arises. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we have previously recorded certain of our investment securities. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be relatively limited, which could adversely affect our results of operations and financial condition.

Changes to the availability and terms of leverage used to finance our business may adversely affect our profitability and result in losses and/or reduced cash available for distribution to our shareholders.

We use leverage in part to finance the acquisition of investments in order to enhance the overall returns on our invested capital. As long as we earn a positive spread between interest and other income we earn on our assets and our borrowing costs, we can generally increase our profitability by using greater amounts of leverage. While the use of leverage enhances the returns on our capital, it also exposes us to certain risks, particularly if such leverage is uncommitted, short-term in nature or has terms which are significantly different from the terms of the related investment being financed.

Repurchase agreements are generally uncommitted financings from lenders with an average term of ninety days or less. We use repurchase agreements to finance Hybrid ARM Agency MBS, Arm Agency MBS, non-Agency securities, and CMBS. Changes in the availability and cost of repurchase agreement borrowings could negatively impact our results. As discussed above, changes in the availability of repurchase agreement financing may occur as a result of volatility in the credit markets from volatility in asset prices, financial stress at the Company or the financial stress at one or more of our lenders. Our return on our assets and cash available for distribution to our shareholders may be reduced due to changes in market conditions which may prevent us from leveraging our investments efficiently, or at all, or may cause the cost of our financing to increase relative to the income that can be derived from the leveraged assets.

In addition to changes in the availability of repurchase agreement financing and rising costs, if the value of the collateral pledged to support the repurchase agreement borrowing should fall below the level required by the lender, the lender could initiate a margin call. This would require that we either pledge additional collateral acceptable to the lender (typically cash or a highly liquid security such as Agency MBS) or repay a portion of the debt in order to meet the margin requirement. Should we be unable to meet a margin call, we may have to liquidate the collateral or other assets quickly. Because a margin call and quick sale could result in a lower than otherwise expected and attainable sale price, we may incur a loss on the sale of the collateral.

Since we expect to rely primarily on borrowings under repurchase agreements to finance certain of our investments, our ability to achieve our investment objectives depends on our ability to borrow money in sufficient amounts and on favorable terms and on our ability to renew or replace maturing borrowings on a continuous basis. Our ability to enter into repurchase agreements in the future will depend on the market value of our investments pledged to secure the specific borrowings, the availability of adequate financing and other conditions existing in the lending market at that time. If we are not able to renew or replace maturing borrowings, we could be forced to sell some of our assets, potentially under adverse circumstances, which would adversely affect our profitability.

In addition, in response to certain market, interest rate and investment environments, we could implement a strategy of reducing our leverage by selling assets or not replacing MBS as they amortize and/or prepay, thereby decreasing the outstanding amount of our related borrowings. Such an action would likely reduce interest income, interest expense and net income, the extent of which would depend on the level of reduction in assets and liabilities as well as the sale prices for which the assets were sold.

If a lender to us in a repurchase transaction defaults on its obligation to resell the underlying security back to us at the end of the transaction term, or if we default on our obligations under a repurchase agreement, we will incur losses.

Repurchase agreement transactions are legally structured as the sale of a security to a lender in return for cash from the lender. These transactions are accounted for as financing agreements since the lenders are obligated to resell the same securities back to us at the end of the transaction term. Because the cash we receive from the lender when we initially sell the securities to the lender is less than the value of those securities, if the lender defaults on its obligation to resell the same securities back to us, we would incur a loss on the transaction equal to the difference between the value of the securities sold and the amount borrowed from the lender. Further, if we default on one of our obligations under a repurchase agreement, the lender can terminate the transaction, sell the underlying collateral and cease entering into any other repurchase transactions with us. Any losses we incur on our repurchase transactions could adversely affect our earnings and reduce our ability to pay dividends to our shareholders.

A decline in the market value of our assets may cause our book value to decline and may result in margin calls that may force us to sell assets under adverse market conditions.

The market value of our assets generally moves inversely to changes in interest rates and, as a result, may be negatively impacted by increases in interest rates. Our investments are generally valued based on a spread to the Treasury curve or the LIBOR swap curve. The movement of the Treasury and LIBOR swap curves can result from a variety of factors, including factors such as Federal Reserve policy, market inflation expectations, and market perceptions of risk. In periods of high volatility, spreads to the respective curve may increase causing reductions in value on these investments. In addition, in a rising interest rate environment, the value of our assets may decline. As most of our investments are considered available for sale under GAAP, the decline in value will cause our shareholders’ equity to correspondingly decline.

In addition, since we utilize recourse collateralized financing such as repurchase agreements, a decline in the market value of our investments may limit our ability to borrow against these assets or result in our lenders initiating margin calls and requiring a pledge of additional collateral or cash. Posting additional collateral or cash to support our borrowings will reduce our liquidity and limit our ability to leverage our assets, which could adversely affect our business. As a result, we could be forced to sell some of our assets in order to maintain liquidity. Forced sales typically result in lower sales prices than do market sales made in the normal course of business. If our investments were liquidated at prices below the amortized cost basis of such investments, we would incur losses, which could result in a rapid deterioration of our financial condition.

Adverse developments involving major financial institutions or one of our lenders could also result in a rapid reduction in our ability to borrow and adversely affect our business and profitability.

Recent turmoil in the financial markets relating to major financial institutions has raised concerns that a material adverse development involving one or more major financial institutions could result in our lenders reducing our access to funds available under our repurchase agreements. All of our repurchase agreements are uncommitted, and such a disruption could cause our lenders to reduce or terminate our access to future borrowings. In such a scenario, we may be forced to sell investments under adverse market conditions. We may also be unable to purchase additional investments without access to additional financing. Either of these events could adversely affect our business and profitability.

Our ownership of securitized mortgage loans subjects us to credit risk and, although we provide for an allowance for loan losses on these loans as required under GAAP, the loss reserves are based on estimates. As a result, actual losses incurred may be larger than our reserves, requiring us to provide additional reserves, which will impact our financial position and results of operations.

We are subject to credit risk as a result of our ownership of securitized mortgage loans. Credit risk is the risk of loss to us from the failure by a borrower (or the proceeds from the liquidation of the underlying collateral) to fully repay the principal balance and interest due on a mortgage loan. A borrower’s ability to repay the loan and the value of the underlying collateral could be negatively impacted by economic and market conditions. These conditions could be global, national, regional or local in nature.

We attempt to mitigate this risk by pledging loans to a securitization trust and issuing non-recourse securitization financing bonds (referred to as a “securitization”), and by obtaining certain insurance policies or other loss reimbursement agreements when available. Upon securitization of a pool of mortgage loans, the credit risk retained by us from an economic point of view is generally limited to the overcollateralization tranche of the securitization trust, inclusive of any subordinated bonds of the trust that we may own. The overcollateralization tranche is generally the excess value of the mortgage loans pledged over the securitization financing bonds issued. However, GAAP does not recognize the transfer of credit risk through the securitization process. Instead, GAAP requires that we provide reserves for estimated losses on the entire pool of loans regardless of the securitization process.

We provide reserves for losses on securitized mortgage loans based on the current performance of the respective pool or on an individual loan basis. If losses are experienced more rapidly due to declining property performance, market conditions or other factors, than we have provided for in our reserves, we may be required to provide additional reserves for these losses. In addition, our allowance for loan losses is based on estimates and to the extent that proceeds from the liquidation of the underlying collateral are less than our estimates, we will record a reduction in our profitability for that period equal to the shortfall.

Our efforts to manage credit risk may not be successful in limiting delinquencies and defaults in underlying loans or losses on our investments. If we experience higher than anticipated delinquencies and defaults, our earnings and our cash flow may be negatively impacted.

There are many aspects of credit performance for our investments that we cannot control. Third party servicers provide for the primary and special servicing of our single-family and commercial mortgage loans and non-Agency securities and CMBS. In that capacity these service providers control all aspects of loan collection, loss mitigation, default management and ultimate resolution of a defaulted loan. We have a risk management function which oversees the performance of these servicers and provides limited asset management services. Loan servicing companies may not cooperate with our risk management efforts, or such efforts may be ineffective. We have no contractual rights with respect to these servicers and our risk management operations may not be successful in limiting future delinquencies, defaults, and losses.

The securitizations in which we have invested may not receive funds that we believe are due from mortgage insurance companies and other counter-parties. Service providers to securitizations, such as trustees, bond insurance providers, guarantors and custodians, may not perform in a manner that promotes our interests or may default on their obligation to the securitization trust. The value of the properties collateralizing the loans may decline causing higher losses

than anticipated on the liquidation of the property. The frequency of default and the loss severity on loans that do default may be greater than we anticipated. If loans become “real estate owned” (“REO”), servicing companies will have to manage these properties and may not be able to sell them. Changes in consumer behavior, bankruptcy laws, tax laws, and other laws may exacerbate loan losses. In some states and circumstances, the securitizations in which we invest have recourse, as the owner of the loan, against the borrower’s other assets and income in the event of loan default; however, in most cases, the value of the underlying property will be the sole source of funds for any recoveries.

We invest in commercial mortgage loans and CMBS collateralized by commercial mortgage loans which are secured by income producing properties. Such loans are typically made to single-asset entities and the repayment of the loan is dependent principally on the performance and value of the underlying property. The volatility of certain mortgaged property values may adversely affect our CMBS.

Our CMBS which are secured by multifamily and commercial property are subject to risks of delinquency, foreclosure, and loss that are greater than similar risks associated with loans secured by single-family residential property. The ability of a borrower to repay a loan secured by an income-producing property typically is dependent upon the successful operation of the property rather than upon the existence of independent income or assets of the borrower. If the net operating income of the property is reduced, the borrower's ability to repay the loan may be impaired. Net operating income of an income-producing property can be affected by, among other things: tenant mix, success of tenant businesses, property management decisions, property location and condition, competition from comparable types of properties, changes in laws that increase operating expenses or limit rents that may be charged, any need to address environmental contamination at the property, changes in national, regional or local economic conditions and/or specific industry segments, declines in regional or local real estate values and declines in regional or local rental or occupancy rates, increases in interest rates, real estate tax rates and other operating expenses, changes in governmental rules, regulations and fiscal policies, including environmental legislation, and acts of God, terrorism, social unrest and civil disturbances.

Commercial and multifamily property values and net operating income derived from them are subject to volatility and may be affected adversely by a number of factors, including, but not limited to, national, regional and local economic conditions (which may be adversely affected by plant closings, industry slowdowns and other factors); local real estate conditions (such as an oversupply of housing, retail, industrial, office or other commercial space); changes or continued weakness in specific industry segments; perceptions by prospective tenants, retailers and shoppers of the safety, convenience, services and attractiveness of the property; the willingness and ability of the property's owner to provide capable management and adequate maintenance; construction quality, age and design; demographic factors; retroactive changes to building or similar codes; and increases in operating expenses (such as energy costs).

Certain investments employ internal structural leverage as a result of the securitization process and are in the most subordinate position in the capital structure, which magnifies the potential impact of adverse events on our cash flows.

As discussed above, securitized mortgage loans have been pledged to securitization trusts which have issued securitization financing bonds collateralized by the loans pledged. By their design, securitization trusts employ a high degree of internal structural leverage (i.e., the securitization financing bonds issued), which results in concentrated credit, interest rate, prepayment, or other risks to our investment in the trust. Generally in a securitization, we will receive the excess of the interest income and principal received on the loans pledged over the interest expense and principal paid on the securitization financing bonds according to the terms of the respective indenture. Our cash flow received is generally subordinate to payments due on the securitization bonds. As a result, our net interest income and related cash flows will vary based on the performance of the assets pledged to the securitization trust. In particular, should assets significantly underperform as to defaults and credit losses, it is possible that net interest income and cash flows which may have otherwise been paid to us as a result of our ownership of the securitization trust may be retained within the trust and payments of principal amounts on our ownership position in the trust may be delayed or permanently reduced. To date, none of our existing trusts have reached or are near the levels of underperformance that would trigger delays or reductions in income or cash flows, but such levels could be reached in the future.

Guarantors may fail to perform on their obligations to our securitization trusts, which could result in additional losses to our Company.

In certain instances we have guaranty of payment on commercial and single family mortgage loans pledged to securitization trusts (See Item 7A. “Quantitative and Qualitative Disclosures About Market Risk”). These guarantors have reported substantial losses since 2007, eroding their respective capital base and potentially impacting their ability to make payments where required. Generally the guarantors will only make payment in the event of the default and liquidation of the collateral supporting the loan. If these guarantors fail to make payment, we may experience losses on the loans that we otherwise would not have.

We may be subject to the risks associated with inadequate or untimely services from third-party service providers, which may harm our results of operations. We also rely on corporate trustees to act on behalf of us and other holders of securities in enforcing our rights.

Our loans and loans underlying securities we own are serviced by third-party service providers. Should a servicer experience financial difficulties, it may not be able to perform these obligations. Servicers who have sought bankruptcy protection may, due to application of provisions of bankruptcy law, not be required to make advance payments to us of amounts due from loan obligors. Even if a servicer were able to advance amounts in respect of delinquent loans, its obligation to make the advances may be limited to the extent that is does not expect to recover the advances due to the deteriorating credit of the delinquent loans. In addition, as with any external service provider, we are subject to the risks associated with inadequate or untimely services for other reasons. Servicers may not advance funds to us that would ordinarily be due because of errors, miscalculations, or other reasons. Many borrowers require notices and reminders to keep their loans current and to prevent delinquencies and foreclosures, which our servicers may fail to provide. In the current economic environment, many servicers are experiencing higher volumes of delinquent loans than they have in the past and, as a result, there is a risk that their operational infrastructures cannot properly process this increased volume. A substantial increase in our delinquency rate that results from improper servicing or loan performance in general may result in credit losses.

We also rely on corporate trustees to act on behalf of us and other holders of securities in enforcing our rights. Under the terms of most securities we hold we do not have the right to directly enforce remedies against the issuer of the security, but instead must rely on a trustee to act on behalf of us and other security holders. Should a trustee not be required to take action under the terms of the securities, or fail to take action, we could experience losses.

Credit ratings assigned to debt securities by the credit rating agencies may not accurately reflect the risks associated with those securities. Changes in credit ratings for securities we own or for similar securities might negatively impact the market value of these securities.

Rating agencies rate securities based upon their assessment of the safety of the receipt of principal and interest payments. Rating agencies do not consider the risks of fluctuations in fair value or other factors that may influence the value of securities and, therefore, the assigned credit rating may not fully reflect the true risks of an investment in securities. Also, rating agencies may fail to make timely adjustments to credit ratings based on available data or changes in economic outlook or may otherwise fail to make changes in credit ratings in response to subsequent events, so that our investments may be better or worse than the ratings indicate. We try to reduce the impact of the risk that a credit rating may not accurately reflect the risks associated with a particular debt security by not relying solely on credit ratings as the indicator of the quality of an investment. We make our acquisition decisions after factoring in other information. However, our assessment of the quality of an investment may also prove to be inaccurate and we may incur credit losses in excess of our initial expectations.

Credit rating agencies may change their methods of evaluating credit risk and determining ratings on securities backed by real estate loans and securities. These changes may occur quickly and often. The market’s ability to understand and absorb these changes, and the impact to the securitization market in general, are difficult to predict. Such changes may have a negative impact on the value of securities that we own.

Fluctuations in interest rates may have various negative effects on us and could lead to reduced profitability and a lower book value.

Fluctuations in interest rates impact us in a number of ways. For example, as more fully explained below, in a period of rising rates, we may experience a decline in our profitability from borrowing rates increasing faster than our assets reset or from our investments adjusting less frequently or relative to a different index (e.g., one-year LIBOR) from our borrowings. We may also experience a reduction in the market value of our Hybrid ARM securities and CMBS as a result of higher yield requirements for these types of securities by the market. In a period of declining interest rates, we may experience increasing prepayments resulting in reduced profitability and returns of our capital in lower yielding investments as discussed elsewhere.

Many of our investments are financed with borrowings which have shorter maturity or interest-reset terms than the associated investment. In addition, our CMBS are fixed-rate and a significant portion of our Agency MBS will have a fixed-rate of interest for a certain period of time and which have an interest rate which resets semi-annually or annually, based on an index such as the one-year CMT or the one-year LIBOR. Agency MBS are financed with repurchase agreements which bear interest based predominantly on one-month LIBOR, and generally have initial maturities between 30 and 90 days. In a period of rising rates our borrowings will typically increase in rate faster than our assets may reset resulting in a reduction in our net interest income. The severity of any such decline would depend on our asset/liability composition at the time as well as the magnitude and period over which interest rates increase.

Additionally, increases in interest rates may negatively affect the market value of our securities. In rare instances increases in short-term rates are rapid enough that short-term rates equal or exceed medium/long-term rates resulting in a flat or inverted yield curve. Any fixed-rate or Hybrid ARM investments will generally be more negatively affected by these increases than securities whose interest-rate periodically adjusts. For those securities that we carry at estimated market value in our financial statements, we are required to reduce our stockholders’ equity, or book value, by the amount of any decrease in the market value of these securities.

Interest rate caps on the adjustable rate mortgage loans collateralizing our investments may adversely affect our profitability if interest rates increase.

The coupons earned on Hybrid ARMs adjust over time as interest rates change after a fixed-rate period. The level of adjustment on the interest rates on ARMs is limited by contract and is based on the limitations of the underlying adjustable rate mortgage loans. Such loans typically have interim and lifetime interest rate caps which limit the amount by which the interest rates on such assets can adjust. Interim interest rate caps limit the amount interest rates can adjust during any given period. Lifetime interest rate caps limit the amount interest rates can increase from inception through maturity of a particular loan. The financial markets primarily determine the interest rates that we pay on the repurchase transactions used to finance the acquisition of our ARMs. These repurchase transactions are not subject to interim and lifetime interest rate caps. Accordingly, in a sustained period of rising interest rates or a period in which interest rates rise rapidly, we could experience a decrease in net income or a net loss because the interest rates paid by us on our borrowings could increase without limitation (as new repurchase transactions are entered into upon the maturity of existing repurchase transactions) while increases in the interest rates earned on the adjustable rate mortgage loans collateralizing our ARMs could be limited due to interim or lifetime interest rate caps.

Our use of hedging strategies to mitigate our interest rate exposure may not be effective, may adversely affect our income, may expose us to counterparty risks, and may increase our contingent liabilities.

We may pursue various types of hedging strategies, including interest rate swap agreements, interest rate caps and other derivative transactions (collectively, “hedging instruments”). We expect hedging to assist us in mitigating and reducing our exposure to higher interest expenses, and to a lesser extent, losses in book value, from adverse changes in interest rates. Our hedging activity will vary in scope based on the level and volatility of interest rates, the type of assets in our investment portfolio and financing sources used. No hedging strategy, however, can completely insulate us from the interest rate risks to which we are exposed, and there is no assurance that the implementation of any hedging strategy will have the desired impact on our results of operations or financial condition. Certain of the U.S. federal income tax requirements that we must satisfy in order to qualify as a REIT may limit our ability to hedge against such risks. In addition, these hedging strategies may adversely affect us because hedging activities involve an expense that we will incur regardless of the effectiveness of the hedging activity.

Interest rate hedging may fail to protect or could adversely affect us because, among other things:

·	interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;

·	available interest rate hedges may not correspond directly with the interest rate risk for which we seek protection;

·	the duration of the hedge may not match the duration of the related liability;

·	the amount of income that a REIT may earn from hedging transactions (other than through taxable REIT subsidiaries) to offset interest rate losses may be limited by U.S. federal income tax provisions governing REITs;

·	the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction;

·	the party owing money in the hedging transaction may default on its obligation to pay;

·	the value of derivatives used for hedging may be adjusted from time to time in accordance with GAAP to reflect changes in fair value. Downward adjustments, or “mark-to-market losses,” would reduce our shareholders’ equity and book value; and

·	hedge accounting under GAAP is extremely complex and any ineffectiveness of our hedges under GAAP will impact our statement of operations.

We expect to primarily use interest rate swap agreements to hedge against anticipated future increases in interest rates on our repurchase agreements. Should an interest rate swap agreement counterparty be unable to make required payments pursuant to the agreement, the hedged liability would cease to be hedged for the remaining term of the interest rate swap agreement. In addition, we may be at risk for any collateral held by a hedging counterparty to an interest rate swap agreement, should the counterparty become insolvent or file for bankruptcy. Our hedging transactions, which are intended to limit losses, may actually adversely affect our earnings, which could reduce our ability to pay dividends to our shareholders.

Hedging instruments involve risk since they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities. Consequently, there are no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions. Furthermore, the enforceability of hedging instruments may depend on compliance with applicable statutory, commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in its default. Default by a party with whom we enter into a hedging transaction may result in the loss of unrealized profits and force us to cover our commitments, if any, at the then current market price. Although generally we will seek to reserve the right to terminate our hedging positions, it may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. In certain circumstances a liquid secondary market may not exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.

Hedging instruments could also require us to fund cash payments in certain circumstances (such as the early termination of a hedging instrument caused by an event of default or other voluntary or involuntary termination event or the decision by a hedging counterparty to request the posting of collateral it is contractually owed under the terms of the hedging instrument). With respect to the termination of an existing interest rate swap agreement, the amount due would generally be equal to the unrealized loss of the open interest rate swap agreement position with the hedging counterparty and could also include other fees and charges. These economic losses would be reflected in our results of operations, and our ability to fund these obligations will depend on the liquidity of our assets and access to capital at the time. Any losses we incur on our hedging instruments could adversely affect our earnings and reduce our ability to pay dividends to our shareholders.

We may change our investment strategy, operating policies, dividend policy and/or asset allocations without shareholder consent.

We may change our investment strategy, operating policies, dividend policy and/or asset allocation with respect to investments, acquisitions, leverage, growth, operations, indebtedness, capitalization and distributions at any time without the consent of our shareholders. A change in our investment strategy may increase our exposure to interest rate and/or credit risk, default risk and real estate market fluctuations. Furthermore, a change in our asset allocation could result in our making investments in asset categories different from our historical investments. These changes could adversely affect our financial condition, results of operations, the market price of our common stock or our ability to pay dividends to our shareholders.

In 2008, we began paying a dividend to our common shareholders for the first time since 1998. During 2009 we paid $0.92 per common share in dividends to our common shareholders, or $0.23 per quarter. Given our ability to offset most of our taxable income with our NOL carryforward, we may not be required to distribute any of our taxable income to common shareholders in order to maintain our REIT status. Our Board of Directors reviews the status of our common dividend on a quarterly basis. We may change our dividend strategy in the future and elect to retain all or a greater portion of our earnings by using our NOL carryforward.

Competition may prevent us from acquiring new investments at favorable yields, and we may not be able to achieve our investment objectives which may potentially have a negative impact on our profitability.

Our net income will largely depend on our ability to acquire mortgage-related assets at favorable spreads over our borrowing costs. The availability of mortgage-related assets meeting our investment criteria depends upon, among other things, the level of activity in the real estate market and the quality of and demand for securities in the mortgage securitization and secondary markets. The size and level of activity in the residential real estate lending market depends on various factors, including the level of interest rates, regional and national economic conditions and real estate values. In acquiring investments, we may compete with other purchasers of these types of investments, including but not limited to other mortgage REITs, broker-dealers, hedge funds, banks, savings and loans, insurance companies, mutual funds, and other entities that purchase assets similar to ours, many of which have greater financial resources than we do. As a result of all of these factors, we may not be able to acquire sufficient assets at acceptable spreads to our borrowing costs, which would adversely affect our profitability.

New assets we acquire may not generate yields as attractive as yields on our current assets, resulting in a decline in our earnings per share over time.

We believe the assets we acquire have the potential to generate attractive economic returns and GAAP yields, but acquiring new assets poses risks. Potential cash flow and mark-to-market returns from new asset acquisitions could be negative, including both new assets that are backed by newly-originated loans, as well as new acquisitions that are backed by more seasoned assets that may experience higher than expected levels of delinquency and default.

In order to maintain our portfolio size and our earnings, we must reinvest in new assets a portion of the cash flows we receive from principal, interest, calls, and sales. We receive monthly payments from many of our assets, consisting of principal and interest. In addition, occasionally some of our residential securities are called (effectively sold). Principal payments and calls reduce the size of our current portfolio and generate cash for us. We may also sell assets from time to time as part of our portfolio management and capital recycling strategies.

If the assets we acquire in the future earn lower GAAP yields than the assets we currently own, our reported earnings per share will likely decline over time as the older assets pay down, are called, or are sold.

Loss of key management could result in material adverse effects on our business.

We are dependent to a significant extent on the continued services of our executive management team. Our executive officers consist of Thomas Akin, our Chief Executive Officer, Byron Boston, our Chief Investment Officer, and Stephen Benedetti, our Chief Operating Officer and Chief Financial Officer. The loss of one or more of Messrs. Akin, Boston or Benedetti could have an adverse effect on our business, financial condition, liquidity, and results of operations regardless of the existence of any current or future key man insurance policies.

Our Chairman and Chief Executive Officer devotes a portion of his time to another company in a capacity that could create conflicts of interest that may harm our investment opportunities; this lack of a full-time commitment could also harm our operating results.

Our Chairman, Thomas Akin, is the managing general partner of Talkot Capital, LLC, where he devotes a portion of his time. Talkot Capital invests in both private and public companies, including investments in common and preferred stocks of other public mortgage REITs. Mr. Akin’s activities with respect to Talkot Capital results in his spending only a portion of his time and effort on managing our activities, as he is under no contractual obligation which mandates that he devote a minimum amount of time to our company. Since he is not fully focused on us at all times, this may harm our overall management and operating results. In addition, though the investment strategy and activities of Talkot Capital are not directly related to us, Mr. Akin’s activities with respect to Talkot Capital may create conflicts. Our corporate governance policies include formal notification policies with respect to potential issues of conflict of interest for competing business opportunities. Compliance by Mr. Akin, and all employees, is closely monitored by our Chief Financial Officer and Board of Directors. Nonetheless, Mr. Akin’s activities with respect to Talkot could create conflicts of interest.

Risks Related to Regulatory and Legal Requirements

Risks Specific to Our REIT Status

Qualifying as a REIT involves highly technical and complex provisions of the Code, and a technical or inadvertent violation could jeopardize our REIT qualification. Maintaining our REIT status may reduce our flexibility to manage our operations.

Qualification as a REIT involves the application of highly technical and complex Code provisions for which only limited judicial and administrative authorities exist. Even a technical or inadvertent violation could jeopardize our REIT qualification. Our qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis. Our operations and use of leverage also subjects us to interpretations of the Code, and technical or inadvertent violations of the Code could cause us to lose our REIT status or to pay significant penalties and interest. In addition, our ability to satisfy the requirements to qualify as a REIT depends in part on the actions of third parties over which we have no control or only limited influence, including in cases where we own an equity interest in an entity that is classified as a partnership for U.S. federal income tax purposes.

Maintaining our REIT status may limit flexibility in managing our operations. For instance:

·	If we make frequent asset sales from our REIT entities to persons deemed customers, we could be viewed as a “dealer,” and thus subject to 100% prohibited transaction taxes or other entity level taxes on income from such transactions.

·	Compliance with the REIT income and asset rules may limit the type or extent of hedging that we can undertake.

Our ability to own non-real estate related assets and earn non-real estate related income is limited. Our ability to own equity interests in other entities is limited. If we fail to comply with these limits, we may be forced to liquidate attractive assets on short notice on unfavorable terms in order to maintain our REIT status.

·	Our ability to invest in taxable subsidiaries is limited under the REIT rules. Maintaining compliance with this limitation could require us to constrain the growth of future taxable REIT affiliates.

·	Notwithstanding our NOL carryforwards, meeting minimum REIT dividend distribution requirements could reduce our liquidity. Earning non-cash REIT taxable income could necessitate our selling assets, incurring debt, or raising new equity in order to fund dividend distributions.

·	Stock ownership tests may limit our ability to raise significant amounts of equity capital from one source.

If we do not qualify as a REIT or fail to remain qualified as a REIT, we may be subject to tax as a regular corporation and could face a tax liability, which would reduce the amount of cash available for distribution to our stockholders.

We intend to operate in a manner that will allow us to qualify as a REIT for federal income tax purposes. Our qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis. Our ability to satisfy the asset tests depends upon our analysis of the characterization and fair market values of our assets, some of which are not susceptible to a precise determination, and for which we will not obtain independent appraisals. Our compliance with the REIT income and quarterly asset requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis.

If we were to fail to qualify as a REIT in any taxable year, we would be subject to federal income tax, after consideration of our NOL carryforwards but not considering any dividends paid to our stockholders during the respective tax year. If we could not otherwise offset this taxable income with our NOL carryforwards, the resulting corporate tax liability could be material to our results and would reduce the amount of cash available for distribution to our stockholders, which in turn could have an adverse impact on the value of our common stock. Unless we were entitled to relief under certain Code provisions, we also would be disqualified from taxation as a REIT for the four taxable years following the year in which we failed to qualify as a REIT.

The failure of investments subject to repurchase agreements to qualify as real estate assets could adversely affect our ability to qualify as a REIT.

Repurchase agreement financing arrangements are structured as a sale and repurchase whereby we sell certain of our investments to a counterparty and simultaneously enter into an agreement to repurchase these securities at a later date in exchange for a purchase price. Economically, these agreements are financings which are secured by the investments sold pursuant thereto. We believe that we would be treated for REIT asset and income test purposes as the owner of the agency MBS that are the subject of any such sale and repurchase agreement, notwithstanding that such agreements may legally transfer record ownership of the securities to the counterparty during the term of the agreement. It is possible, however, that the IRS could assert that we did not own the securities during the term of the sale and repurchase agreement, in which case we could fail to qualify as a REIT.

Even if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow and our profitability.

Even if we remain qualified for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income and assets, including taxes on any undistributed income, tax on income from some activities conducted as a result of a foreclosure or considered prohibited transactions under the Code, and state or local income taxes. Any of these taxes would decrease cash available for distribution to our stockholders. In addition, in order to meet the REIT qualification requirements, or to avert the imposition of a 100% tax that applies to certain gains derived by a REIT from prohibited transactions (i.e., dealer property or inventory), we may hold some of our assets through a taxable REIT subsidiary (“TRS”) or other subsidiary corporations that will be subject to corporate-level income tax at regular rates to the extent that such TRS does not have an NOL carryforward. Any of these taxes would decrease cash available for distribution to our stockholders.

If we fail to maintain our REIT status, our ability to utilize repurchase agreements as a source of financing may be impacted.

Most of our repurchase agreements require that we maintain our REIT status as a condition to engaging in a repurchase transaction with us. Even though repurchase agreements are not committed facilities with our lenders, if we failed to maintain our REIT status our ability to enter into new repurchase agreement transactions or renew existing, maturing repurchase agreements will likely be limited. As such, we may be required to sell investments, potentially under adverse circumstances, that were previously financed with repurchase agreements.

Certain of our securitization trusts, which qualify as “taxable mortgage pools,” require us to maintain equity interests in the securitization trusts. If we do not, our profitability and cash flow may be reduced

Certain of our commercial mortgage and single-family mortgage securitization trusts are considered taxable mortgage pools for federal income tax purposes. These securitization trusts are exempt from taxes so long as we, or another REIT, own 100% of the equity interests in the trusts. If we fail to maintain sufficient equity interest in these securitization trusts or if we fail to maintain our REIT status, then the trusts may be considered separate taxable entities. If the trusts are considered separate taxable entities, they will be required to compute taxable income and pay tax on such income. Our profitability and cash flow will be impacted by the amount of taxes paid. Moreover, we may be precluded from selling equity interests, including debt securities issued in connection with these trusts that might be considered to be equity interests for tax purposes, to certain outside investors.

Risks Related to Accounting and Reporting Requirements

Our reported income depends on GAAP and conventions in applying GAAP which are subject to change in the future and which may not have a favorable impact on our reported income.

Accounting rules for our assets and for the various aspects of our current and future business change from time to time. Changes in GAAP, or the accepted interpretation of these accounting principles, can affect our reported income and shareholders’ equity.

Estimates are inherent in the process of applying GAAP, and management may not always be able to make estimates which accurately reflect actual results, which may lead to adverse changes in our reported GAAP results.

Interest income on our assets and interest expense on our liabilities may be partially based on estimates of future events. These estimates can change in a manner that negatively impacts our results or can demonstrate, in retrospect, that revenue recognition in prior periods was too high or too low. For example, we use the effective yield method of accounting for many of our investments which involves calculating projected cash flows for each of our assets. Calculating projected cash flows involves making assumptions about the amount and timing of credit losses, loan prepayment rates, and other factors. The yield we recognize for GAAP purposes generally equals the discount rate that produces a net present value for actual and projected cash flows that equals our GAAP basis in that asset. We update the yield recognized on these assets based on actual performance and as we change our estimates of future cash flows. The assumptions that underlie our projected cash flows and effective yield analysis may prove to be overly optimistic, or conversely, overly conservative. In these cases, our GAAP yield on the asset or cost of the liability may change, leading to changes in our reported GAAP results.

Other Regulatory Risks

In the event of bankruptcy either by ourselves or one or more of our third party lenders, assets pledged as collateral under repurchase agreements may not be recoverable by us. We may incur losses equal to the excess of the collateral pledged over the amount of the associated repurchase agreement borrowing.

Borrowings made under repurchase agreements may qualify for special treatment under the U.S. Bankruptcy Code. In the event that a lender under our repurchase agreements files for bankruptcy, it may be difficult for us to recover our assets pledged as collateral to such lender. In addition, if we ever file for bankruptcy, lenders under our repurchase agreements may be able to avoid the automatic stay provisions of the U.S. Bankruptcy Code and take possession of and liquidate our collateral under our repurchase agreements without delay. In the event of a bankruptcy, we may incur losses equal to the excess of our collateral pledged over the amount of repurchase agreement borrowing due to the lender.

If we fail to properly conduct our operations we could become subject to regulation under the Investment Company Act of 1940. Conducting our business in a manner so that we are exempt from registration under and compliance with the Investment Company Act of 1940 may reduce our flexibility and could limit our ability to pursue certain opportunities.

We seek to conduct our operations so as to avoid falling under the definition of an investment company pursuant to the Investment Company Act of 1940 (the “1940 Act”). Specifically, we currently seek to conduct our operations under one of the exemptions afforded under the 1940 Act. We primarily expect to use the exemption provided under Section 3(c)(5)(C) of the 1940 Act, a provision available to companies primarily engaged in the business of purchasing and otherwise acquiring

mortgages and other liens on and interests in real estate. According to SEC no-action letters, companies relying on this exemption must ensure that at least 55% of their assets are mortgage loans and other qualifying assets, and at least 80% of their assets are real estate-related. The 1940 Act requires that we and each of our subsidiaries evaluate our qualification for exemption under the Act. Our subsidiaries will rely either on Section 3(c)(5)(C) or other sections that provide exemptions from registering under the 1940 Act, including Sections 3(a)(1)(C) and 3(c)(7).

Under the 1940 Act, an investment company is required to register with the SEC and is subject to extensive restrictive and potentially adverse regulations relating to, among other things, operating methods, management, capital structure, dividends, and transactions with affiliates. If we were determined to be an investment company, our ability to use leverage and conduct business as we do today would be impaired.

Risks Related to Owning Our Stock

The stock ownership limit imposed by the Code for REITs and our Articles of Incorporation may restrict our business combination opportunities. The stock ownership limitation may also result in reduced liquidity in our stock and may result in losses to an acquiring shareholder.

To qualify as a REIT under the Code, not more than 50% in value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the Code to include certain entities) at any time during the last half of each taxable year after our first year in which we qualify as a REIT. Our Articles of Incorporation, with certain exceptions, authorizes our Board of Directors to take the actions that are necessary and desirable to qualify as a REIT. Pursuant to our Articles of Incorporation, no person may beneficially or constructively own more than 9.8% of our common or capital stock. Our Board of Directors may grant an exemption from this 9.8% stock ownership limitation, in its sole discretion, subject to such conditions, representations and undertakings as it may determine are reasonably necessary. Our Board of Directors has waived this ownership limitation with respect to Talkot Capital, LLC, of which Mr. Thomas B. Akin, our Chairman and Chief Executive Officer, is managing general partner. Per the terms of the waiver, Talkot Capital may own up to 15% of our outstanding common stock on a fully diluted basis, provided, however, that no single beneficial owner has a greater than two-thirds ownership stake in Talkot Capital.

The ownership limits imposed by the tax law are based upon direct or indirect ownership by “individuals,” but only during the last half of a tax year. The ownership limits contained in our Articles of Incorporation apply to the ownership at any time by any “person,” which includes entities, and are intended to assist us in complying with the tax law requirements and to minimize administrative burdens. However, these ownership limits might also delay or prevent a transaction or a change in our control that might involve a premium price for our common stock or otherwise be in the best interest of our stockholders.

Whether we would waive ownership limitation for any other shareholder will be determined by our Board of Directors on a case by case basis. Our Articles of Incorporation’s constructive ownership rules are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity. As a result, the acquisition of less than these percentages of the outstanding stock by an individual or entity could cause that individual or entity to own constructively in excess of these percentages of the outstanding stock and thus be subject to the ownership limit. Any attempt to own or transfer shares of our common or preferred stock (if and when issued) in excess of the ownership limit without the consent of the Board of Directors will result in the shares being automatically transferred to a charitable trust or, if the transfer to a charitable trust would not be effective, such transfer being void ab initio.

Dividends payable by REITs do not qualify for the reduced tax rates available for some dividends.

The maximum tax rate applicable to income from “qualified dividends” payable to domestic stockholders that are individuals, trusts and estates has been reduced by legislation to 15% through the end of 2010. Dividends payable by REITs, however, generally are not eligible for the reduced rates. Although this legislation does not adversely affect the taxation of REITs or dividends payable by REITs, the more favorable rates applicable to regular corporate qualified dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the stock of REITs, including our common stock.

Recognition of excess inclusion income by us could have adverse consequences to us or our shareholders.

Certain of our securities have historically generated excess inclusion income and may continue to do so in the future. Certain categories of stockholders, such as foreign stockholders eligible for treaty or other benefits, stockholders with net operating losses, and certain tax-exempt stockholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion of their dividend income from us that is attributable to excess inclusion income. In addition, to the extent that our stock is owned by tax-exempt “disqualified organizations,” such as certain government-related entities and charitable remainder trusts that are not subject to tax on unrelated business income, we may incur a corporate level tax on a portion of our income. In that case, we may reduce the amount of our distributions to any disqualified organization whose stock ownership gave rise to the tax.

ITEM 1B.

UNRESOLVED STAFF COMMENTS

There are no unresolved comments from the SEC Staff.

ITEM 2.

PROPERTIES

We lease one facility located at 4991 Lake Brook Drive, Suite 100, Glen Allen, Virginia 23060 which provides office space for our executive officers and administrative staff. As of December 31, 2009, we leased 7,068 square feet. The term of the lease runs to December 2013, but may be renewed at our option for one additional five-year period at a rental rate 3% greater than the rate in effect during the preceding 12-month period. We believe that our property is maintained in good operating condition and is suitable and adequate for our purposes.

ITEM 3.

LEGAL PROCEEDINGS

We and our subsidiaries may be involved in certain litigation matters arising in the ordinary course of business. Although the ultimate outcome of these matters cannot be ascertained at this time, and the results of legal proceedings cannot be predicted with certainty, we believe, based on current knowledge, that the resolution of any such matters arising in the ordinary course of business will not have a material adverse effect on our financial position but could materially affect our consolidated results of operations in a given period. Information on litigation arising out of the ordinary course of business is described below.

One of our subsidiaries, GLS Capital, Inc. (“GLS”), and the County of Allegheny, Pennsylvania are defendants in a class action lawsuit (“Pentlong”) filed in 1997 in the Court of Common Pleas of Allegheny County, Pennsylvania (the "Court of Common Pleas"). Between 1995 and 1997, GLS purchased delinquent county property tax receivables for properties located in Allegheny County. The Pentlong Plaintiffs allege that GLS did not enjoy the same rights as its assignor, Allegheny County, to recover from delinquent taxpayers certain attorney fees, costs and expenses and interest in the collection of the tax receivables. Class action status has been certified in this matter, but a motion to reconsider is pending. The Pentlong litigation had been stayed pending the outcome of similar litigation before the Pennsylvania Supreme Court in a case in which GLS was not a defendant. The plaintiff in that case had disputed the application of curative legislation enacted in 2003 but retroactive to 1996 which specifically set forth the right of owners of delinquent property tax receivables such as GLS to collect reasonable attorney fees, costs, and interest which were properly taxable as part of the tax debt owed. The Pennsylvania Supreme Court has issued an opinion in favor of the defendants in that matter, which we believe favorably impacts the Pentlong litigation by substantially reducing Pentlong Plaintiffs’ universe of actionable claims against GLS in connection with the collection of the tax receivables. Based on the opinion issued by the Pennsylvania Supreme Court, the Court of Common Pleas requested GLS file a motion for summary judgment and heard arguments on such motion in November 2009. As of March 1, 2010, the court has not yet rendered a decision with respect to such motion. Pentlong Plaintiffs have not enumerated their damages in this matter.

We and Dynex Commercial, Inc. (“DCI”), a former affiliate of the Company and now known as DCI Commercial, Inc., were appellees (or respondents) in the Supreme Court of Texas related to the matter of Basic Capital Management, Inc. et al. (collectively, “BCM” or the “Plaintiffs”) versus DCI et al. The appeal seeks to overturn the trial court’s judgment, and the subsequent affirmation of the trial court by the Fifth Court of Appeals at Dallas, in our and DCI’s favor which denied any recovery to Plaintiffs in this matter. Specifically, Plaintiffs are seeking reversal of the trial court’s judgment and sought rendition of judgment against us for alleged breach of loan agreements for tenant improvements in the amount of $0.3 million. They also seek reversal of the trial court’s judgment and rendition of judgment against DCI in favor of BCM under two mutually exclusive damage models, for $2.2 million and $25.6 million, respectively, related to the alleged breach by DCI of a $160.0 million “master” loan commitment. Plaintiffs also seek reversal and rendition of a judgment in their favor for attorneys’ fees in the amount of $2.1 million. Alternatively, Plaintiffs seek a new trial. The original litigation was filed in 1999, and the trial was held in January 2004. Even if Plaintiffs were to be successful on appeal, DCI is a former affiliate of ours, and we believe that we would have no obligation for amounts, if any, awarded to the Plaintiffs as a result of the actions of DCI.

We and MERIT Securities Corporation, a subsidiary (“MERIT”), as well as the former president and current Chief Operating Officer and Chief Financial Officer of Dynex Capital, Inc., (together, “Defendants”) are defendants in a putative class action alleging violations of the federal securities laws in the United States District Court for the Southern District of New York (“District Court”) by the Teamsters Local 445 Freight Division Pension Fund (“Teamsters”). The complaint was filed on February 7, 2005, and purports to be a class action on behalf of purchasers between February 2000 and May 2004 of MERIT Series 12 and MERIT Series 13 securitization financing bonds (“Bonds”), which are collateralized by manufactured housing loans. After a series of rulings by the District Court and an appeal by us and MERIT, on February 22, 2008 the United States Court of Appeals for the Second Circuit dismissed the litigation against us and MERIT. Teamsters filed an amended complaint on August 6, 2008 with the District Court which essentially restated the same allegations as the original complaint and added our former president and our current Chief Operating Officer as defendants. Teamsters seeks unspecified damages and alleges, among other things, fraud and misrepresentations in connection with the issuance of and subsequent reporting related to the Bonds On October 19, 2009, the District Court substantially denied the Defendants’ motion to dismiss the Teamsters’ second amended complaint. On December 11, 2009, the Defendants’ filed an answer to the second amended complaint. The Company has evaluated the allegations made in the complaint and believes them to be without merit and intends to vigorously defend itself against them.

ITEM 4.

RESERVED

PART II

ITEM 5.

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is traded on the New York Stock Exchange under the trading symbol “DX”. The common stock was held by approximately 5,138 holders of record as of March 1, 2010. On that date, the closing price of our common stock on the New York Stock Exchange was $8.96 per share. During the last two years, the high and low stock prices and cash dividends declared on common stock were as follows:

	High		Low		Dividends Declared
2009:
First quarter	$	7.47	$	6.30	$	0.23
Second quarter	$	8.70	$	6.75	$	0.23
Third quarter	$	8.92	$	7.82	$	0.23
Fourth quarter	$	9.33	$	7.80	$	0.23

2008:
First quarter	$	9.90	$	8.23	$	0.10
Second quarter	$	9.99	$	8.50	$	0.15
Third quarter	$	9.23	$	6.52	$	0.23
Fourth quarter	$	8.00	$	5.79	$	0.23

During the year ended December 31, 2009, the Company paid common dividends totaling $0.92 per share. Any dividends declared by the Board of Directors have generally been for the purpose of maintaining our REIT status and maintaining compliance with dividend requirements of the Series D Preferred Stock. The stated quarterly dividend on Series D Preferred Stock is $0.2375 per share. In accordance with the terms of the Series D Preferred Shares, if we fail to pay two consecutive quarterly preferred dividends or if we fail to maintain consolidated shareholders’ equity of at least 200% of the aggregate issue price of the Series D Preferred Stock, then these shares automatically convert into a new series of 9.50% senior unsecured notes. Dividends for the preferred stock must be fully paid before dividends can be paid on common stock.

The following graph is a five year comparison of cumulative total returns for the shares of our common stock, the Standard & Poor’s 500 Stock Index (“S&P 500”), and the Bloomberg Mortgage REIT Index. The table below assumes $100 was invested at the close of trading on December 31, 2004 in each of our common stock, the S&P 500, and the Bloomberg Mortgage REIT Index.

Comparative Five-Year Total Returns (1)

Dynex Capital, Inc., S&P 500, and Bloomberg Mortgage REIT Index

(Performance Results through December 31, 2009)

	Cumulative Total Stockholder Returns as of December 31,
Index	2004		2005		2006		2007		2008		2009
Dynex Capital, Inc.	$	100.00	$	88.24	$	90.67	$	113.43	$	91.43	$	136.37
S&P 500 (1)	$	100.00	$	104.21	$	121.48	$	128.14	$	80.73	$	102.10
Bloomberg Mortgage REIT Index (1)	$	100.00	$	83.56	$	100.36	$	54.42	$	31.97	$	40.63

(1)	Cumulative total return assumes reinvestment of dividends. The source of this information is Bloomberg and Standard & Poor’s, which management believes to be reliable sources.

ITEM 6.

SELECTED FINANCIAL DATA

The following selected financial information should be read in conjunction with the audited consolidated financial statements of the Company and notes thereto contained in Item 8 of this Annual Report on Form 10-K.

Years ended December 31,	2009			2008			2007			2006			2005
(amounts in thousands except share and per share data)
Net interest income	$	24,565		$	10,547		$	10,683		$	11,087		$	11,889
Net interest income after (provision for) recapture of loan losses		23,783			9,556			11,964			11,102			6,109
Equity in income (loss) of joint venture		2,400			(5,733	)		709			(852	)		–
Loss on capitalization of joint venture		–			–			–			(1,194	)		–
Gain (loss) on sale of investments		171			2,316			755			(183	)		9,609
Impairment charges		–			–			–			–			(2,474	)
Fair value adjustments, net		205			7,147			–			–			–
Other (expense) income		(2,262	)		7,467			(533	)		557			2,022
General and administrative expenses		(6,716	)		(5,632	)		(3,996	)		(4,521	)		(5,681	)
Net income	$	17,581		$	15,121		$	8,899		$	4,909		$	9,585
Net income to common shareholders	$	13,571		$	11,111		$	4,889		$	865		$	4,238
Net income per common share:
Basic	$	1.04		$	0.91		$	0.40		$	0.07		$	0.35
Diluted	$	1.02		$	0.91		$	0.40		$	0.07		$	0.35
Dividends declared per share:
Common	$	0.92		$	0.71		$	–		$	–		$	–
Series D Preferred	$	0.95		$	0.95		$	0.95		$	0.95		$	0.95

As of December 31,	2009		2008		2007		2006		2005
Investments	$	917,981	$	572,255	$	331,795	$	401,186	$	751,294
Total assets		958,062		607,191		374,758		466,557		805,976
Repurchase agreements		638,329		274,217		4,612		95,978		133,315
Securitization financing		143,081		177,157		203,199		210,135		513,140
Total liabilities		789,309		466,782		232,822		330,019		656,642
Shareholders’ equity		168,753		140,409		141,936		136,538		149,334
Common shares outstanding		13,931,512		12,169,762		12,136,262		12,131,262		12,163,391
Book value per common share	$	9.08	$	8.07	$	8.22	$	7.78	$	7.65

ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of the consolidated financial condition and results of operations should be read together with the audited consolidated financial statements of the Company and notes thereto contained in Item 8 of this Annual Report on Form 10-K.

EXECUTIVE SUMMARY

For most of 2009, our principal investment strategy for 2009 was acquiring Hybrid Agency ARMs. Toward the latter part of 2009, as Hybrid Agency ARM prices increased and correspondingly yields decreased, we expanded our investment activities and sought to acquire non-Agency securities with more attractive risk-adjusted returns. As discussed below, in the fourth quarter of 2009, we acquired ‘AAA’ rated non-Agency CMBS backed by loans originated by us in 1998. These securities have characteristics that complement the risk and return profile of the Agency MBS.

For 2010, we expect to continue to purchase Agency MBS and ‘AAA’ rated non-Agency securities Generally we are targeting to invest half of our investment capital in Agency MBS and the other half in non-Agency securities. To the extent that we raise capital in 2010 through our controlled equity offering program or otherwise, we expect to continue to maintain that ratio. Our continued investment in Agency MBS and ‘AAA’ rated non-Agency securities, however, is dependent on market conditions and the risk-adjusted returns on these securities compared to other investment opportunities.

As of December 31, 2009, we had total investments of $918.0 million. Our investments consisted substantially of $594.1 million of Agency MBS, $109.1 million in non-Agency securities consisting of $103.2 million in CMBS and $5.9 million in RMBS, $62.1 million of securitized single-family mortgage loans and $150.4 million of securitized commercial mortgage loans.

We generally finance our acquisition of securities by borrowing against a substantial portion of the market value of these assets utilizing repurchase agreements. Repurchase agreements are financings under which we will pledge our securities as collateral to secure loans made by repurchase agreement counterparties. During 2009, we had $364.1 million of net additional borrowings under our repurchase agreement facilities, which were used to finance our acquisition of Agency MBS and non-Agency securities during the year, and ended 2009 with $638.3 million in repurchase agreement borrowings. We may also opportunistically use other types of financing such as TALF for our assets. As of February 28, 2010, we have purchased $15.1 million of non-Agency CMBS using $12.8 million in TALF financing.

The results of our operations are affected by a number of factors, many of which are beyond our control, and primarily depend on, among other things, the level of our net interest income, the market value of our assets, the supply of and demand for MBS in the marketplace, and the cost and availability of financing. Our net interest income varies primarily as a result of changes in interest rates, the slope of the yield curve (i.e. the differential between long-term and short-term interest rates), the credit performance of our securitized commercial and single-family mortgage loans, borrowing costs (i.e., our interest expense) and prepayment speeds on our MBS portfolio, the behavior of which involves various risks and uncertainties. Interest rates and prepayment speeds, as measured by the constant prepayment rate (“CPR”), vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty.

In general, with respect to our business operations, increases in interest rates over time may cause: (i) the interest expense associated with our borrowings to increase: (ii) the value of our securities to decline; (iii) coupons on our variable-rate investments to reset, although on a delayed basis, to higher interest rates; and (iv) prepayments on our investments to slow, thereby slowing the amortization of our MBS purchase premiums. Conversely, decreases in interest rates, in general, may over time cause: (i) prepayments on our investments to increase, thereby accelerating the amortization of premiums; (ii) the interest expense associated with our borrowings to decrease; (iii) the value of our securities to increase, and (iv) coupons on our variable-rate investments to reset, although on a delayed basis, to lower interest rates.

For further discussion of risks inherent in our investment strategy see Item 7A. “Quantitative and Qualitative Disclosures About Market Risk”.

MARKET CONDITIONS

The well publicized disruptions in the financial markets that began in 2007 and escalated in 2008 have led to various initiatives by the U.S. federal government to address credit and liquidity issues as discussed above in Item 1. Business and as discussed further in Item 1A. Risk Factors. In addition, in December 2008, in response to severe disruptions in the credit markets, the Federal Reserve lowered the targeted Federal Funds rate to a range of 0.0% to 0.25%. Despite recent improvements in the credit markets, the Federal Reserve has continued to maintain this targeted federal funds rate into 2010

as a result of current economic conditions. These initiatives impact our business in several ways. First, Fannie Mae and Freddie Mac, which guarantee the timely payment of principal and interest on our Agency MBS, are under federal conservatorship and have liquidity and preferred capital commitments from the government. Without such intervention, it is unlikely that government sponsored entities could perform under their guaranty of payment on the Agency MBS. Second, as of February 16, 2010 the Treasury and Federal Reserve have purchased approximately $1.4 trillion in 15 and 30-year fixed-rate Agency MBS which has reduced overall mortgage rates while driving up prices on all Agency MBS, including Hybrid Agency ARMs and Agency ARMs. Third, our repurchase agreement borrowing costs have benefitted by the lowered Federal Funds rate, increasing our net interest income and as a result our profitability. Over time, the government and Federal Reserve will change the above policies (and other policies not discussed above) with respect to the credit markets. For instance, the Treasury discontinued its purchases of Agency MBS as of December 31, 2009, and the Federal Reserve is expected to discontinue its purchases in March 2010. When these policies change or reverse, our profitability, the market value of our investments, and our investment opportunities will likely all be impacted. While liquidity returned to many markets in 2009, we believe the stability of the global credit markets remains fragile, particularly given global economic fundamentals. The long-term success of our business model is generally predicated on the stability of the capital markets.

On February 10, 2010, Fannie Mae and Freddie Mac announced their intentions to buy out delinquent loans that are past due 120 or more days from Agency MBS pools. Freddie Mac announced that it would buy all such loans in February 2010 and Fannie Mae indicated that it would purchase loans over a period of a few months subject to certain conditions. The purchase of delinquent loans will likely impact certain of our Agency MBS investments, resulting in an increase in prepayments on our Agency MBS for those periods. Neither of the government-sponsored entities has published sufficient information to precisely predict the ultimate impact on the Company’s investment portfolio from these actions. However, based on published information, the Company believes that Agency MBS with coupons greater than 5.00% and originated between 2005 and 2008 are likely to have the most seriously delinquent loans and are at the greatest risk for buy-outs. As of January 31, 2010, approximately $216.6 million, or 40%, of the Company’s investment in Agency MBS have these characteristics. Overall, the Company expects that its concentration in lower coupon MBS should reduce the overall impact of the buy-outs. Additional information on the potential impact of these buyouts is discussed within the “Liquidity and Capital Resources” section of Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

CRITICAL ACCOUNTING POLICIES

The discussion and analysis of our financial condition and results of operations are based in large part upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of the financial statements 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 revenue and expenses during the reported period. Actual results may differ from the estimated amounts we have recorded.

Critical accounting policies are defined as those that are reflective of significant judgments or uncertainties, and which may result in materially different results under different assumptions and conditions, or the application of which may have a material impact on our financial statements.

Consolidation of Subsidiaries. The consolidated financial statements represent our accounts after the elimination of all inter-company transactions. We consolidate entities in which we own more than 50% of the voting equity and control does not rest with others and variable interest entities in which we are determined to be the primary beneficiary in accordance with Accounting Standards Codification (“ASC” or “Codification”) Topic 810. We follow the equity method of accounting for investments with greater than 20% and less than a 50% interest in partnerships and corporate joint ventures or when we are able to influence the financial and operating policies of the investee but own less than 50% of the voting equity.

Securitization. We have securitized mortgage loans in a securitization transaction by transferring financial assets to a wholly owned trust, and the trust issues non-recourse securitization financing bonds pursuant to an indenture. Generally, we retain some form of control over the transferred assets, and/or the trust is not deemed to be a qualified special purpose entity. In instances where the trust is deemed not to be a qualified special purpose entity, the trust is included in our consolidated financial statements. For accounting and tax purposes, the loans and securities financed through the issuance of bonds in a securitization financing transaction are treated as our assets (presented as securitized mortgage loans), and the

associated bonds issued are treated as our debt as securitization financing. We may retain certain of the bonds issued by the trust, and we have generally transferred collateral in excess of the bonds issued. This excess is typically referred to as over-collateralization. Each securitization trust generally provides us the right to redeem, at our option, the remaining outstanding bonds prior to their maturity date.

Other-than-Temporary Impairments. We evaluate all securities in our investment portfolio for other-than-temporary impairments. A security is generally defined to be other-than-temporarily impaired if the carrying value of such security exceeds its estimated fair value. Under the provisions of ASC Topic 320, a security is considered to be other-than-temporarily impaired if the present value of cash flows expected to be collected is less than the security’s amortized cost basis (the difference being defined as the credit loss) or if the fair value of the security is less than the security’s amortized cost basis and the investor intends, or more-likely-than-not will be required, to sell the security before recovery of the security’s amortized cost basis. The charge to earnings is limited to the amount of credit loss if the investor does not intend, and it is more-likely-than-not that it will not be required, to sell the security before recovery of the security’s amortized cost basis. Any remaining difference between fair value and amortized cost is recognized in other comprehensive income, net of applicable taxes. Otherwise, the entire difference between fair value and amortized cost is charged to earnings. In certain instances, as a result of the other-than-temporary impairment analysis, the recognition or accrual of interest will be discontinued and the security will be placed on non-accrual status. Securities normally are not placed on non-accrual status if the servicer continues to advance on the impaired mortgage loans in the security.

Allowance for Loan Losses. An allowance for loan losses has been estimated and established for currently existing and probable losses for mortgage loans that are considered impaired. Provisions made to increase the allowance are charged as a current period expense. Commercial mortgage loans are secured by income-producing real estate and are evaluated individually for impairment when the debt service coverage ratio on the mortgage loan is less than 1:1 or when the mortgage loan is delinquent. An allowance may be established for a particular impaired commercial mortgage loan. Commercial mortgage loans not evaluated for individual impairment or not deemed impaired are evaluated for a general allowance. Certain of the commercial mortgage loans are covered by mortgage loan guarantees that limit the Company’s exposure on these mortgage loans. Single family mortgage loans are considered homogeneous and according are evaluated on a pool basis for a general allowance.

We consider various factors in determining our specific and general allowance requirements. Such factors include whether a loan is delinquent, our historical experience with similar types of loans, historical cure rates of delinquent loans, and historical and anticipated loss severity of the mortgage loans as they are liquidated. The factors may differ by mortgage loan type (e.g., single-family versus commercial) and collateral type (e.g., multifamily versus office property). The allowance for loan losses is evaluated and adjusted periodically by management based on the actual and estimated timing and amount of probable credit losses as well as industry loss experience.

In reviewing both general and specific allowance requirements for commercial mortgage loans, for loans secured by low-income housing tax credit (“LIHTC”) properties, the Company considers the remaining life of the tax compliance period in its analysis. Because defaults on mortgage loan financings for these properties can result in the recapture of previously received tax credits for the borrower, the potential cost of this recapture provides an incentive to support the property during the compliance period, which has historically decreased the likelihood of defaults.

Derivatives. As required by ASC Topic 815, we record all derivatives on our balance sheet at fair value. The accounting for changes in the fair value of each derivative depends on whether we designate the derivative as a trading position or as a hedging position for a financial instrument or forecasted transaction. If we designate a derivative as a trading position, changes in its fair value are immediately recognized in the current period’s consolidated statement of income as trading income or loss. If we designate a derivative as a hedging position and we satisfy certain criteria established within ASC Topic 815, then we may apply hedge accounting to record changes in the derivative’s fair value. Hedge accounting involves evaluating the effectiveness of the hedge against the financial instrument or transaction being hedged. The ineffective portion of the hedge relationship is immediately recognized in the current period’s statement of income as a portion of other income (expense) while the effective portion of the hedge relationship is reported in accumulated other comprehensive income (“AOCI”) and later reclassified into the statement of income as a portion of interest expense in the same period during which the hedged financial instrument or transaction affects earnings. If our management decides to terminate any or all derivatives designated as hedging positions or if our management decides to sell or terminate the underlying financial instruments being hedged, any changes in fair value of the associated derivatives recorded in other comprehensive income at the time of termination will be recognized in that period’s statement of income. In addition, our

interest rate agreements contain covenants which require us to maintain a minimum level of equity and earnings as well as maintain our REIT status. If we breach any of these covenants, our counterparties will be allowed to immediately terminate any interest rate agreement they have with us. At the time of this termination, any changes in fair value of the derivatives recorded in other comprehensive income will be recognized in that period’s statement of income.

Fair Value. As defined in ASC Topic 820, the fair value of a financial instrument is the exchange price in an orderly transaction, that is not a forced liquidation or distressed sale, between market participants to sell an asset or transfer a 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/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/liability. ASC Topic 820 provides a consistent definition of fair value which focuses on exit price and prioritizes, within a measurement of fair value, the use of market-based inputs over entity-specific inputs. In addition, ASC Topic 820 provides a framework for measuring fair value and 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.

The three levels of valuation hierarchy established by ASC Topic 820 are as follows:

·	Level 1 — Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date. Our investments included in Level 1 fair value generally are equity securities listed in active markets.

Level 2 — Inputs (other than quoted prices included in Level 1) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life. Fair valued assets and liabilities that are generally included in this category are Agency MBS, which are valued based on the average of multiple dealer quotes that are active in the Agency MBS market, and interest rate swaps, which are valued using a third-party pricing service, and the valuations are tested with internally developed models that apply readily observable market variables.

Level 3 — Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model. Generally, assets and liabilities carried at fair value and included in this category are non-Agency mortgage-backed securities, delinquent property tax receivables and the obligation under payment agreement liability.

Estimates of fair value for financial instruments are based primarily on management’s judgment. Since the fair value of our financial instruments is based on estimates, actual fair values recognized may differ from those estimates recorded in the consolidated financial statements. Please see Note 12 of the Notes to Consolidated Financial Statements for additional information regarding ASC Topic 820 with respect to specific assets.

We account for our Agency MBS and non-Agency securities in accordance with ASC Topic 320, which requires that investments in debt and equity securities be designated as either “held-to-maturity,” “available-for-sale” or “trading” at the time of acquisition. All of our securities are designated as available-for-sale and are carried at their fair value with unrealized gains and losses excluded from earnings and reported in other comprehensive (loss)/income as a component of shareholders’ equity. We determine the fair value of our non-Agency securities by discounting the estimated future cash flows derived from pricing models that utilize information such as the security’s coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected losses, and credit enhancement as well as certain other relevant information. The fair value of our other investment securities is based upon prices obtained from a third-party pricing service and broker quotes.

Although we generally intend to hold our investment securities until maturity, we may, from time to time, sell any of our securities as part of the overall management of our business. The available-for-sale designation provides us with the flexibility to sell any of our investment securities. Upon the sale of an investment security, any unrealized gain or loss is reclassified out of AOCI to earnings as a realized gain or loss using the specific identification method.

RECENT ACCOUNTING PRONOUNCEMENTS

The following section discusses recent accounting pronouncements issued prior to the filing of this Annual Report on Form 10-K which will likely have a material impact our future financial condition or results of operations.

In December 2009, FASB issued Accounting Standards Update (“ASU” or “Update”) No. 2009-16 and ASU No. 2009-17 which amends ASC Topic 860 and ASC Topic 810, respectively. The purpose of the amendment to ASC Topic 860 is to eliminate the concept of a “qualifying special-purpose entity” (“QSPE”) and to require more information about transfers of financial assets, including securitization transactions as well as a company’s continuing exposure to the risks related to transferred financial assets. The purpose of the amendment to ASC Topic 810 is to change how a reporting entity determines when to consolidate another entity that is insufficiently capitalized or is not controlled by voting rights. Instead of focusing on quantitative determinants, consolidation is to be determined based on, among other things, qualitative factors such as the other entity’s purpose and design as well as the reporting entity’s ability to direct the activities of the other entity that most significantly impact its performance. The reporting entity is also required to add significant disclosures regarding its involvement with variable interest entities and any changes in risk exposure due to this involvement. Both of these amendments to the ASC are effective for transactions and events occurring after the beginning of a reporting entity’s first fiscal year that begins after November 15, 2009. Early adoption is prohibited, and the application will be prospective. We have one QSPE that we will consolidate as a result of the adoption of these standards on January 1, 2010. As a result, our investments will increase by approximately $15 million as a result of the consolidation of this QSPE with a corresponding $15 million increase in its securitization financing. We do not anticipate that the adoption of this standard will have a material impact on our results of operations.

Subsequently, FASB issued Update No. 2010-10 which allowed certain reporting entities to defer the consolidation requirements amended in ASC Topic 810 by Update No. 2009-17. Our company is not eligible for this deferral.

In January 2010, FASB issued Update No. 2010-06 which amends ASC Topic 820 to require additional disclosures and to clarify existing disclosures. Specifically, entities will be required to disclose reasons for and amounts of transfers in and out of levels 1 and 2 as well as a reconciliation of level 3 measurements to include separate information about purchases, sales, issuances, and settlements. Additionally, this amendment clarifies that a “class” of assets or liabilities is often a subset of assets or liabilities within a line item on the entity’s balance sheet, and that a reporting entity should provide fair value measurement disclosures for each class. This amendment also clarifies that disclosures about valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements is required for those measurements that fall in either level 2 or 3. The effective date for the new disclosure requirements relating to the rollforward of activity in level 3 fair value measurements is for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. All other new disclosures and clarifications of existing disclosures issued in this Update are effective for interim and annual reporting periods beginning after December 15, 2009. Management will comply with these new disclosure requirements in the future applicable periods. Because these amendments to ASC Topic 820 relate only to disclosures and do not alter GAAP, they will not impact our financial condition or results of operations.

FINANCIAL CONDITION

The following discussion includes our balance sheet items that had significant activity during the past fiscal year and should be read in conjunction with the Notes to the Financial Statements contained within Item 8 of this Annual Report on Form 10-K.

Agency MBS

Our Agency MBS investments, which are classified as available-for-sale and carried at fair value, are comprised as follows:

(amounts in thousands)	December 31, 2009		December 31, 2008
Agency MBS:
Hybrid ARMs	$	293,428	$	217,800
ARMs		297,002		92,626
		590,430		310,426
Fixed-rate		131		194
		590,561		310,620
Principal receivable		3,559		956
	$	594,120	$	311,576

Agency MBS increased $282.5 million to $594.1 million as of December 31, 2009 from $311.6 million as of December 31, 2008 primarily as a result of our purchase of approximately $389.2 million of Agency MBS. In addition, the weighted average price on our Agency MBS increased to 104.2 from 101.3 as of December 31, 2009 and 2008, respectively. Partially offsetting these increases was the receipt of $116.7 million of principal on the securities during the twelve-month period ended December 31, 2009. Approximately $575.4 million of the Agency MBS are pledged to counterparties as security for repurchase agreement financing.

As of December 31, 2009, our portfolio of Agency MBS included net unamortized premiums of $12.9 million, or 2.3% of the par value of the securities, compared to net unamortized premiums of $3.5 million, or 1.1% of the par value of the securities, as of December 31, 2008. The average constant prepayment rate (“CPR”) realized on our Agency MBS portfolio was 17.0% for the years ended December 31, 2009 and 2008.

Securitized Mortgage Loans, Net

Securitized mortgage loans are comprised of loans secured by first deeds of trust on single-family residential and commercial properties. Our net basis in these loans at amortized cost, which includes discounts, premiums, deferred costs, and allowance for loan losses, is presented in the following table by the type of property collateralizing the loan.

(amounts in thousands)	December 31, 2009		December 31, 2008
Securitized mortgage loans, net:
Commercial	$	150,371	$	170,806
Single-family		62,100		71,483
	$	212,471	$	242,289

Our securitized commercial mortgage loans are pledged to two securitization trusts, which were issued in 1993 and 1997, and have outstanding principal balances, including defeased loans, of $13.1 million and $142.0 million, respectively, as of December 31, 2009 compared to $22.9 million and $152.2 million, respectively, as of December 31, 2008. The decrease in the balance of these mortgage loans from December 31, 2008 to December 31, 2009 was primarily related principal payments, net of amounts received on loans entering defeasance, of $20.3 million. We provided approximately $0.3 million for estimated losses on these commercial mortgage loans as a result of an increase in estimated losses on the commercial loan portfolio.

Our securitized single-family mortgage loans are pledged to a securitization trust issued in 2002 using loans that were principally originated between 1992 and 1997. The decrease in the balance of these mortgage loans is primarily related to principal payments on the loans of $9.1 million, $5.8 million of which was unscheduled, and the provision of approximately $0.3 million for estimated loan losses during the 2009 fiscal year. These loans are comprised of approximately 87% ARMs, 62% of which are based on six-month LIBOR, and the remaining 13% being fixed rate loans. These loans have a loan to original appraised value of approximately 49.6%, based on the unpaid principal balance as of December 31, 2009. In addition, approximately 32.7% of the loans are covered by pool insurance. Although the portfolio experienced an increase in the percentage of single-family mortgage loans more than 60 days delinquent from 4.45% as of

December 31, 2008 to 6.77% as of December 31, 2009, the loans continue to perform well with realized losses of only $0.2 million for the year ended December 31, 2009 and no realized losses for the year ended December 31, 2008. Due to the seasoning of these loans, pool insurance, and other credit support, we provided approximately $0.3 million estimated losses on the single-family mortgage loans during the year.

Non-Agency securities

Non-Agency securities increased $102.8 million to $109.1 million as of December 31, 2009 from $6.3 million as of December 31, 2008. In November of 2009, we acquired all of the interests in our previous joint venture and now consolidate the assets of the former joint venture. One of the assets we acquired was a subordinate CMBS with a fair value of approximately $4.1 million, which is included in non-Agency securities. We also acquired the redemption rights for $182.5 million CMBS issued in 1998 when we purchased the controlling interest in the joint venture.

We exercised certain of the redemption rights and redeemed $111.3 million of ‘AAA’ rated CMBS. We refinanced these CMBS through a securitization transaction in December 2009 and sold $15.0 million of the securitization bonds as part of the transaction on which we recognized a loss of less than $0.1 million. As of December 31, 2009, we held $99.1 million of the securitization bonds in our investment portfolio.

Other Investments

In 2009, we sold all of our remaining investment in equity securities of $3.4 million, which generated net proceeds of approximately $3.6 million and a gain of $0.2 million.

Other loans and investments declined approximately $0.6 million primarily due to the receipt of principal on the mortgage loans. The balance as of December 31, 2009 is comprised of $2.1 million of seasoned residential and commercial mortgage loans and $0.1 million related to an investment in delinquent property tax receivables.

Repurchase Agreements

Repurchase agreements increased to $638.3 million as of December 31, 2009 from $274.2 million as of December 31, 2008. The increase is primarily related to our use of repurchase agreements to finance our acquisition of Agency MBS and non-Agency securities, net of repayments during the year. The following table presents our repurchase agreement borrowings and the fair value of the investments collateralizing those borrowing by collateral type as of December 31, 2009 and 2008.

	December 31, 2009				December 31, 2008
(amounts in thousands)	Repurchase agreement		Estimated fair value of collateral		Repurchase agreement		Estimated fair value of collateral
Collateral type:
Agency MBS	$	540,586	$	575,386	$	274,217	$	300,277
Non-Agency securities - CMBS		73,338		82,770	─		─
Securitization financing bonds (1)		24,405		34,431	─		─
	$	638,329	$	692,587	$	274,217	$	300,277

(1)

The securities collateralizing these repurchase agreements are two securitization financing bonds, which were issued by trusts that we consolidate and which were redeemed by us. Although these securities remain outstanding, which enables us to finance them with repurchase agreements, because we consolidate the trusts that issued these bonds, they are eliminated in our consolidated financial statements.

Our repurchase agreements generally have original maturities of thirty to sixty days and bear interest at a spread to LIBOR. As of December 31, 2009 and 2008, our repurchase agreements had the following weighted average maturities and interest rates:

	December 31, 2009		December 31, 2008
(amounts in thousands)	Weighted average original maturity (in days)	Interest rate	Weighted average original maturity (in days)	Interest rate
Collateral type:
Agency MBS	64	0.60%	41	2.70%
Non-Agency securities - CMBS	33	1.73%	─	─
Securitization financing bonds	33	1.59%	─	─

Securitization Financing

Securitization financing consists of fixed and variable rate bonds. The balances in the table below include unpaid principal, premiums, discounts, and deferred costs.

(amounts in thousands)	December 31, 2009		December 31, 2008
Securitization financing bonds:
Fixed, secured by commercial mortgage loans	$	119,713	$	149,584
Variable, secured by single-family mortgage loans		23,368		27,573
	$	143,081	$	177,157

The fixed-rate bonds were issued pursuant to two separate indentures (via two securitization trusts) and finance our securitized commercial mortgage loans, which are also fixed-rate. The fixed-rate bonds have a range of rates from 6.7% to 7.2% and a weighted average rate of 6.9% as of December 31, 2009. Approximately $15.5 million of the decrease in fixed-rate securitization financing was related to the Company’s redemption of a senior bond issued by one of the securitization trusts. The bond was redeemed at its par value and was partially financed with a repurchase agreement with a balance of $6.1 million as of December 31, 2009, which is referred to in the repurchase agreement discussion above. The remainder of the decrease in fixed-rate bonds is primarily related to principal payments on the bonds of $12.9 million and bond premium and deferred cost amortization of approximately $1.5 million during the year ended December 31, 2009.

Our securitized single-family mortgage loans are financed by a variable-rate securitization financing bond issued pursuant to a single indenture. As of December 31, 2009, the interest rate for this variable-rate bond was 0.5%. The balance decreased $4.2 million to $23.4 million as of December 31, 2009 from $27.6 million as of December 31, 2008 and is primarily related to principal payments on the bonds of $4.3 million partially offset by $0.1 million of bond discount amortization.

Shareholders’ Equity

Shareholders’ equity increased $28.3 million to $168.8 million as of December 31, 2009. The increase was primarily related to net income of $17.6 million, an increase in AOCI of $14.0 million primarily related to an increase in the average price of our Agency MBS portfolio to 104.2 as of December 31, 2009 from 101.3 as of December 31, 2008, and a $12.9 million increase for the issuance of 1,751,750 shares of our common stock at an average price of $7.59 (net of issuance costs). These increases were partially offset by dividends declared on our common and preferred stock dividends of $16.1 million.

Supplemental Discussion of Investments

The tables below summarize our investment portfolio by major category as of December 31, 2009 and December 31, 2008, and provide our investment basis, associated financing, net invested capital (which is the difference between our investment basis and the associated financing as reported in our audited consolidated financial statements), and the estimated fair value of the net invested capital as of December 31, 2009. Net invested capital in the table below represents the approximate allocation of our shareholders’ capital by major investment category. Because our business model employs the use of leverage, our investment portfolio presented on a gross basis may not reflect the true commitment of our shareholders’

equity capital to a particular investment category, and it may not indicate to our shareholders where our capital is at risk. We believe this analysis is particularly important when we use financing which is recourse to us such as repurchase agreements. Our capital allocation decisions are in large part determined based on risk adjusted returns for our capital available in the marketplace. Such risk-adjusted returns are based on the leveraged return on investment (i.e., return on equity or, alternatively, return on invested capital). We present the information in the table below to show where our capital is allocated by investment category. We believe that our shareholders view our actual capital allocations as important in their understanding of the risks in our business and the earnings potential of our business model.

For investments carried at fair value in our consolidated financial statements, the estimated fair value of net invested capital (presented in the last column of the following table) is equal to the basis as presented in the consolidated financial statements less the financing amount associated with that investment. For investments carried at an amortized cost basis (principally securitized mortgage loans), the estimated fair value of net invested capital is based on the present value of the projected cash flow from the investment, adjusted for the impact and assumed level of future prepayments and credit losses, less the projected principal and interest due on the associated financing. In general, because of the uniqueness and age of these investments, an active secondary market does not currently exist so management makes assumptions as to market expectations of prepayment speeds, losses and discount rates. Therefore, if we actually were to have attempted to sell these investments as of December 31, 2009 or as of December 31, 2008, there can be no assurance that the amounts set forth in the tables below could have been realized. In all cases, we believe that these valuation techniques are consistent with the methodologies used in our fair value disclosures included in Note 12 in the Notes to the Consolidated Financial Statements.

Estimated Fair Value of Net Invested Capital

	December 31, 2009 (amounts in thousands)
Investment	Investment basis		Financing (1)		Net invested capital		Estimated fair value of net invested capital
Agency MBS (2)	$	594,120	$	540,586	$	53,534	$	53,534

Securitized mortgage loans: (3)
Single-family mortgage loans – 2002 Trust		62,100		41,716		20,384		13,911
Commercial mortgage loans – 1993 Trust		11,574		6,057		5,517		5,762
Commercial mortgage loans – 1997 Trust		138,797		119,713		19,084		10,235
		212,471		167,486		44,985		29,908

Non-Agency securities (4)
CMBS		103,203		73,338		29,865		29,865
RMBS		5,907	─			5,907		5,907
		109,110		73,338		35,772		35,772

Other investments		2,280	─			2,280		2,079

Total	$	917,981	$	781,410	$	136,571	$	121,293

(1)	Financing includes repurchase agreements and securitization financing issued to third parties.

(2)	Estimated fair values are based on a third-party pricing service and dealer quotes. Net invested capital excludes cash maintained to support investment in Agency MBS financed with repurchase agreement borrowings.

(3)	Estimated fair values are based on discounted cash flows using assumptions set forth in the table below, inclusive of amounts invested in unredeemed securitization financing bonds.

(4)	Estimated fair values are calculated as the net present value of expected future cash flows.

The following table summarizes management’s assumptions used in our calculation of estimated fair value of net invested capital as of December 31, 2009 for the securitized mortgage loan and non-Agency CMBS portions of our investment portfolio.

	Fair Value Assumptions
Investment type	Approximate year of investment origination or issuance	Weighted-average prepayment speeds(1)	Projected annual losses (2)	Weighted-average discount rate(3)

Single-family mortgage loans – 2002 Trust	1994	15% CPR	0.2%	11%
Commercial mortgage loans – 1993 Trust	1993	0% CPR	0.8%	11%
Commercial mortgage loans – 1997 Trust	1997	20% CPY(4)	1.5%	21%

Non-Agency CMBS	1998	20% CPY(4)	0.0%	6%

(1)	Assumed CPR speeds generally are governed by underlying pool characteristics. Loans currently delinquent in excess of 30 days are assumed to be liquidated in six months at a loss amount that is calculated for each loan based on its specific facts.

(2)	Management’s estimate of losses that would be used by a third party in valuing these or similar assets.

(3)	Represents management’s estimate of the market discount rate that would be used by a third party in valuing these or similar assets.

(4)	CPR with yield maintenance provision. 20% CPY assumes a CPR of 20% per annum on the pool upon expiration of the prepayment lock-out period.

	December 31, 2008 (amounts in thousands)
Investment	Investment basis		Financing (1)		Net invested capital		Estimated fair value of net invested capital
Agency MBS (2)	$	311,576	$	274,217	$	37,359	$	37,359

Securitized mortgage loans: (3)
Single-family mortgage loans – 2002 Trust		71,483		27,573		43,910		35,594
Commercial mortgage loans – 1993 Trust		21,314		18,218		3,096		3,307
Commercial mortgage loans – 1997 Trust		149,492		139,900		9,592	─
		242,289		185,691		56,598		38,901

Non-Agency securities (4)
CMBS	─		─		─		─
RMBS		6,259	─			6,259		6,259
		6,259	─			6,259		6,259

Investment in joint venture (5)		5,655	─			5,655		5,595

Other investments		6,476	─			6,476		6,099

Total	$	572,255	$	459,908	$	112,347	$	94,213

(1)	Financing includes repurchase agreements and securitization financing issued to third parties. Financing for the 1997 Trust also includes our obligation under payment agreement, which at December 31, 2008 had a balance of $8,534.

(2)	Estimated fair values are based on a third-party pricing service and dealer quotes.

(3)	Estimated fair values are based on discounted cash flows and are inclusive of amounts invested in unredeemed securitization financing bonds.

(4)	Estimated fair values are calculated as the net present value of expected future cash flows.

(5)	Estimated fair values for investment in joint venture represents our share of the estimated fair value of the joint venture’s assets.

The following table presents the information from the “Net Invested Capital” column included in the “Estimated Fair Value of Net Invested Capital” tables by rating classification as of December 31, 2009 and 2008. These ratings are derived based on the rating of the asset in which such capital is invested. Investments in the unrated and non-investment grade classification primarily include other loans that are not rated but are substantially seasoned and performing loans. Securitization overcollateralization generally includes the excess of the securitized mortgage loan collateral pledged over the outstanding bonds issued by the securitization trust.

(amounts in thousands)	December 31, 2009		December 31, 2008
Investments by rating classification:
Agency MBS	$	53,534	$	37,359
AAA rated non-Agency securities		42,793		40,622
AA and A rated non-Agency securities		355		337
Securitization overcollateralization		33,116		21,457
Unrated and non-investment grade		6,773		6,917
Investment in joint venture	─			5,655
Net invested capital	$	136,571	$	112,347

The following table reconciles net invested capital to shareholders’ equity as presented on the Company’s consolidated balance sheets as of December 31, 2009 and 2008:

(amounts in thousands)	December 31, 2009			December 31, 2008
Net invested capital	$	136,571		$	112,347
Cash and cash equivalents		30,173			27,309
Derivative assets		1,008		─
Accrued interest, net		3,375			1,559
Other assets and liabilities, net		(2,374	)		(806	)
Shareholders’ equity	$	168,753		$	140,409

RESULTS OF OPERATIONS

The following discussion for our consolidated results of operation should be read in conjunction with the Notes to the Financial Statements contained within Item 8 of this Annual Report on Form 10-K.

Year Ended December 31, 2009 Compared to Year Ended December 31, 2008

Interest Income

Interest income includes interest earned on our investment portfolio and also reflects the amortization of any related discounts, premiums and deferred costs. The following tables present the significant components of our interest income.

	Year Ended December 31,
(amounts in thousands)	2009		2008
Interest income - Investments:
Agency MBS	$	20,962	$	6,731
Securitized mortgage loans		17,169		20,886
Non-Agency securities		863		709
Other investments		226		642
Cash and cash equivalents		16		685
	$	39,236	$	29,653

Interest Income – Agency MBS

The increase of $14.2 million in interest income on Agency MBS is related to the increase in Agency MBS investments from net purchases of approximately $389.2 million of Agency MBS during 2009, which increased the average balance from $149.2 million for the year ended December 31, 2008 to $492.9 million for the year ended December 31, 2009. This increase is offset by a 26 basis point decrease in the average yield on Agency MBS from 4.51% for 2008 to 4.25% for 2009 as well as an increase of $2.4 million in net premium amortization to $3.0 million for the year ended December 31, 2009 compared to $0.6 million for the year ended December 31, 2008.

Interest Income – Securitized Mortgage Loans

The following table summarizes the detail of the interest income earned on securitized mortgage loans.

	Year Ended December 31,
	2009							2008
(amounts in thousands)	Interest Income		Net Amortization			Total Interest Income		Interest Income		Net Amortization			Total Interest Income
Securitized mortgage loans:
Commercial	$	13,506	$	(32	)	$	13,474	$	15,282	$	409		$	15,691
Single-family		3,710		(15	)		3,695		5,474		(279	)		5,195
	$	17,216	$	(47	)	$	17,169	$	20,756	$	130		$	20,886

The majority of the decrease of $2.2 million in interest income on securitized commercial mortgage loans is related to the lower average balance of the commercial mortgage loans outstanding for the year ended December 31, 2009, which decreased approximately $17.6 million, or 10%, compared to the average balance for the year ended December 31, 2008. The decrease in the average balance is primarily related to principal payments received of $20.3 million, which includes both scheduled and unscheduled payments net of amounts received on loans entering defeasance, during 2009. In addition, net amortization of premiums on commercial mortgage loans changed from an amortization benefit of $0.4 million for the year ended December 31, 2008 to an amortization expense of less than $0.1 million for the same period in 2009. Current and expected market conditions are expected to make it more difficult for commercial borrowers to refinance, which should slow unscheduled payments.

The decline of $1.5 million in interest income on securitized single-family mortgage loans was related to the decrease in the average balance of the loans outstanding to $67.1 million for the year ended December 31, 2009 from $78.9 million for the year ended December 31, 2008. Interest income on single-family mortgage loans also declined as a result of an approximately 108 basis point decrease in the average yield on our single-family mortgage loan portfolio to 5.47% for the year ended December 31, 2009 from 6.56% for the year ended December 31, 2008. For a discussion of the reasons for the decrease in average yields, see the section “Average Balances and Effective Interest Rates” below.

Interest Income – Cash and Cash Equivalents

The decrease of $0.7 million in interest income on cash and cash equivalents is primarily the result of a $6.1 million decrease in the average balance of cash and cash equivalents for the year ended December 31, 2009 compared to the year ended December 31, 2008 and a decrease in short-term interest rates during 2009. The average balance of cash and cash equivalents declined during 2009 as we continued to deploy our cash in investments. The average yield on cash and cash equivalents decreased from 1.90% for the year ended December 31, 2008 to 0.05% for the year ended December 31, 2009.

Interest Expense

The following table presents the significant components of our interest expense.

	Year Ended December 31,
(amounts in thousands)	2009			2008
Interest expense:
Securitization financing	$	9,801		$	13,416
Repurchase agreements		3,288			4,079
Obligation under payment agreement		1,589			1,608
Other		(7	)		3
	$	14,671		$	19,106

Interest Expense – Securitization Financing

The following table summarizes the detail of the interest expense recorded on securitization financing bonds.

	Year Ended December 31,
	2009							2008
(amounts in thousands)	Interest Expense		Net Amortization			Total Interest Expense		Interest Expense		Net Amortization			Total Interest Expense
Securitization financing:
Commercial	$	10,797	$	(1,472	)	$	9,325	$	12,903	$	(995	)	$	11,908
Single-family		171		128			299		995		155			1,150
Other bond related costs		177		–			177		358		–			358
	$	11,145	$	(1,344	)	$	9,801	$	14,256	$	(840	)	$	13,416

The decrease of $2.6 million in interest expense on securitization financing secured by commercial mortgage loans is primarily related to the $28.2 million, or approximately 18%, decrease in the average balance of securitization financing to $131.5 million for the year ended December 31, 2009 from $159.7 million for the year ended December 31, 2008. The decrease in average balance of securitization financing is due to principal payments of $12.9 million on the mortgage loans collateralizing these bonds. We also redeemed a securitization financing bond with a balance of $15.5 million during the period, which is discussed previously in more detail in the “Financial Condition” section above. In addition, securitization financing secured by commercial mortgage loans is fixed-rate and had a weighted average cost, net of amortization, of 7.09% and 7.46% for the years ended December 31, 2009 and 2008, respectively.

The decrease of $0.9 million in interest expense on securitization financing secured by single-family mortgage loans is related to the $5.1 million, or approximately 17%, decrease in the average balance of securitization financing to $25.4 million for the year ended December 31, 2009 from $30.6 million for the year ended December 31, 2008. This decrease in average balance of securitization financing is related to the prepayments on the mortgage loans collateralizing these bonds. In addition, the cost of financing decreased to 1.18% for the year ended December 31, 2009 from 3.76% for the year ended December 31, 2008. The financing is variable-rate based on one-month LIBOR which declined during the 2009 period.

Interest Expense – Repurchase Agreements

The following table summarizes the components of interest expense by the type of securities collateralizing the repurchase agreements.

	Year Ended December 31,
(amounts in thousands)	2009		2008
Interest expense:
Repurchase agreements collateralized by Agency MBS	$	2,847	$	3,978
Repurchase agreements collateralized by securitization financing bonds		409		101
Repurchase agreements collateralized by CMBS		32		–
	$	3,288	$	4,079

The decrease of $1.2 million in interest expense on repurchase agreements collateralized by Agency MBS is primarily related to a 235 basis point decrease in the average rate on the repurchase agreements to 0.63% for the year ended December 31, 2009 from 2.96% for the year ended December 31, 2008. The benefit from the decrease in the average rate of borrowing costs was offset in part by a $314.0 million increase in the average balance of repurchase agreements outstanding for the year ended December 31, 2009 to $448.3 million from $134.3 million for the year ended December 31, 2008.

Interest expense on repurchase agreements collateralized by securitization bonds increased $0.3 million due to a $17.7 million increase in the average balance outstanding to $20.9 million for the year ended December 31, 2009 from $3.2 million for the year ended December 31, 2008. The increase in balance was primarily related to financing the securitization bond that was redeemed during 2009 with a repurchase agreement. The effect of the increased balance on interest expense was partially offset by a 119 basis point decrease in the average rate on the repurchase agreements to 1.96% for the year ended December 31, 2009 from 3.15% for the year ended December 31, 2008.

Provision for Loan Losses

During the year ended December 31, 2009, we added approximately $0.8 million of reserves for estimated losses on our securitized mortgage loan portfolio. We provided $0.4 million for estimated losses on our commercial mortgage loans, which include $15.3 million of loans delinquent for 30 or more days at December 31, 2009. We also provided approximately $0.3 million for estimated losses on our portfolio of securitized single-family mortgage loans.

Gain on Sale of Investments, Net

The gain on sale of investments for the year ended December 31, 2009 is primarily related to the sale of our remaining investment in the equity securities of publicly traded companies during the year which generated proceeds of approximately $3.6 million on equity securities in which we had a cost basis of approximately $3.4 million resulting in a gain of approximately $0.2 million. The gain of $2.3 million for the year ended December 31, 2008 is primarily related to the sale of approximately $14.2 million of equity securities during that period.

Fair Value Adjustments, Net

Fair value adjustments, net for the year ended December 31, 2009 was primarily comprised of an unfavorable fair value adjustment of $2.0 million related to the obligation under payment agreement offset by a favorable fair value adjustment of $1.9 million related to certain bond redemption rights. Prior to our acquisition of the remaining interests of the joint venture, market discount rates declined which resulted in an increase in the fair value of the obligation under payment agreement and the recognition of the unfavorable fair value adjustment of $2.0 million. When we acquired the remaining interests of the joint venture and consolidated its assets into our balance sheet, we recognized $2.7 million in redemption rights for CMBS which subsequently increased in fair value by $1.9 million.

Other (Expense) Income

Other expense of $2.3 million for the year ended December 31, 2009 was primarily related to a $2.5 million charge recognized in relation to our acquisition in November 2009 of the remaining 50.125% interest in the joint venture, Copperhead Ventures, LLC, in which we previously owned 49.875%.

General and Administrative Expenses

Compensation and Benefits

Compensation and benefits expense increased $1.3 million to $3.6 million for the year ended December 31, 2009 from $2.3 million for the year ended December 31, 2008. Our stock-based compensation expense increased $0.8 million primarily due to an increase in the closing price of our common stock from $6.54 at December 31, 2008 to $8.73 at December 31, 2009. The remaining increase in compensation and benefits is primarily related to the salary, bonus and benefits associated with hiring two additional executive officers during the second half of 2008.

Other General and Administrative

The decrease of $0.2 million in other general and administrative expenses is primarily related to consulting and related expenses associated with expanding our investment platform and the related infrastructure that were incurred in 2008.

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007

Interest Income

	Year Ended December 31,
(amounts in thousands)	2008		2007
Interest income - Investments:
Agency MBS	$	6,731	$	110
Securitized mortgage loans		20,886		26,424
Other investments		1,351		1,633
Cash and cash equivalents		685		2,611
	$	29,653	$	30,778

Interest Income – Agency MBS

Interest income on Agency MBS increased to $6.7 million for the year ended December 31, 2008 from $0.1 million for the same period in 2007. The increase is related to the net purchase of approximately $335.6 million of Agency MBS during the year ended December 31, 2008, which increased the average balance from $1.2 million for the year ended December 31, 2007 to $149.2 million for the same period in 2008. The average balance increased less than the gross purchases during 2008 because the Agency MBS purchases occurred throughout 2008.

Interest income on Agency MBS for 2008 of $6.7 million was reduced by approximately $0.6 million of net premium amortization during the year.

Interest Income – Securitized Mortgage Loans

The following table summarizes the detail of the interest income earned on securitized mortgage loans.

	Year Ended December 31,
	2008							2007
(amounts in thousands)	Interest Income		Net Amortization			Total Interest Income		Interest Income		Net Amortization			Total Interest Income
Securitized mortgage loans:
Commercial	$	15,282	$	409		$	15,691	$	18,114	$	485		$	18,599
Single-family		5,474		(279	)		5,195		7,887		(62	)		7,825
	$	20,756	$	130		$	20,886	$	26,001	$	423		$	26,424

The majority of the decrease of $2.9 million in interest income on securitized commercial mortgage loans is primarily related to the decline in the average balance of the commercial mortgage loans outstanding during 2008, which decreased approximately $31.6 million (15%) from the balance for the same period in 2007. The decrease in the average balance between the periods is primarily related to payments on the commercial mortgage loans of $22.3 million, which includes both scheduled and unscheduled payments, during 2008.

Interest income on securitized single-family mortgage loans declined $2.6 million to $5.2 million for the year ended December 31, 2008. The decline in interest income on single-family mortgage loans was primarily related to the decrease in the average balance of the loans outstanding, which declined approximately $21.8 million, or approximately 22%, to $78.9 million for the year ended December 31, 2008 compared to the same period in 2007. Approximately $12.3 million of unscheduled payments were received on our single-family mortgage loans during 2008, which represented approximately 14% of outstanding unpaid principal balance as of December 31, 2007. Interest income on our single-family mortgage loans also declined as a result of a decrease in the average yield on our single-family mortgage loan portfolio, which declined from 7.7% to 6.6% for the years ended December 31, 2007 and 2008, respectively. Approximately 87% of our single-family mortgage loans were variable rate as of December 31, 2008.

Interest Income – Cash and Cash Equivalents

Interest income on cash and cash equivalents decreased $1.9 million to $0.7 million for the year ended December 31, 2008 from $2.6 million for the same period in 2007. This decrease is primarily the result of a $16.8 million decrease in the average balance of cash and cash equivalents for 2008 compared to 2007 and a decrease in short-term interest rates during 2008. The average balance of cash and cash equivalents declined during 2008 as we deployed our cash in investments. The yield on cash decreased from 5.0% for the year ended December 31, 2007 to 1.9% for the same period in 2008.

Interest Expense

The following table presents the significant components of interest expense.

	Year Ended December 31,
(amounts in thousands)	2008		2007
Interest expense:
Securitization financing	$	13,416	$	14,999
Repurchase agreements		4,079		3,546
Obligation under payment agreement		1,608		1,525
Other		3		25
	$	19,106	$	20,095

Interest Expense – Securitization Financing

The following table summarizes the detail of the interest expense recorded on securitization financing bonds.

	Year Ended December 31,
	2008							2007
(amounts in thousands)	Interest Expense		Net Amortization			Total Interest Expense		Interest Expense		Net Amortization			Total Interest Expense
Securitization financing:
Commercial	$	12,903	$	(995	)	$	11,908	$	15,856	$	(1,831	)	$	14,025
Single-family		995		155			1,150		387		62			449
Other bond related costs		358		–			358		525		–			525
	$	14,256	$	(840	)	$	13,416	$	16,768	$	(1,769	)	$	14,999

Interest expense on commercial securitization financing decreased from $14.0 million for the year ended December 31, 2007 to $11.9 million for the same period in 2008. The majority of this $2.1 million decrease is related to the $34.2 million (18%) decrease in the weighted average balance of securitization financing, from $193.9 million for the year ended December 31, 2007 to $159.7 million for the same period in 2008 related to principal payments on the mortgage loans collateralizing these bonds.

The interest expense on single-family securitization financing is related to a securitization bond that we redeemed in 2005 and reissued in the fourth quarter of 2007. The net amortization of $0.2 million during the year ended December 31, 2008 is attributable to the discount at which the bond was reissued.

Interest Expense – Repurchase Agreements

The increase of $0.5 million of interest expense to $4.1 million on the repurchase agreements in 2008 is primarily the result of an increase of the average balance of repurchase agreements from $64.2 million for the year ended December 31, 2007 to $134.3 million for the same period in 2008. The increase in the balance of repurchase agreements was related to our purchase of additional Agency MBS, which we financed with repurchase agreements. The increase in expense related to the increase in the average balance was partially offset by a decrease in the yield on the repurchase agreements from 5.5% to 3.0% for the years ended December 31, 2007 and 2008, respectively.

(Provision for) Recapture of Provision for Loan Losses

During the year ended December 31, 2008, we added approximately $1.0 million of reserves for estimated losses on our securitized mortgage loan portfolio. The majority of this amount was provided for estimated losses on our commercial mortgage loans, with less than $0.1 million provided for estimated losses on our portfolio of single–family mortgage loans.

Equity in (Loss) Income of Joint Venture

Our interest in the operations of the joint venture, in which we held a 49.875% interest, decreased from income of $0.7 million to a loss of $5.7 million for the year ended December 31, 2007 and 2008, respectively. The joint venture had interest income of approximately $4.0 million for the year ended December 31, 2008. The joint venture’s results for the year ended December 31, 2008 were reduced by an other-than-temporary impairment charge of $7.3 million that it recognized on its interests in a subordinate CMBS and a $7.4 million decrease in the estimated fair value of certain interests in a subordinate CMBS, for which it elected the fair value option under SFAS 159. Our proportionate share of these items was a $5.7 million loss.

Fair Value Adjustments, Net

The $7.1 million fair value adjustment is primarily related to a decline in the fair value of our obligation under a payment agreement to the joint venture, with respect to which we elected to apply fair value accounting under SFAS 159, which we adopted on January 1, 2008. The decline in fair value of the obligation resulted from an increase in the rate used to discount estimated future cash flows to 36.50% from 14.75% as spreads to interest rate indices widened during the year. In addition, the estimated prepayments on the loans covered by the obligation under payment agreement were slowed due to economic conditions which make refinancing commercial loans difficult. The reduced prepayments resulted in estimated cash flows occurring later than was previously forecast, which, along with the increase in the discount rate, reduced the carrying value of the obligation during the year.

Gain on Sale of Investments, Net

The $2.3 million gain on sale of investments for the year ended December 31, 2008 is primarily related to a $2.6 million net gain recognized on the sale of approximately $14.2 million of equity securities during the period. That gain was partially offset by a $0.2 million loss on the sale of a senior convertible debt security with a par value of $5.0 million.

Other Income (Expense)

Other income of $7.5 million for the year ended December 31, 2008 includes the recognition of $2.7 million of income related to the redemption of a commercial securitization bond. Of that amount approximately $1.4 million relates to the unamortized premium on the redeemed bond on the redemption date and $1.3 million relates to the release of a contingency reserve at the time of redemption. In addition, we recognized a $3.4 million benefit related to our release from an obligation to fund certain mortgage servicing payments. The obligation was related to payments we had been required to make to a former affiliate that was the servicer of manufactured housing loans that were originated by one of our subsidiaries in 1998 and 1999. The servicer resigned effective July 1, 2008, which resulted in our release from the obligation to make further payments. Other income also includes $1.2 million in dividend income we earned during 2008 on our investment in equity securities.

General and Administrative Expenses

Compensation and Benefits

Compensation and benefits expense increased $0.4 million from $1.9 million to $2.3 million for the years ended December 31, 2007 and 2008, respectively. This increase is primarily due to an increase in salaries and bonuses of approximately $1.0 million, the majority of which is related to the hiring of two additional executive officers during the year. This increase in salaries and bonuses was partially offset by a $0.5 million decrease in stock based compensation expense related to outstanding stock appreciation rights, which decreased from an expense of $0.2 million to a benefit of $0.3 million as a result of decreases in our common stock price and the stock price volatility.

Other General and Administrative

Other general and administrative expenses increased by $1.2 million to $3.3 million for the year ended December 31, 2008. This increase was primarily related to additional costs associated with expanding our investment platform and evaluating potential investment opportunities of approximately $0.9 million and $0.2 million for certain consulting services.

Average Balances and Effective Interest Rates

The following table summarizes the average balances of interest-earning investment assets and their average effective yields, along with the average interest-bearing liabilities and the related average effective interest rates, for each of the periods presented. Cash and cash equivalents and assets that are on non-accrual status are excluded from the table below for each period presented.

	Year ended December 31,
(amounts in thousands)	2009					2008					2007
	Average Balance(1)(2)		Effective Rate(3)			Average Balance(1)(2)		Effective Rate(3)			Average Balance(1)(2)		Effective Rate(3)
Agency MBS
Agency MBS	$	492,900		4.25	%	$	149,229		4.51	%	$	1,214		9.03	%
Repurchase agreements		448,279		0.63	%		134,252		2.96	%		–		–	%
Net interest spread				3.62	%				1.55	%				9.03	%

Securitized Mortgage Loans
Securitized mortgage loans	$	233,120		7.36	%	$	262,482		7.95	%	$	315,962		8.35	%
Securitization financing (4)		156,891		6.13	%		190,234		6.86	%		201,148		7.19	%
Repurchase agreements		20,869		1.96	%		3,201		3.15	%		64,231		5.45	%
Net interest spread				1.71	%				1.15	%				1.56	%