Edgar Filing: DYNEX CAPITAL INC

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2011

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

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	23060-9245
(Address of principal executive offices)	(Zip Code)

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes 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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes o No o

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

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 Exchange Act).

Yes o No þ

On May 6, 2011, the registrant had 40,323,159 shares outstanding of common stock, $0.01 par value, which is the registrant’s only class of common stock.

DYNEX CAPITAL, INC.

FORM 10-Q

INDEX

			Page
PART I.	FINANCIAL INFORMATION

	Item 1.	Financial Statements

		Consolidated Balance Sheets as of March 31, 2011 (unaudited) and December 31, 2010	1

		Consolidated Statements of Income for the three months ended March 31, 2011 (unaudited) and March 31, 2010 (unaudited)	2

		Consolidated Statements of Comprehensive Income for the three months ended March 31, 2011 (unaudited) and March 31, 2010 (unaudited)	3

		Consolidated Statements of Shareholders’ Equity for the three months ended March 31, 2011 (unaudited)	4

		Consolidated Statements of Cash Flows for the three months ended March 31, 2011 (unaudited) and March 31, 2010 (unaudited)	5

		Notes to Unaudited Consolidated Financial Statements	6

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	26

	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	42

	Item 4.	Controls and Procedures	48

PART II.	OTHER INFORMATION

	Item 1.	Legal Proceedings	49

	Item 1A.	Risk Factors	50

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	50

	Item 3.	Defaults Upon Senior Securities	50

	Item 4.	(Removed and Reserved)	50

	Item 5.	Other Information	50

	Item 6.	Exhibits	51

SIGNATURES

PART I. FINANCIAL INFORMATION

Item 1.Financial Statements

DYNEX CAPITAL, INC.

CONSOLIDATED BALANCE SHEETS

(amounts in thousands except share data)

	March 31, 2011			December 31, 2010
ASSETS	(unaudited)
Agency MBS (including pledged of $1,723,957 and $1,090,174, respectively)	$	1,869,765		$	1,192,579
Non-Agency MBS (including pledged of $262,459 and $259,350, respectively)		265,229			267,356
Securitized mortgage loans, net		143,445			152,962
Other investments, net		1,171			1,229
		2,279,610			1,614,126

Cash and cash equivalents		49,840			18,836
Derivative assets		3,021			692
Principal receivable on investments		10,903			3,739
Accrued interest receivable		9,563			6,105
Other assets, net		6,879			6,086
Total assets	$	2,359,816		$	1,649,584

LIABILITIES AND SHAREHOLDERS’ EQUITY

Liabilities:
Repurchase agreements	$	1,848,883		$	1,234,183
Non-recourse collateralized financing		106,223			107,105
Derivative liabilities		3,236			3,532
Accrued interest payable		1,311			1,079
Accrued dividends payable		10,886			8,192
Other liabilities		5,784			3,136
		1,976,323			1,357,227
Commitments and Contingencies (Note 13)

Shareholders’ equity:
Common stock, par value $.01 per share, 100,000,000 shares authorized; 40,318,159 and 30,342,897 shares issued and outstanding, respectively		403			303
Additional paid-in capital		633,620			538,304
Accumulated other comprehensive income		6,383			10,057
Accumulated deficit		(256,913	)		(256,307	)
		383,493			292,357
Total liabilities and shareholders’ equity	$	2,359,816		$	1,649,584

See notes to unaudited consolidated financial statements.

DYNEX CAPITAL, INC.

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

(amounts in thousands except per share data)

	Three Months Ended
	March 31,
	2011			2010
Interest income:
Agency MBS	$	11,518		$	4,868
Non-Agency MBS		3,691			2,501
Securitized mortgage loans		2,219			3,623
Other investments		33			32
Cash and cash equivalents		4			3
		17,465			11,027
Interest expense:
Repurchase agreements		3,428			1,263
Non-recourse collateralized financing		1,306			2,567
		4,734			3,830

Net interest income		12,731			7,197
Provision for loan losses		(250	)		(409	)
Net interest income after provision for loan losses		12,481			6,788

Gain on sale of investments, net		–			77
Fair value adjustments, net		(126	)		82
Other income, net		43			669
General and administrative expenses:
Compensation and benefits		(1,132	)		(972	)
Other general and administrative expenses		(986	)		(1,107	)

Net income		10,280			5,537
Preferred stock dividends		–			(1,003	)

Net income to common shareholders	$	10,280		$	4,534

Weighted average common shares:
Basic		33,153			14,210
Diluted		33,157			18,437
Net income per common share:
Basic	$	0.31		$	0.32
Diluted	$	0.31		$	0.30

Dividends declared per common share	$	0.27		$	0.23

See notes to unaudited consolidated financial statements.

DYNEX CAPITAL, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(UNAUDITED)

(amounts in thousands)

	Three Months Ended
	March 31,
	2011			2010
Net income	$	10,280		$	5,537
Other comprehensive income:
Available-for-sale securities:
Change in market value		(6,631	)		5,313
Reclassification adjustment for net gain on sale of investments		–			(77	)
Net unrealized gain (loss) on cash flow hedging instruments		2,957			(1,185	)
Other comprehensive (loss) income		(3,674	)		4,051

Comprehensive income		6,606			9,588
Dividends declared on preferred stock		–			(1,003	)
Comprehensive income to common shareholders	$	6,606		$	8,585

See notes to unaudited consolidated financial statements.

DYNEX CAPITAL, INC.

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(UNAUDITED)

(amounts in thousands)

	Common Stock		Additional Paid-in Capital			Accumulated Other Comprehensive Income			Accumulated Deficit			Total
Balance as of December 31, 2010	$	303	$	538,304		$	10,057		$	(256,307	)	$	292,357
Common stock issuance		100		98,483			–			–			98,583
Restricted stock granting and vesting		–		(3,026	)		–			–			(3,026	)
Capitalized expenses		–		(141	)		–			–			(141	)
Net income		–		–			–			10,280			10,280
Dividends on common stock		–		–			–			(10,886	)		(10,886	)
Other comprehensive income		–		–			(3,674	)		–			(3,674	)
Balance as of March 31, 2011	$	403	$	633,620		$	6,383		$	(256,913	)	$	383,493

See notes to unaudited consolidated financial statements.

DYNEX CAPITAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(amounts in thousands)

	Three Months Ended March 31,
	2011			2010
Operating activities:
Net income	$	10,280		$	5,537
Adjustments to reconcile net income to cash provided by operating activities:
(Increase) decrease in accrued interest receivable		(3,458	)		313
Increase (decrease) in accrued interest payable		232			(46	)
Provision for loan losses		250			409
Gain on sale of investments, net		–			(77	)
Fair value adjustments, net		127			(82	)
Amortization and depreciation		4,385			1,570
Stock-based compensation expense		95			58
Net change in other assets and other liabilities		2,041			(2,078	)
Net cash and cash equivalents provided by operating activities		13,952			5,604

Investing activities:
Purchase of investments		(769,785	)		(100,431	)
Principal payments received on investments		84,366			59,296
Increase in principal receivable on investments		(7,164	)		(16,568	)
Proceeds from sales of investments		–			31,405
Principal payments received on securitized mortgage loans		9,065			7,770
Other investing activities		(6	)		(175	)
Net cash and cash equivalents used in investing activities		(683,524	)		(18,703	)

Financing activities:
Borrowings under (repayment of) repurchase agreements, net		614,700			(35,878	)
Borrowings under non-recourse collateralized financing		–			50,678
Principal payments on non-recourse collateralized financing		(1,138	)		(6,406	)
Proceeds from issuance of common stock		95,206			9,453
Dividends paid		(8,192	)		(4,207	)
Net cash and cash equivalents provided by financing activities		700,576			13,640

Net increase in cash and cash equivalents		31,004			541
Cash and cash equivalents at beginning of period		18,836			30,173
Cash and cash equivalents at end of period	$	49,840		$	30,714

Supplemental Disclosure of Cash Activities:
Cash paid for interest	$	4,305		$	4,145

See notes to unaudited consolidated financial statements.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

(amounts in thousands except share and per share data)

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying consolidated financial statements of Dynex Capital, Inc. and its qualified real estate investment trust (“REIT”) subsidiaries and its taxable REIT subsidiary (together, “Dynex” or the “Company”) have been prepared in accordance with the instructions to the Quarterly Report on Form 10-Q and Article 10, Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements. In the opinion of management, all significant adjustments, consisting of normal recurring accruals considered necessary for a fair presentation of the consolidated financial statements, have been included. Operating results for the three months ended March 31, 2011 are not necessarily indicative of the results that may be expected for any other interim periods or for the entire year ending December 31, 2011. The unaudited consolidated financial statements included herein should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, filed with the SEC.

Certain items in the prior year’s consolidated financial statements have been reclassified to conform to the current year’s presentation. The Company’s consolidated balance sheets now present separately its principal receivable on investments, which was previously included within the fair value amounts shown on the consolidated balance sheets for Agency and non-Agency MBS. The Company’s consolidated statements of cash flows now present separately “change in principal receivable on investments”, which was previously included within “other investing activities”. The respective amounts on the consolidated balance sheet as of December 31, 2010 and statement of cash flows for the three months ended March 31, 2010 presented herein have been reclassified to conform to the current year presentation and have no effect on reported total assets or total liabilities or results of operations.

Consolidation of Subsidiaries

The consolidated financial statements include the accounts of the Company, its qualified REIT subsidiaries and its taxable REIT subsidiary. The consolidated financial statements represent the Company’s accounts after the elimination of intercompany balances and transactions. The Company consolidates entities in which it owns more than 50% of the voting equity and control does not rest with others and variable interest entities in which it is determined to be the primary beneficiary in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 810. The Company follows the equity method of accounting for investments with greater than a 20% and less than 50% interest in partnerships and corporate joint ventures or when it is able to influence the financial and operating policies of the investee but owns less than 50% of the voting equity.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reported period. Actual results could differ from those estimates. The most significant estimates used by management include but are not limited to fair value measurements of its investments, allowance for loan losses, other-than-temporary impairments, commitments and contingencies, and amortization of premiums and discounts. These items are discussed further below within this note to the consolidated financial statements.

Federal Income Taxes

The Company believes it has complied with the requirements for qualification as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”). As such, the Company believes that it qualifies as a REIT for federal income tax purposes, and it generally will not be subject to federal income tax on the amount of its income or gain that is distributed as dividends to shareholders. The Company uses the calendar year for both tax and financial reporting purposes. There may be differences between taxable income and income computed in accordance with GAAP.

Investments

The Company’s investments include Agency mortgage-backed securities (“MBS”), non-Agency MBS, securitized mortgage loans, and other investments.

Agency MBS. Agency MBS are comprised of residential mortgage-backed securities (“RMBS”) and commercial mortgage-backed securities (“CMBS”) issued or guaranteed by a federally chartered corporation, such as Federal National Mortgage Corporation, or Fannie Mae, or Federal Home Loan Mortgage Corporation, or Freddie Mac, or an agency of the U.S. government, such as Government National Mortgage Association, or Ginnie Mae. The Company’s Agency RMBS are comprised primarily of hybrid Agency ARMs and Agency ARMs. Hybrid Agency ARMs are MBS collateralized by hybrid adjustable-rate mortgage loans which are loans that have a fixed rate of interest for a specified period (typically three to ten years) and which then adjust their interest rate at least annually to an increment over a specified interest rate index as further discussed below. 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. Agency ARMs also include hybrid Agency ARMs that are past their fixed-rate periods.

Interest rates on the adjustable-rate mortgage loans collateralizing the hybrid Agency ARMs or Agency ARMs are based on specific index rates, such as the one-year constant maturity treasury rate, or CMT, the London Interbank Offered Rate, or LIBOR, the Federal Reserve U.S. 12-month cumulative average one-year CMT, or MTA, or the 11th District Cost of Funds Index, or COFI. These 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.

The Company’s Agency CMBS are typically comprised of fixed-rate securities issued primarily by Fannie Mae. These securities are collateralized mostly by first mortgage loans on multifamily properties that are usually either locked out of prepayment options or have yield maintenance provisions which provide the Company protection against prepayment of the investment.

The Company accounts for its Agency MBS 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. As of March 31, 2011, the Company has Agency MBS that are designated as either available-for-sale or trading. Although the Company generally intends to hold its available-for-sale securities until maturity, it may, from time to time, sell any of these securities as part of the overall management of its business. The available-for-sale designation provides the Company with this flexibility.

All of the Company’s Agency MBS are recorded at their fair value on the consolidated balance sheet. The Company determines the fair value of its Agency MBS based upon prices obtained from a third-party pricing service and broker quotes. Changes in the fair value of Agency MBS designated as trading are recognized in net income within “fair value adjustments, net”. Gains (losses) realized upon the sale, impairment, or other disposal of a trading security is also recognized within “fair value adjustments, net”. Alternatively, changes in the fair value of Agency MBS designated as available-for-sale are reported in other comprehensive income until the security is collected, disposed of, or determined to be other than temporarily impaired. Upon the sale of an available-for-sale security, any unrealized gain or loss is reclassified out of accumulated other comprehensive income (“AOCI”) into net income as a realized “gain (loss) on sale of investments, net” using the specific identification method.

Non-Agency MBS. The Company’s non-Agency MBS are comprised of RMBS and CMBS, the majority of which are rated as investment grade. Interest rates for non-Agency MBS collateralized with ARMs are based on indices similar to those of Agency MBS. Like Agency MBS, the Company accounts for its non-Agency MBS in accordance with ASC Topic 320. As of March 31, 2011, all of the Company’s non-Agency MBS are designated as available-for-sale and are recorded at their fair value on the consolidated balance sheet. Changes in fair value are reported in other comprehensive income until the security is collected, disposed of, or determined to be other than temporarily impaired. Upon the sale of an available-for-sale security, any unrealized gain or loss is reclassified out of AOCI into net income as a realized “gain (loss) on sale of investments, net” using the specific identification method.

The Company determines the fair value for certain of its non-Agency MBS based upon prices obtained from a third-party pricing service and broker quotes. The remainder of the non-Agency MBS are valued 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, credit enhancement, as well as certain other relevant information.

Securitized Mortgage Loans. Securitized mortgage loans consist of loans pledged to support the repayment of securitization financing bonds issued by the Company. Securitized mortgage loans are reported at amortized cost. An allowance has been established for currently existing estimated losses on such loans. Securitized mortgage loans can only be sold subject to the lien of the respective securitization financing indenture.

Other Investments. Other investments include unsecuritized single-family and commercial mortgage loans which are carried at amortized cost.

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 are evaluated on a pool basis for a general allowance.

The Company considers various factors in determining its specific and general allowance requirements, including whether a loan is delinquent, the Company’s 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, using the above factors, as well as industry loss experience.

Repurchase Agreements

Repurchase agreements are treated as financings in accordance with the provision of ASC Topic 860 under which the Company pledges its securities as collateral to secure a loan, which is equal in value to a specified percentage of the estimated fair value of the pledged collateral. The Company retains beneficial ownership of the pledged collateral. At the maturity of a repurchase agreement, the Company is required to repay the loan and concurrently receives back its pledged collateral from the lender or, with the consent of the lender, the Company may renew the agreement at the then prevailing financing rate. A repurchase agreement lender may require the Company to pledge additional collateral in the event of a decline in the fair value of the collateral pledged. Repurchase agreement financing is recourse to the Company and the assets pledged. The Company’s repurchase

agreements are based on the September 1996 version of the Bond Market Association Master Repurchase Agreement, which generally provides that the lender, as buyer, is responsible for obtaining collateral valuations from a generally recognized source agreed to by both the Company and the lender, or, in an instance when such source is not available, the value determination is made by the lender.

Securitization Transactions

The Company has securitized mortgage loans and non-Agency CMBS through securitization transactions by transferring financial assets to a wholly owned trust, where the trust issues non-recourse securitization financing bonds pursuant to an indenture. The Company retains some form of control over the transferred assets, and therefore the trust is included in the consolidated financial statements of the Company. For accounting and tax purposes, the loans and securities financed through the issuance of bonds in a securitization financing transaction are treated as assets of the Company (presented as securitized mortgage loans on the balance sheet), and the associated bonds issued are treated as debt of the Company (presented as a portion of non-recourse collateralized financing on the balance sheet). The Company has retained certain of the bonds issued by the trust and has transferred collateral in excess of the bonds issued. This excess is typically referred to as over-collateralization. Each securitization trust generally provides the Company the right to redeem, at its option, the remaining outstanding bonds prior to their maturity date.

Derivative Instruments

The Company may enter into interest rate swap agreements, interest rate cap agreements, interest rate floor agreements, financial forwards, financial futures and options on financial futures (“interest rate agreements”) to manage its sensitivity to changes in interest rates. The Company accounts for its interest rate agreements under ASC Topic 815, designating each as either cash flow hedging positions or trading positions using criteria established therein. In order to qualify as a cash flow hedge, ASC Topic 815 requires formal documentation to be prepared at the inception of the interest rate agreement that meets certain conditions. If these conditions are not met, an interest rate agreement will be classified as a trading position.

For interest rate agreements designated as trading positions, the Company records these instruments at fair value on the Company’s balance sheet in accordance with ASC Topic 815. Changes in their market value are measured at each reporting date and recognized in the current period’s statement of income.

For interest rate agreements designated as cash flow hedges, the Company evaluates the effectiveness of these hedges against the financial instrument being hedged. The effective portion of the hedge relationship on an interest rate agreement designated as a cash flow hedge is reported in AOCI and is later reclassified into the statement of income in the same period during which the hedged transaction affects earnings. The ineffective portion of such hedge is immediately reported in the current period’s statement of income. These derivative instruments are carried at fair value on the Company’s balance sheet in accordance with ASC Topic 815. Cash posted to meet margin calls, if any, is included on the consolidated balance sheets in other assets.

The Company may be required periodically to terminate hedging instruments. Any basis adjustments or changes in the fair value of hedges recorded in AOCI are recognized into income or expense in conjunction with the original hedge or hedged exposure.

If the underlying asset, liability or commitment is sold or matures, the hedge is deemed partially or wholly ineffective, or if the criterion that was established at the time the hedging instrument was entered into no longer exists, the interest rate agreement no longer qualifies as a designated hedge. Under these circumstances, such changes in the market value of the interest rate agreement are recognized in the current period’s statement of income.

Interest Income

Interest income on Agency and non-Agency MBS that are rated “AAA” and loans is recognized over the expected life of the investment using the effective interest method. Interest income on non-Agency MBS that are rated “AA” or lower is recognized over the expected life as adjusted for estimated prepayments and credit losses of the securities in accordance with ASC Topic 325. For loans, the accrual of interest is discontinued when, in the opinion of management, the interest is not collectible in the normal course of business, when the loan is significantly past due or when the primary servicer of the loan fails to advance the interest and/or principal due on the loan. Loans are considered past due when the borrower fails to make a timely payment in accordance with the underlying loan agreement. For securities and other investments, the accrual of interest is discontinued when, in the opinion of management, it is probable that all amounts contractually due will not be collected. All interest accrued but not collected for investments that are placed on a non-accrual status or are charged-off is reversed against interest income. Interest on these investments is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual status. Investments are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Amortization of Premiums, Discounts, and Deferred Issuance Costs

Premiums and discounts on investments and obligations, as well as debt issuance costs and hedging basis adjustments, are amortized into interest income or expense, respectively, over the contractual life of the related investment or obligation using the effective interest method in accordance with ASC Topic 310 and ASC Topic 470. For securities representing beneficial interests in securitizations that are not highly rated, unamortized premiums and discounts are recognized over the expected life, as adjusted for estimated prepayments and credit losses of the securities, in accordance with ASC Topic 325. Actual prepayment and credit loss experience are reviewed, and effective yields are recalculated, when originally anticipated prepayments and credit losses differ from amounts actually received plus anticipated future prepayments.

Other-than-Temporary Impairments

The Company evaluates all debt securities in its investment portfolio for other-than-temporary impairments by applying the guidance prescribed in ASC Topic 320, which states that a debt 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 Company intends, or is required, to sell the security before recovery of the security’s amortized cost basis. Although the principal and interest related to Agency MBS are guaranteed by the issuers, who have the implicit guarantee of the U.S. government, the Company assesses its ability to hold an Agency MBS with an unrealized loss until the recovery in its value. Please see Note 10 for additional information related to the Company’s evaluation for other-than-temporary impairments.

Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. Any remaining difference between fair value and amortized cost is recognized in other comprehensive income.

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 delinquent mortgage loans in the security.

Contingencies

In the normal course of business, there are various lawsuits, claims, and contingencies pending against the Company. In accordance with ASC Topic 450, we evaluate whether to establish provisions for estimated losses from pending claims, investigations and proceedings. Although the ultimate outcome of the various matters cannot be ascertained at this point, it is the opinion of management, after consultation with counsel, that the resolution of

the foregoing matters will not have a material adverse effect on the financial condition of the Company taken as a whole. Such resolution may, however, have a material effect on the results of operations or cash flows in any future period, depending on the level of income for such period.

Recent Accounting Pronouncements

In April 2011, FASB issued Accounting Standards Update (“ASU” or “Update”) No. 2011-02, which amends ASC Topic 310 to clarify the guidance on evaluating whether a restructuring constitutes a troubled debt restructuring. Specifically, a creditor must separately conclude that the restructuring constitutes a concession and that the debtor is experiencing financial difficulties. If a debtor does not otherwise have access to funds at a market rate for debt with similar risk characteristics as the restructured debt, the restructuring would be considered to be at a below-market rate, which may indicate that the creditor has granted a concession. A temporary or permanent increase in the contractual interest rate does not preclude the restructuring from being considered a concession because the contractual interest rate on the restructured debt may still be below the market interest rate for new debt with similar characteristics. If the creditor determines that it has granted a concession to the debtor, it must then evaluate whether a debtor is experiencing financial difficulties. The amendments clarify that a debtor does not have to be currently in payment default in order to be considered as experiencing financial difficulties. Additionally, a creditor should evaluate whether it is probable that the debtor will be in payment default on any of its debt in the foreseeable future without the modification. The amendments in this Update are effective for the first interim or annual reporting period beginning on or after June 15, 2011, and early adoption is permitted. The amendments should be applied retrospectively to the beginning of the annual period of adoption. As a result of its retrospective application, an entity may identify receivables that are newly considered impaired. For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011. An entity should disclose the total amount of receivables and the allowance for credit losses as of the end of the period of adoption related to those receivables that are newly considered impaired under ASC Topic 310 for which impairment was previously measured under ASC Topic 450. In addition, ASU No. 2011-02 requires an entity to disclose the information required by ASU No. 2010-20 which was subsequently deferred temporarily by ASU No. 2011-01. Management has evaluated these amendments and has determined that they do not currently have a material impact on the Company’s financial condition or results of operations.

NOTE 2 – NET INCOME PER COMMON SHARE

Net income per common share is presented on both a basic and diluted basis. Diluted net income per common share assumes the exercise of stock options using the treasury stock method, and for the first quarter of 2010 the conversion of the Company’s formerly outstanding convertible preferred stock into common stock using the two-class method, but only if these items are dilutive. Each share of Series D preferred stock is convertible into one share of common stock. The following tables reconcile the numerator and denominator for both basic and diluted net income per common share:

	Three Months Ended March 31,
	2011				2010(1)
	Income		Weighted-Average Common Shares		Income			Weighted- Average Common Shares
Net income	$	10,280			$	5,537
Preferred stock dividends		–				(1,003	)
Net income to common shareholders		10,280		33,153		4,534			14,210
Effect of dilutive items		–		4		1,003			4,227
Diluted	$	10,280		33,157	$	5,537			18,437

Net income per common share:
Basic			$	0.31				$	0.32
Diluted			$	0.31				$	0.30

Components of dilutive items:
Convertible preferred stock	$	–		–	$	1,003			4,221
Stock options		–		4		–			6
	$	–		4	$	1,003			4,227

(1) For the three months ended March 31, 2010, the calculation of diluted net income per common share excludes 40,000 unexercised stock option awards because their inclusion would have been anti- dilutive.

NOTE 3 – AGENCY MBS

The following table presents the components of the Company’s investment in Agency MBS as of March 31, 2011 and December 31, 2010:

	March 31, 2011									December 31, 2010
	RMBS			CMBS			Total			RMBS			CMBS			Total
Principal/par value	$	1,542,818		$	226,613		$	1,769,431		$	937,376		$	190,511		$	1,127,887
Unamortized premium		77,873			26,516			104,389			43,776			18,757			62,533
Unamortized discount		(34	)		–			(34	)		(36	)		–			(36	)
Amortized cost		1,620,657			253,129			1,873,786			981,116			209,268			1,190,384
Unrealized gains:
Available for sale		8,038			393			8,431			8,266			567			8,833
Trading		–			121			121			–			–			–
Unrealized losses:
Available for sale		(8,003	)		(4,568	)		(12,571	)		(3,371	)		(3,267	)		(6,638	)
Trading		–			(2	)		(2	)		–			–			–
Fair value	$	1,620,692		$	249,073		$	1,869,765		$	986,011		$	206,568		$	1,192,579
Weighted average coupon		4.41	%		5.27	%		4.53	%		4.46	%		5.41	%		4.62	%

During the three months ended March 31, 2011, the Company purchased $718,730 and $45,227 of Agency RMBS and CMBS, respectively. Of the Agency CMBS purchases, $24,195 were designated as trading, and as of March 31, 2011, their amortized cost and fair value included in the table above is $24,147 and $24,266, respectively. The Company has not designated any of its Agency RMBS purchases as trading, nor did it hold any Agency CMBS

or RMBS designated as trading securities as of December 31, 2010. The Company has not sold any of its trading securities purchased during the three months ended March 31, 2011, and has recorded a net unrealized gain of $119, which is included within “fair value adjustments, net” in its consolidated statement of income for the three months ended March 31, 2011 related to their changes in fair value.

NOTE 4 – NON-AGENCY MBS

The following table presents the components of the Company’s non-Agency MBS as of March 31, 2011 and December 31, 2010:

	March 31, 2011									December 31, 2010
	RMBS			CMBS			Total			RMBS			CMBS			Total
Principal/par value	$	15,676		$	244,688		$	260,364		$	16,101		$	247,494		$	263,595
Unamortized premium		126			7,138			7,264			138			5,352			5,490
Unamortized discount		(1,086	)		(11,698	)		(12,784	)		(1,115	)		(11,296	)		(12,411	)
Amortized cost		14,716			240,128			254,844			15,124			241,550			256,674
Unrealized gains		517			10,609			11,126			632			10,978			11,610
Unrealized losses		(392	)		(349	)		(741	)		(348	)		(580	)		(928	)
Fair value	$	14,841		$	250,388		$	265,229		$	15,408		$	251,948		$	267,356
Weighted average coupon		6.33	%		4.81	%		6.25	%		4.54	%		6.49	%		6.37	%

All of the Company’s non-Agency MBS are designated as available-for-sale and are comprised primarily of investment-grade rated securities with a fair value of $256,816 and $262,234 as of March 31, 2011 and December 31, 2010, respectively. The Company purchased $5,827 of non-Agency CMBS during the three months ended March 31, 2011, and did not purchase any non-Agency RMBS.

NOTE 5 – SECURITIZED MORTGAGE LOANS, NET

The following table summarizes the components of securitized mortgage loans as of March 31, 2011 and December 31, 2010:

	March 31, 2011									December 31, 2010
	Commercial			Single-family			Total			Commercial			Single-family			Total
Principal/par value	$	92,331		$	51,760		$	144,091		$	99,432		$	54,181		$	153,613
FHBT(1)		3,439			–			3,439			3,455			–			3,455
Unamortized premium, net		–			839			839			–			884			884
Unamortized discount, net		(438	)		–			(438	)		(520	)		–			(520	)
Amortized cost		95,332			52,599			147,931			102,367			55,065			157,432
Allowance for loan losses		(4,237	)		(249	)		(4,486	)		(4,200	)		(270	)		(4,470	)
	$	91,095		$	52,350		$	143,445		$	98,167		$	54,795		$	152,962

(1)

Funds held by trustees includes $3,232 and $3,306 as of March 31, 2011 and December 31, 2010, respectively, of cash and cash equivalents held by the trust for defeased commercial mortgage loans. These funds were paid by the borrower to the securitization trust pursuant to the contractual terms of the mortgage loan and represent replacement collateral for defeased loans. In accordance with the underlying agreements, cash payments are made by the securitization trust using these defeased amounts until the funds held for that particular defeased mortgage loan equal the scheduled principal balance of the original loan. At that point a final distribution is made to the trust as payment in full of the principal amount due on the loan.

Commercial mortgage loans were originated principally in 1996 and 1997 and are collateralized by first deeds of trust on income producing properties. Approximately 79.9% of commercial mortgage loans are secured by multifamily properties. The Company identified securitized commercial mortgage loans with combined unpaid principal balances of $11,660 as being impaired as of March 31, 2011 compared to impairments of $18,219 as of December 31, 2010. The Company recognized $86 of interest income on impaired securitized commercial mortgage loans for the three months ended March 31, 2011 compared to $260 of interest income for the three months ended March 31, 2010.

Single-family mortgage loans are secured by first deeds of trust on residential real estate and were originated principally from 1992 to 1997. The Company identified securitized single-family mortgage loans with combined unpaid principal balances of $2,965 as being impaired as of March 31, 2011 compared to impairments of $3,587 as of December 31, 2010. Of these amounts, $1,070 and $1,480 represent the unpaid principal balances of the loans in foreclosure as of March 31, 2011 and December 31, 2010, respectively. The Company recognized $42 of interest income on impaired securitized single-family mortgage loans for the three months ended March 31, 2011 compared to $51 on impaired single-family mortgage loans for the three months ended March 31, 2010.

All of the securitized mortgage loans are pledged as collateral for the associated securitization financing bonds, which are discussed further in Note 9.

NOTE 6 – ALLOWANCE FOR LOAN LOSSES

The following table presents the components of the allowance for loan losses as of the periods indicated:

	March 31, 2011		December 31, 2010
Securitized commercial mortgage loans	$	4,237	$	4,200
Securitized single-family mortgage loans		249		270
	$	4,486	$	4,470

The following table presents certain information on impaired single-family and commercial securitized mortgage loans as of March 31, 2011 and December 31, 2010:

	March 31, 2011						December 31, 2010
	Commercial			Single-family			Commercial			Single-family
Amortized cost basis of impaired loans	$	11,632		$	3,013		$	18,154		$	3,646
Allowance for loan losses		(4,237	)		(249	)		(4,200	)		(270	)
Investment in excess of allowance	$	7,395		$	2,764		$	13,954		$	3,376

The following table summarizes the aggregate activity for the portion of the allowance for loan losses that relates to the securitized mortgage loan portfolio for the periods indicated:

	Three Months Ended March 31,
	2011						2010
	Commercial			Single-family			Commercial		Single-family
Allowance at beginning of period	$	4,200		$	270		$	3,935	$	277
Provision for loan losses(1)		250			–			150		–
Credit losses, net of recoveries		(213	)		(21	)		–		–
Allowance at end of period	$	4,237		$	249		$	4,085	$	277

(1)

Activity shown for the three months ended March 31, 2010 excludes provision of $259 related to the Company’s unsecuritized mortgage loan portfolio.

NOTE 7 – DERIVATIVES

Please see Note 1 for additional information related to the Company’s accounting policies for derivative instruments.

As of March 31, 2011 and December 31, 2010, the Company’s derivative financial instruments are comprised entirely of interest rate swaps, and are designated as either hedging instruments or trading instruments. With respect to hedging instruments, the Company’s objective for using interest rate swaps is to minimize its exposure to the risk of increased interest expense resulting from its existing and forecasted short-term, fixed-rate borrowings. The Company continuously borrows funds via sequential fixed-rate, short-term repurchase agreement borrowings. As each fixed-rate repurchase agreement matures, it is replaced with new fixed-rate agreements based on the market interest rate in effect at the time of such replacement. This sequential rollover borrowing program creates a variable interest expense pattern. The changes in the cash flows of the interest rate swaps are expected to be highly effective at offsetting changes in the interest portion of the cash flows expected to be paid at maturity of each borrowing.

With respect to trading instruments, the Company’s objective for using interest rate swaps is to offset the changes in market value of the investments also designated as trading. See Note 3 for a discussion of investments designated as trading.

The tables below summarize information about the Company’s derivative financial instruments on the balance sheet as of the periods indicated:

As of March 31, 2011
Accounting Designation	Balance Sheet Location	Fair Value			Cumulative Notional Amount		Weighted-average Fixed Rate Swapped
Hedging instruments	Derivative assets	$	3,021		$	525,000		1.58	%
Trading instruments	Derivative assets		–			–		–
		$	3,021

Hedging instruments	Derivative liabilities	$	(2,903	)	$	320,000		1.60	%
Trading instruments	Derivative liabilities		(333	)		27,000		2.88	%
		$	(3,236	)


As of December 31, 2010
Accounting Designation	Balance Sheet Location	Fair Value			Cumulative Notional Amount		Weighted-average Fixed Rate Swapped
Hedging instruments	Derivative assets	$	692		$	100,000		1.89	%
Trading instruments	Derivative assets		–			–		–
		$	692

Hedging instruments	Derivative liabilities	$	(3,532	)	$	245,000		1.58	%
Trading instruments	Derivative liabilities		–			–		–
		$	(3,532	)

As of March 31, 2011, the Company had margin requirements with its swap counterparties for these interest rate swaps totaling $4,635 for which Agency MBS with a fair value of $3,306 and cash of $1,495 have been posted as collateral. The following table summarizes the contractual maturities remaining for the Company’s outstanding interest rate swap agreements as of March 31, 2011:

Remaining Maturity	Notional Amount: Trading		Notional Amount: Hedging		Notional Amount: Total		Number of Swaps		Weighted-Average Fixed Rate Swapped
0-12 months	$	–	$	100,000	$	100,000		2		1.02	%
13-36 months		–		375,000		375,000		7		1.29	%
37-60 months		27,000		370,000		397,000		12		2.10	%
	$	27,000	$	845,000	$	872,000		21		1.63	%

The table below presents the effect of the derivatives designated as trading instruments on the Company’s consolidated statement of income for the periods indicated.

		Amount of Loss Recognized in Net Income For the Three Months Ended
Type of Derivative Designated as Trading	Location of Amount Recognized in Net Income	March 31, 2011		March 31, 2010
Interest rate swaps	Fair value adjustments, net	$	333	$	–

The table below presents the effect of the derivatives designated as hedging instruments on the Company’s consolidated statement of comprehensive income for the three months ended March 31, 2011.

Type of Derivative Designated as Cash Flow Hedge	Amount of (Gain) Loss Recognized in OCI (Effective Portion)	Location of Amount Reclassified from OCI into Net Income (Effective Portion)	Amount Reclassified from OCI into Net Income (Effective Portion)	Location of (Gain) Loss Recognized in Net Income (Ineffective Portion)	Amount of (Gain) Loss Recognized in Net Income Ineffective Portion)
Interest rate swaps	$ (1,088)	Interest expense	$ 1,869	Other income, net	$ (1)

The table below presents the effect of the derivatives designated as hedging instruments on the Company’s consolidated statement of comprehensive income for the three months ended March 31, 2010.

Type of Derivative Designated as Cash Flow Hedge	Amount of (Gain) Loss Recognized in OCI (Effective Portion)	Location of Amount Reclassified from OCI into Net Income (Effective Portion)	Amount Reclassified from OCI into Net Income (Effective Portion)	Location of (Gain) Loss Recognized in Net Income (Ineffective Portion)	Amount of (Gain) Loss Recognized in Net Income (Ineffective Portion)
Interest rate swaps	$ 1,638	Interest expense	$ 453	Other income, net	$ 10

The table below presents a rollforward of the activity in the Company’s AOCI related to its derivatives designated as hedging instruments for the periods presented:

	2011			2010
Balance as of January 1,	$	(2,820	)	$	1,008
Change in fair value of interest rate swaps		1,088			(1,638	)
Reclassification adjustment for amounts included in statement of income		1,869			453
Balance as of March 31,	$	137		$	(177	)

The Company estimates that an additional $9,982 related to its derivatives designated as hedging instruments will be recognized as an increase to interest expense during the next 12 months.

The interest rate agreements the Company has with its derivative counterparties contain various covenants related to the Company’s credit risk. Specifically, if the Company defaults on any of its indebtedness, including those circumstances whereby repayment of the indebtedness has not been accelerated by the lender, then the Company could also be declared in default of its derivative obligations. Additionally, the agreements outstanding with one of the derivative counterparties allow that counterparty to require settlement of its outstanding derivative transactions if the Company fails to earn GAAP net income greater than one dollar as measured on a rolling two quarter basis. These interest rate agreements also contain provisions whereby, if the Company fails to maintain a minimum net amount of shareholders’ equity, then the Company may be declared in default on its derivative obligations. As of March 31, 2011, the Company had derivatives in a net liability position with one of its derivative counterparties totaling $1,961, inclusive of accrued interest but excluding any adjustment for nonperformance risk, for which it had pledged Agency MBS with a fair value of $3,306 as collateral. If the Company had breached any of these agreements as of March 31, 2011, it could have been required to settle those derivatives at their estimated termination value of $1,961.

NOTE 8 – REPURCHASE AGREEMENTS

The Company uses repurchase agreements, which are recourse to the Company, to finance certain of its investments. The following tables present the components of the Company’s repurchase agreements as of March 31, 2011 and December 31, 2010 by the type of securities collateralizing the repurchase agreement:

	March 31, 2011
Collateral Type	Balance		Weighted Average Rate			Fair Value of Collateral Pledged
Agency RMBS	$	1,457,047		0.29	%	$	1,514,578
Agency CMBS		175,110		0.29	%		187,836
Non-Agency RMBS		11,451		1.22	%		13,177
Non-Agency CMBS		143,064		1.16	%		162,455
Securitization financing bonds (see Note 9)		62,211		1.23	%		72,092
	$	1,848,883		0.39	%	$	1,950,138

	December 31, 2010
Collateral Type	Balance		Weighted Average Rate			Fair Value of Collateral Pledged
Agency RMBS	$	869,537		0.33	%	$	908,375
Agency CMBS		150,178		0.31	%		161,143
Non-Agency CMBS		135,143		1.29	%		164,871
Non-Agency RMBS		12,126		1.31	%		13,628
Securitization financing bonds (see Note 9)		67,199		1.36	%		79,080
	$	1,234,183		0.50	%	$	1,327,097

The combined weighted average term to original maturity for the Company’s repurchase agreements was 50 days as of both March 31, 2011 and December 31, 2010. The following table provides a summary of the original maturity as of March 31, 2011 and December 31, 2010:

Original Maturity	March 31, 2011		December 31, 2010
30 days or less	$	355,816	$	478,848
31 to 60 days		967,357		372,702
61 to 90 days		418,640		202,569
Greater than 90 days		107,070		180,064
	$	1,848,883	$	1,234,183

As of March 31, 2011, the maximum amount of equity at risk under repurchase agreements with any individual counterparty is $39,958.

Our repurchase agreement counterparties require us to comply with various customary operating and financial covenants, including, but not limited to, minimum net worth, minimum liquidity, and leverage requirements as well as maintaining our REIT status. In addition, some of the covenants contain cross default features, whereby default under one agreement simultaneously causes default under another agreement. To the extent that we fail to comply with the covenants contained in our financing agreements or are otherwise found to be in default under the terms of such agreements, we could be restricted from paying dividends or from engaging in other transactions that are necessary for us to maintain our REIT status. We were in compliance with all covenants as of and for the three months ended March 31, 2011.

NOTE 9 – NON-RECOURSE COLLATERIZED FINANCING

The following table summarized information about the Company’s non-recourse collateralized financing for the periods indicated:

		March 31, 2011
	Interest Rate	Weighted Average Life Remaining (in years)		Balance Outstanding			Value of Collateral
Securitization financing:
Secured by commercial mortgage loans	7.2% fixed		3.4	$	23,669		$	92,062	(1)
Secured by non-Agency CMBS	6.2% fixed		3.0		15,000			16,576
Secured by single-family mortgage loans	1-month LIBOR plus 0.30%		3.4		20,107			20,972
TALF financing:(2)
Secured by non-Agency CMBS	2.7% fixed		3.0		50,651			70,251
Unamortized net bond premium and deferred costs					(3,204	)		n/a
				$	106,223		$	199,861

		December 31, 2010
	Interest Rate	Weighted Average Life Remaining (in years)		Balance Outstanding			Value of Collateral
Securitization financing:
Secured by commercial mortgage loans	7.2% fixed		3.7	$	23,669		$	97,959	(1)
Secured by non-Agency CMBS	6.2% fixed		3.4		15,000			16,754
Secured by single-family mortgage loans	1-month LIBOR plus 0.30%		3.4		21,183			21,889
TALF financing: (2)
Secured by non-Agency CMBS	2.7% fixed		2.2		50,713			64,097
Unamortized net bond premium and deferred costs					(3,460	)		n/a
				$	107,105		$	200,699

(1)

The value of the commercial mortgage loans collateralizing the bond class with $23,669 remaining outstanding represents the unpaid principal balance, which includes proceeds from defeased loans. The value of the commercial mortgage loans also includes the amounts collateralizing the bond classes of the trust that the Company has redeemed. These redeemed classes are senior to the outstanding class and have a balance as of March 31, 2011 and December 31, 2010 of $48,894 and $54,519, respectively, which must be paid in full before any proceeds from the collateral may be used to pay the balance of the outstanding class.

(2)	Financing provided by the Federal Reserve Bank of New York under its Term Asset-Backed Securities Loan Facility (“TALF”).

The Company has redeemed securitization bonds in the past, and in certain instances, the Company has kept the bond outstanding and used it as collateral for additional repurchase agreement borrowings.

These additional borrowings may have been used to either finance the bond redemption or to purchase additional investments. Although these bonds are legally outstanding, the balances are eliminated in consolidation because the issuing trust is included in the Company’s consolidated financial statements.

The following table summarizes information regarding all of the Company’s redeemed bonds that have an outstanding balance as of March 31, 2011:

Collateral Type	Par Value Outstanding		Fair Value		Repurchase Agreement Balance
Single-family mortgage loans	$	24,398	$	22,277	$	20,383
Commercial mortgage loans		48,894		49,815		41,828
	$	73,292	$	72,092	$	62,211

NOTE 10 – FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company utilizes fair value measurements at various levels within the hierarchy established by ASC Topic 820 for certain of its assets and liabilities. 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.

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. The Company’s fair valued assets and liabilities that are generally included in this category are Agency MBS, certain non-Agency CMBS, and derivatives.

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, the Company’s assets and liabilities carried at fair value and included in this category are non-Agency MBS and delinquent property tax receivables.

The following table presents the fair value of the Company’s assets and liabilities measured at fair value on a recurring basis as of March 31, 2011, segregated by the hierarchy level of the fair value estimate:

			Fair Value Measurements
	Fair Value		Level 1		Level 2		Level 3
Assets:
Agency MBS	$	1,869,765	$	–	$	1,869,765	$	–
Non-Agency MBS:
CMBS		250,388		–		111,412		138,976
RMBS		14,841		–		6,054		8,787
Other investments		25		–		–		25
Derivative assets		3,021		–		3,021		–
Total assets carried at fair value	$	2,138,040	$	–	$	1,990,252	$	147,788

Liabilities:
Derivative liabilities	$	3,236	$	–	$	3,236	$	–
Total liabilities carried at fair value	$	3,236	$	–	$	3,236	$	–

The Company’s Agency MBS, as well a portion of its non-Agency CMBS, are substantially similar to securities that either are currently actively traded or have been recently traded in their respective market. Their fair values are derived from an average of multiple dealer quotes and thus are considered Level 2 fair value measurements.

The Company’s remaining non-Agency CMBS and non-Agency RMBS are comprised of securities for which there are not substantially similar securities that trade frequently. As such, the Company determines the fair value of those securities by discounting the estimated future cash flows derived from pricing models using assumptions that are confirmed to the extent possible by third party dealers or other pricing indicators. Significant inputs into those pricing models are Level 3 in nature due to the lack of readily available market quotes. Information utilized in those pricing models include the security’s credit rating, coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected credit losses, credit enhancement, as well as certain other relevant information. The following tables present the beginning and ending balances of the Level 3 fair value estimates for the three months ended March 31, 2011:

	Level 3 Fair Values
	Non-Agency CMBS			Non-Agency RMBS			Other		Total assets
Balance as of January 1, 2011	$	146,671		$	9,307		$	25	$	156,003
Total unrealized losses:
Included in other comprehensive income		(774	)		(91	)		–		(865	)
Principal payments		(6,564	)		(427	)		–		(6,991	)
Amortization		(357	)		(2	)		–		(359	)
Balance as of March 31, 2011	$	138,976		$	8,787		$	25	$	147,788

The following table presents the recorded basis and estimated fair values of the Company’s financial instruments as of March 31, 2011 and December 31, 2010:

	March 31, 2011				December 31, 2010
	Recorded Basis		Fair Value		Recorded Basis		Fair Value
Assets:
Agency MBS	$	1,869,765	$	1,869,765	$	1,192,579	$	1,192,579
Non-Agency CMBS		250,388		250,388		251,948		251,948
Non-Agency RMBS		14,841		14,841		15,408		15,408
Securitized mortgage loans, net		143,445		132,312		152,962		142,177
Other investments		1,171		1,065		1,229		1,112
Derivative assets		3,021		3,021		692		692

Liabilities:
Repurchase agreements	$	1,848,883	$	1,848,883	$	1,234,183	$	1,234,183
Non-recourse collateralized financing		106,223		107,626		107,105		109,395
Derivative liabilities		3,236		3,236		3,532		3,532

There were no assets or liabilities which were measured at fair value on a non-recurring basis as of March 31, 2011 or December 31, 2010.

The following table presents certain information for Agency MBS and non-Agency MBS that were in an unrealized loss position as of March 31, 2011 and December 31, 2010:

	March 31, 2011				December 31, 2010
	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
Unrealized loss position for:
Less than one year:
Agency MBS	$	1,343,683	$	12,104	$	695,854	$	6,638
Non-Agency MBS		49,506		399		45,602		592
One year or more:
Agency MBS		26,524		469
Non-Agency MBS		3,431		341		3,494		337
	$	1,423,144	$	13,313	$	744,950	$	7,567

Because the principal and interest related to Agency MBS are guaranteed by issuers who have the implicit guarantee of the U.S. government, the Company does not consider any of the unrealized losses on its Agency MBS to be credit related. The Company assesses its ability to hold an Agency MBS with an unrealized loss until the recovery in its value. This assessment is based on the amount of the unrealized loss and significance of the related investment as well as the Company’s current leverage and anticipated liquidity. Based on this analysis, the Company has determined that the unrealized losses on its Agency MBS as of March 31, 2011 are temporary.

The Company reviews the estimated future cash flows for its non-Agency MBS to determine whether there have been adverse changes in the cash flows that necessitate recognition of other-than-temporary impairment amounts. Approximately $44,557 of the $52,937 non-Agency MBS in an unrealized loss position as of March 31, 2011 are investment grade MBS collateralized by mortgage loans that were originated during or prior to 1999. Based on the credit rating of these MBS and the seasoning of the mortgage loans collateralizing these securities, the Company has determined that the impairment of these MBS is not other-than-temporary as of March 31, 2011.

The estimated cash flows of the remaining $8,380 of non-Agency MBS were reviewed based on the performance of the underlying mortgage loans collateralizing the MBS as well as projected loss and prepayment rates. Based on that review, management did not determine any adverse changes in the timing or amount of estimated cash flows that necessitate recognition of other-than-temporary impairment amounts as of March 31, 2011.

NOTE 11 – COMMON STOCK

The Company has a continuous equity placement program (“EPP”) whereby the Company may offer and sell through its sales agent shares of its common stock in negotiated transactions or transactions that are deemed to be “at the market offerings,” as defined in Rule 415 under the 1933 Act, including sales made directly on the New York Stock Exchange or sales made to or through a market maker other than on an exchange. During the three months ended March 31, 2011, the Company has received proceeds of $4,332, net of broker sales commission, for 409,237 shares of common stock sold under this program at an average price of $10.75. The Company originally registered 5,000,000 shares under the EPP, and as of March 31, 2011, has 538,147 remaining shares to be issued under the EPP.

During the three months ended March 31, 2011, the Company closed a public offering of 9,200,000 shares of its common stock, including 1,200,000 shares pursuant to an overallotment option that was fully exercised by the underwriters, at a public offering price of $10.35 per share for total net proceeds of $90,459 after deduction of underwriting discounts, commissions, and expenses. The Company has used a substantial amount of these proceeds to acquire additional investments consistent with its investment policy.

The following table presents a summary of the changes in the number of common shares outstanding for the periods indicated:

	Three Months Ended March 31,
	2011		2010
Balance at beginning of period		30,342,897		13,931,512
Common stock issued under EPP		409,237		1,070,100
Common stock issued via public offering		9,200,000		–
Common stock redeemed under 2004 Stock and Incentive Plan		10,000		–
Common stock issued under 2009 Stock and Incentive Plan		356,025		36,190
Balance at end of period		40,318,159		15,037,802

On March 15, 2011, the Company declared common dividends of $0.27 to be paid on April 29, 2011 to shareholders of record on March 31, 2011.

NOTE 12 – EMPLOYEE BENEFITS

Stock Incentive Plan

Pursuant to the Company’s 2009 Stock and Incentive Plan, the Company may grant stock-based compensation to eligible employees, directors or consultants or advisors to the Company, including stock awards, stock options, stock appreciation rights (“SARs”), dividend equivalent rights, performance shares, and restricted stock units. Of the 2,500,000 shares of common stock authorized for issuance under this plan, 2,143,975 shares remain available as of March 31, 2011. Although the Company is no longer issuing stock-based compensation under its 2004 Stock Incentive Plan, there are stock options, SARs, and restricted stock still outstanding (and exercisable if vested) thereunder as of March 31, 2011.

Stock options and restricted stock that the Company has issued may be settled only in shares of its common stock, and therefore are treated as equity awards with their fair value measured at the grant date as required by ASC Topic 718. The compensation cost related to all stock options has been expensed in prior periods. As of March 31, 2011, the fair value of the Company’s outstanding restricted stock remaining to be amortized into net income is $3,128.

The following table presents a rollforward of the stock option activity for the periods presented:

	Three Months Ended March 31,
	2011					2010
	Number of Shares			Weighted-Average Exercise Price		Number of Shares		Weighted- Average Exercise Price
Options outstanding at beginning of period		45,000		$	8.75		95,000	$	8.59
Options granted		–			–		–		–
Options forfeited		–			–		–		–
Options exercised		(10,000	)		7.43		–		–
Options outstanding at end of period (all vested and exercisable)		35,000		$	9.13		95,000	$	8.59

The following table presents a rollforward of the restricted stock activity for the periods presented:

	Three Months Ended March 31,
	2011			2010
Restricted stock at beginning of period		25,000			32,500
Restricted stock granted		303,000			–
Restricted stock forfeited		–			–
Restricted stock vested		(7,500	)		(7,500	)
Restricted stock outstanding at end of period		320,500			25,000

SARs issued by the Company may be settled only in cash, and therefore have been treated as liability awards with their fair value measured at the grant date and remeasured at the end of each reporting period as required by ASC Topic 718. As of March 31, 2011 and December 31, 2010, the fair value of the Company’s outstanding SARs of $377 and $492, respectively, are recorded as liabilities on its consolidated balance sheet for the respective periods. The fair value of SARs is estimated using the Black-Scholes option valuation model based upon the assumptions in the table below.

	March 31, 2011			December 31, 2010
Expected volatility		12.5%-16.6	%		16.2%-18.6	%
Weighted-average volatility		14.8	%		17.3	%
Expected dividends		11.1%-11.3	%		9.9%-10.3	%
Expected term (in months)		10			12
Weighted-average risk-free rate		0.84	%		0.81	%
Range of risk-free rates		0.4%-1.4	%		0.4%-1.3	%

As of March 31, 2011, the Company has 136,875 SARs outstanding, all of which are vested and exercisable at a weighted average price of $7.31 at any time prior to their expiration dates. The weighted average remaining contractual term on these outstanding SARs as of March 31, 2011 is 21 months, and 60,000 of the outstanding SARs are set to expire if they are not exercised on or before December 31, 2011. As of March 31, 2010, there were 278,146 SARs outstanding at a weighted average price of $7.27, and 258,146 of those SARs were vested and exercisable at that time at a weighted average price of $7.29. No SARs were granted, forfeited, or exercised during the three months ended March 31, 2011 or March 31, 2010.

Total stock-based compensation expense recognized by the Company for the three months ended March 31, 2011 and March 31, 2010 is $95 and $59, respectively.

Employee Savings Plan

The Company provides an Employee Savings Plan under Section 401(k) of the Code. The Employee Savings Plan allows eligible employees to defer up to 25% of their income on a pretax basis. The Company matches the employees’ contribution up to 6% of the employees’ eligible compensation. The Company may also make discretionary contributions based on the profitability of the Company. The total expense related to the Company’s matching and discretionary contributions for the three months ended March 31, 2011 and March 31, 2010 is $84 and $59, respectively. The Company does not provide post-employment or post-retirement benefits to its employees.

NOTE 13 – COMMITMENTS AND CONTINGENCIES

The Company and its subsidiaries are parties to various legal proceedings, including those described below. Although the ultimate outcome of these legal proceedings cannot be ascertained at this time, and the results of legal proceedings cannot be predicted with certainty, the Company believes, based on current knowledge, that the resolution of any of these proceedings, including those described below, will not have a material adverse effect on the Company’s consolidated financial condition or liquidity. However, the resolution of any of the proceedings described below could have a material impact on consolidated results of operations or cash flows in a given reporting period as the proceedings are resolved.

One of the Company’s subsidiaries, GLS Capital, Inc. (“GLS”), and the County of Allegheny, Pennsylvania are defendants in a class action lawsuit filed in 1997 in the Court of Common Pleas of Allegheny County, Pennsylvania (the “Court”). Between 1995 and 1997, GLS purchased from Allegheny County delinquent county property tax receivables for properties located in the County. The plaintiffs in this matter have alleged that GLS improperly recovered or sought recovery for certain attorneys’ fees expenses associated with the forced collection of delinquent property tax receivables. The Court granted class action status in August 2007. Throughout the course of this litigation, the Court has dismissed all claims against GLS except for the reasonableness of attorneys’ fees charged by GLS in connection with the collection of the delinquent property tax receivables which were permitted to be assessed under the Municipal Claims and Tax Lien Act and set by ordinance approved by the County Council for the County of Allegheny. Specifically, the Court has allowed the pursuit by the named plaintiffs on behalf of the certified class of the claim that the ordinance(s) adopted by the County of Allegheny, set forth in the ordinance and used by GLS for certain legal work are unreasonable. Plaintiffs have not enumerated their damages in this matter.

On April 1, 2011 in the matter styled Basic Capital Management et al (the “BCM Plaintiffs”) versus Dynex Commercial, Inc. (“DCI”) and Dynex Capital, Inc. (DCI and the Company, together, the “Respondents”), the Supreme Court of Texas partially reversed the Fifth Court of Appeals at Dallas (the “Court of Appeals”) and remanded the case back to the Court of Appeals for consideration of arguments not previously reached by the Court of Appeals. The appeal to the Supreme Court of Texas was filed by the BCM Plaintiffs. On remand, the BCM Plaintiffs are seeking reversal of the trial court’s judgment and rendition of judgment against the Company for alleged breach of loan agreements for tenant improvements in the amount of $300. 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 $2,200 and $25,600, respectively, related to the alleged breach by DCI of a $160,000 “master” loan commitment. The BCM Plaintiffs also seek reversal and rendition of judgment in their favor for attorneys’ fees in the amount of $2,100. Alternatively, the BCM Plaintiffs seek a new trial. DCI is a former affiliate of the Company, and management does not believe that the Company would be obligated for any amounts awarded to the BCM Plaintiffs as a result of the actions of DCI. Dynex Capital and DCI intend to file a motion to reconsider with the Supreme Court of Texas on or before May 16, 2011.

Dynex Capital, Inc., MERIT Securities Corporation, a subsidiary ("MERIT"), and the former President/Chief Executive Officer and current Chief Operating Officer/Chief Financial Officer of Dynex Capital, Inc., (together, the "Defendants") are defendants in a putative class action brought by the Teamsters Local 445 Freight Division Pension Fund (the "Teamsters") in the United States District Court for the Southern District of New York (the "District Court"). The original complaint, which was filed on February 7, 2005, alleged violations of the federal securities laws and was purportedly filed on behalf of purchasers between February 2000 and May 2004 of MERIT Series 12 and MERIT Series 13 securitization financing bonds (the "Bonds"), which are collateralized by manufactured housing loans. After a series of rulings by the District Court and an appeal by the Company and MERIT, on February 22, 2008 the United States Court of Appeals for the Second Circuit dismissed the litigation against the Company and MERIT. The Teamsters filed an amended complaint on August 6, 2008, which essentially restated the same allegations as the original complaint and added the Company’s former President/Chief Executive Officer and current Chief Operating Officer/Chief Financial Officer as defendants. The District Court denied Defendants’ motion to dismiss the amended complaint. The Teamsters seek unspecified damages and allege, among other things, fraud and misrepresentation in connection with the issuance of and subsequent reporting related to the Bonds. On March 7, 2011, the District Court granted the Teamsters’ motion to certify the class for this action. On March 18, 2011, the Defendants filed a Petition for Permission to Appeal with the United States Court of Appeals for the Second Circuit, seeking to reverse the class certification by the District Court. Prior to the District Court’s certification of the class, the Defendants also filed with the District Court a motion to dismiss on the basis of fraud on the court related to statements attributed to alleged confidential witnesses in the amended complaint which the Company believes to be fabricated by plaintiff’s counsel. The District Court referred the motion to dismiss to a Magistrate Judge, who, on April 29, 2011, recommended that the motion be denied. The Company intends to file in the District Court an objection to the Magistrate Judge’s recommendation. The Company has evaluated the allegations made in the amended complaint, and continues to believe them to be without merit and is vigorously defending itself in this matter.

NOTE 14 – ACCUMULATED OTHER COMPREHENSIVE INCOME

Accumulated other comprehensive income as of March 31, 2011 and December 31, 2010 is comprised of the following items:

	March 31, 2011			December 31, 2010
Available for sale investments:
Unrealized gains	$	19,557		$	20,443
Unrealized losses		(13,311	)		(7,566	)
		6,246			12,877
Hedging instruments:
Unrealized gains		3,016			692
Unrealized losses		(2,879	)		(3,512	)
		137			(2,820	)

Accumulated other comprehensive income	$	6,383		$	10,057

Due to the Company’s REIT status, the items comprising other comprehensive income do not have related tax effects.

NOTE 15 – SUBSEQUENT EVENTS

Management has evaluated events and circumstances occurring as of and through the date this Quarterly Report on Form 10-Q was filed with the SEC and made available to the public and has determined that there have been no significant events or circumstances that qualify as recognized or nonrecognized “subsequent events” as defined by ASC Topic 855.

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis is provided to increase understanding of, and should be read in conjunction with, our unaudited consolidated financial statements and accompanying notes included in this Quarterly Report on Form 10-Q and our audited Annual Report on Form 10-K for the year ended December 31, 2010. References herein to “Dynex,” the “company,” “we,” “us,” and “our” include Dynex Capital, Inc. and its consolidated subsidiaries, unless the context otherwise requires. In addition to current and historical information, the following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our future business, financial condition or results of operations. For a description of certain factors that may have a significant impact on our future business, financial condition or results of operations, see “Forward-Looking Statements” at the end of this discussion and analysis.

EXECUTIVE OVERVIEW

Company Overview

We are an internally-managed real estate investment trust, or REIT, which invests in mortgage assets on a leveraged basis. Our objective is to provide attractive risk-adjusted returns to our shareholders over the long term that are reflective of a leveraged, high quality fixed income portfolio with a focus on capital preservation. We seek to provide returns to our shareholders through regular quarterly dividends and through capital appreciation.

We were formed in 1987 and commenced operations in 1988. Beginning with our inception through 2000, our operations largely consisted of originating and securitizing various types of loans, principally single-family and commercial mortgage loans and manufactured housing loans. Since 2000, we have been an investor in mortgage-backed securities (“MBS”), and we are no longer originating or securitizing mortgage loans.

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. Our investment strategy as approved by our Board of Directors is a hybrid-investment strategy that targets higher credit quality, shorter duration investments in Agency MBS and non-Agency MBS. Investments considered to be of higher credit quality have less or limited exposure to loss of principal while investments which have shorter durations have less exposure to changes in interest rates.

Agency MBS consist of residential MBS (“RMBS”) and commercial MBS (“CMBS”), which come with a guaranty of payment by the U.S. government or a U.S. government-sponsored entity such as Fannie Mae and Freddie Mac. Non-Agency MBS (also consisting of RMBS and CMBS) have no such guaranty of payment. We currently target an overall investment portfolio composition of 50%-70% in Agency MBS with the balance in non-Agency MBS and securitized mortgage loans. Securitized mortgage loans are loans which were originated and securitized by us during the 1990s.

In executing our investment strategy, we seek to balance the various risks of owning mortgage assets, such as interest rate, credit, prepayment, and liquidity risk with the earnings opportunity on the investment. We believe our strategy of investing in Agency and non-Agency mortgage assets provides superior diversification of these risks across our investment portfolio and therefore provides plentiful opportunities to generate attractive risk-adjusted returns while preserving our shareholders’ capital.

Factors that Affect Our Results of Operations and Financial Condition

Our financial condition and results of operations are affected by a variety of factors, many of which are beyond our control. The success of our investment strategy and our results of operations and financial condition are impacted by a variety of industry and economic factors including interest rates, trends of interest rates, the steepness of interest rate curves, prepayment rates on our investments, competition for investments, economic conditions and their impact on the credit performance of our investments, and actions taken by the U.S. government, including the U.S. Federal Reserve and/or the U.S. Department of the Treasury (“Treasury”).

Our investment strategy may also be impacted by other factors such as the state of the overall credit markets, which could impact the availability and costs of financing. Reductions in the availability of financing for our investments could significantly impact our business and force us to sell assets that we otherwise would not sell.

Investing in mortgage-related securities on a leveraged basis subjects us to interest rate risk from the change in the absolute level of rates (e.g., the level of LIBOR or Treasury securities rates), the changes in relationships between rate indices (e.g., LIBOR versus Treasury securities rates), and changes in the relationships between short-term and long-term rates (e.g., the 2-year Treasury securities rate versus the 10-year Treasury securities rate). Interest rate risk also arises from changes in market spreads reflecting the perceived riskiness of assets (e.g., swap rates and mortgage rates relative to the Treasury securities rates). We attempt to manage our exposure to changes in interest rates by investing in shorter duration instruments and managing our investment portfolio within risk tolerances set by our Board of Directors. Our current goal is to maintain a portfolio duration target (a measure of interest rate risk) within a range of 0.5 to 1.5 years. Our portfolio duration could drift outside of our target range due to changes in market conditions, interest rates, and activity in our investment portfolio. We will use interest rate swaps to help manage our interest rate risk and, where practical, we will attempt to fund our assets with financings that have similar terms as the related investments. In general, mortgage portfolios with positive duration that use repurchase agreement financing will underperform in a period of rising interest rates and outperform in a period of declining interest rates.

The interest rates on our assets will generally reset less frequently than the interest rates on our liabilities, particularly our repurchase agreement financing. As such, during periods of rising interest rates, we will generally experience a reduction in our net interest income, notwithstanding our efforts to manage interest rate risk. This reduction in net interest income will be larger when short-term interest rates are rising rapidly. With the maturities of our assets generally of longer term than those of our liabilities, interest rate increases will also tend to decrease the market value of our assets (and therefore our book value).

Many of our investments are purchased at premiums to their par balance. Because we amortize premiums based on contractual payments as well as actual and expected future principal prepayments on the investments, changes in actual and expected prepayment rates will impact our yield on these investments. Principal prepayments on our investments are influenced by changes in market interest rates and a variety of economic, geographic, and other factors beyond our control. In addition, actions taken by the U.S. government could increase prepayments as discussed further below under “Trends and Recent Market Impacts”. Increasing prepayments on premium assets will reduce their overall yield negatively impacting our results. We attempt to manage the risks of purchasing assets at a premium by purchasing assets with protection from prepayments (e.g., Agency CMBS) and by purchasing assets which we believe will have less susceptibility to prepayments (e.g., hybrid Agency ARMs collateralized by interest-only loans).

Trends and Recent Market Impacts

The following marketplace conditions and prospective trends have impacted and may continue to impact our future results of operations:

Credit Markets and Liquidity Risk

Our business model requires that we have access to leverage, principally the repurchase agreement market. Repurchase agreement financing is uncommitted financing and as such, there can be no guarantee that we will always have access to such financing. During periods of sustained volatility in the credit markets, such as was experienced in 2008, access to repurchase agreement financing may be limited as liquidity providers reduce their exposure to the short term funding credit markets, which includes repurchase agreement markets. In an attempt to manage this risk, we seek to diversify our exposure to repurchase agreement counterparties and seek to extend the maturity dates of our repurchase agreements where practicable. We believe the diversification of counterparties reduces, but does not eliminate, our liquidity risk resulting from the exit or failure of one or more of our repurchase

agreement counterparties. For additional information regarding liquidity risk, please refer to “Quantitative and Qualitative Disclosures about Market Risk” within Part I, Item 3 of this Quarterly Report on Form 10-Q, as well Item 1A “Risk Factors” contained within the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

Interest Rates

In response to the volatility and lack of liquidity in the credit markets in 2008, the Federal Reserve lowered the Federal Funds Target Rate (the rate at which U.S. banks may borrow from each other) from 4.25% at the beginning of 2008 to its current targeted rate of 0.25%. While the credit markets are functioning more normally and liquidity has generally returned, economic activity in the U.S. has remained muted, as measured by gross domestic product, low rates of capacity utilization and high rates of unemployment. As a result, the U.S. Federal Reserve has pledged to keep the Federal Funds Target Rate at the historically low target rate of 0.25% for an extended period. As economic activity improves, the Federal Reserve may decide to increase the Federal Funds Target Rate. Such an increase would likely increase our funding costs because, as discussed above, our repurchase agreement financing is based on LIBOR, which typically closely tracks the Federal Funds Target Rate.

Yield Curve

As of March 31, 2011, the spread between the two-year Treasury security and the ten-year Treasury security was 2.65% versus a similar spread as of December 31, 2010 of 2.70%. During the first quarter, the yields on the two-year Treasury and ten-year Treasury securities increased 0.23% and 0.18%, respectively. While our borrowing costs are based on short-term market rates such as LIBOR and the Federal Funds Target Rate, our asset yields more closely correlate with longer-term Treasury rates and longer-term swap rates. In addition, the market prices of our Agency and non-Agency MBS also correlate more closely with longer term Treasury and swap rates, particularly our CMBS which typically will have longer durations than our RMBS. With the yield curve remaining steep, our MBS continue to produce high yields relative to our financing costs and enjoy strong liquidity and favorable pricing. A change in the shape of the yield curve could impact the market value of our investments and our net interest income. As discussed previously, we may hedge our exposure to changes in interest rates by entering into pay-fixed interest rate swaps.

Prepayments and Agency MBS

We have continued to experience favorable prepayment activity on our Agency RMBS due in large part to the inability of borrowers to refinance their mortgages, although we experienced an increase in prepayments in the first quarter of 2011. Our average constant prepayment rate, or CPR, for our Agency RMBS during the first quarter of 2011 was 21.9% versus 24.0% for the fourth quarter of 2010, and 25.8% for all of 2010. As of March 31, 2011, the weighted average coupon on the mortgage loans underlying our Agency RMBS was 4.92%, while the annual average 30-year fixed mortgage rate and the 5-year hybrid ARM mortgage rate were 4.86% and 3.70%, respectively, as published by Freddie Mac. Generally, this type of interest rate environment encourages the average borrower to refinance their mortgage loans at lower rates. However, in many cases, obstacles exist to refinancing, including but not limited to, the lack of borrower’s equity in the underlying real estate and the lack of an acceptable level of income. These obstacles are currently contributing to the limited refinancing of loans in our Agency RMBS portfolio and are keeping prepayment speeds relatively low. If mortgage rates remain low and the obstacles to refinancing are removed either through changes in government or Agency policies, through more housing price appreciation or other reasons, we may experience increased prepayments. As discussed above, increased prepayments may impact our net interest income by increasing the amortization expense on any investments which we own at premiums to their par balance.

GSE Reform

On February 11, 2011, the Treasury released proposals to limit or potentially wind down the role that Fannie Mae and Freddie Mac play in the mortgage market. Any such proposals, if enacted, may have broad adverse implications for the MBS market and our business, operations and financial condition. We expect such proposals to be the subject of significant discussion, and it is not yet possible to determine whether such proposals will be enacted. We do not believe the ultimate reform of Fannie Mae and Freddie Mac will occur in 2011.

Financial Regulatory Reform Bill and Other Government Activity

In July 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was enacted into law. This legislation aims to restore responsibility and accountability to the financial system. It is unclear how this legislation may impact the borrowing environment, the investing environment for Agency and non-Agency MBS, or interest rate swaps and other derivatives because much of the Dodd-Frank Act’s implementation has not yet been defined by regulators.

In addition to the lowering of the Federal Funds Target Rate discussed above, the Federal Reserve has also responded to the instability that began in 2008 by purchasing Agency MBS and Treasury securities. From January 2009 through March 31, 2010, the Federal Reserve purchased approximately $1.25 trillion of Agency MBS. More recently in November 2010, the Federal Reserve announced a program to purchase up to $600 billion in Treasury securities of varying maturities through the end of the second quarter of 2011. The impact of the Federal Reserve terminating its purchases is unknown.

The U.S. government is providing homeowners with assistance in avoiding residential mortgage loan foreclosures. The programs may involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans, the rate of interest payable on the loans, or to extend the payment terms of the loans. While the effect of these programs has not been as extensive as originally expected, the government may change them or add new programs in the future. The impact of these programs may have the effect of increasing prepayment rates and reducing the principal or interest payments on residential mortgage loans held by certain types of borrowers. The effect of such programs for holders of Agency RMBS could be that such holders would experience changes in the anticipated yields of their Agency RMBS due to increased prepayment rates and lower interest and principal payments.

Highlights of the First Quarter and Second Quarter Outlook

Our results for the first quarter of 2011 were positively impacted by the continued growth in our investment portfolio. During the quarter we raised $94.8 million in new equity capital and deployed a majority of these proceeds, increasing our investment portfolio from $1,614.1 million as of December 31, 2010 to $2,279.6 million as of March 31, 2011. Substantially all of the growth in our investment portfolio was in Agency RMBS which is where we identified the most significant investment opportunity. Given the amount of competition for Agency RMBS during the quarter, most of these purchases that we made were at higher dollar prices than our existing Agency RMBS and consequently at lower yields. However, we expect that these investments will positively impact our net interest income. As of March 31, 2011, we have an estimated $15.0 million in capital remaining to deploy from the $94.8 million raised during the quarter. Although our leverage ratio is up slightly since year end to 5.2 times equity capital, it is below our target of 6.0.

Our net interest spread on our total investment portfolio declined for the first quarter of 2011 to 2.68% from 3.07% for the fourth quarter of 2010 primarily due to a decline in our yields on assets. See further discussion below in “Results of Operations”.

Our macroeconomic view remains the same as in recent quarters, namely that the yield curve will remain steep and short-term interest rates will remain low. Our challenge for the balance of 2011 will be finding attractive investment alternatives given the lower interest rate, higher priced investment environment. The mortgage market

continues to present challenges to leveraged investors given the uncertainly regarding government policy and potential actions by the Federal Reserve. Significant friction in the refinancing market continues to persist, and, absent a government-induced refinance wave, we expect voluntary prepayments on Agency RMBS to remain somewhat muted for the foreseeable future despite the near historic low rate environment. As such, our current focus is on acquiring shorter duration, higher coupon Agency RMBS. We plan to acquire these investments at leverage levels of 8-9 times equity capital using repurchase agreement financing which should continue to increase our overall leverage toward six times our equity capital.

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 these financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. We base these estimates and judgments on historical experience and assumptions believed to be reasonable under current facts and circumstances. Actual results, however, may differ from the estimated amounts we have recorded.

Our accounting policies that require the most significant management estimates, judgments or assumptions and are considered most critical to our results of operations or financial position relate to consolidation of subsidiaries, securitization, impairments, allowance for loan losses, derivatives, fair value measurements, and amortization of premiums/discounts on Agency MBS. Our critical accounting policies are discussed in our Annual Report on Form 10-K for the year ended December 31, 2010 under “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies” and in Note 1 of the Notes to Unaudited Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. There have been no changes in our critical accounting policies as discussed in our Annual Report on Form 10-K for the year ended December 31, 2010, except as discussed in Note 1 of the Notes to the Unaudited Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.

FINANCIAL CONDITION

The following discussion addresses our balance sheet items that had significant activity during the past quarter and should be read in conjunction with the Notes to Unaudited Consolidated Financial Statements contained within Item 1 of Part I to this Quarterly Report on Form 10-Q.

Agency MBS