DX 2011 Q2 10Q


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC  20549
FORM 10-Q
  R
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2011
or
  £
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           R           No           £

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           R           No           £

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
£
Accelerated filer
R
Non-accelerated filer
£ (Do not check if a smaller reporting company)
Smaller reporting company
£

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

On August 1, 2011, the registrant had 40,343,806 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

DYNEX CAPITAL, INC.
CONSOLIDATED BALANCE SHEETS
(amounts in thousands except share data)

 
June 30, 2011
 
December 31, 2010
ASSETS
(unaudited)
 
 
Agency MBS (including pledged of $2,039,227 and $1,090,174, respectively)
$
2,181,850

 
$
1,192,579

Non-Agency MBS (including pledged of $251,316 and $259,350, respectively)
277,195

 
267,356

Securitized mortgage loans, net
130,925

 
152,962

Other investments, net
1,127

 
1,229

 
2,591,097

 
1,614,126

Cash and cash equivalents
33,975

 
18,836

Derivative assets
432

 
692

Principal receivable on investments
14,402

 
3,739

Accrued interest receivable
11,380

 
6,105

Other assets, net
5,417

 
6,086

Total assets
$
2,656,703

 
$
1,649,584

LIABILITIES AND SHAREHOLDERS’ EQUITY
 

 
 

Liabilities:
 

 
 

Repurchase agreements
$
2,133,249

 
$
1,234,183

Non-recourse collateralized financing
105,983

 
107,105

Derivative liabilities
13,295

 
3,532

Accrued interest payable
1,437

 
1,079

Accrued dividends payable
10,893

 
8,192

Other liabilities
4,986

 
3,136

 Total liabilities
2,269,843

 
1,357,227

Commitments and Contingencies (Note 12)


 


Shareholders’ equity:
 

 
 

Common stock, par value $.01 per share, 100,000,000 shares
authorized; 40,343,159 and 30,342,897 shares issued and outstanding, respectively
403

 
303

Additional paid-in capital
633,969

 
538,304

Accumulated other comprehensive income
6,699

 
10,057

Accumulated deficit
(254,211
)
 
(256,307
)
 Total shareholders' equity
386,860

 
292,357

Total liabilities and shareholders’ equity
$
2,656,703

 
$
1,649,584


See notes to unaudited consolidated financial statements.



1


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
 (amounts in thousands except per share data)

 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2011
 
2010
 
2011
 
2010
Interest income:
 
 
 
 
 
 
 
Agency MBS
$
15,244

 
$
4,610

 
$
26,762

 
$
9,478

Non-Agency MBS
3,830

 
3,741

 
7,521

 
6,241

Securitized mortgage loans
1,961

 
3,355

 
4,180

 
6,978

Other investments
29

 
32

 
62

 
64

Cash and cash equivalents
1

 
2

 
5

 
5

 
21,065

 
11,740

 
38,530

 
22,766

Interest expense:
 

 
 

 
 
 
 
Repurchase agreements
4,760

 
1,362

 
8,188

 
2,625

Non-recourse collateralized financing
1,272

 
2,446

 
2,578

 
5,013

 
6,032

 
3,808

 
10,766

 
7,638

Net interest income
15,033

 
7,932

 
27,764

 
15,128

Provision for loan losses
(200
)
 
(150
)
 
(450
)
 
(559
)
Net interest income after provision for loan losses
14,833

 
7,782

 
27,314

 
14,569

Gain on sale of investments, net
742

 
716

 
742

 
794

Fair value adjustments, net
131

 
71

 
5

 
153

Other income, net
143

 
555

 
186

 
1,224

General and administrative expenses:
 

 
 

 
 

 
 

Compensation and benefits
(1,209
)
 
(870
)
 
(2,341
)
 
(1,842
)
Other general and administrative
(1,046
)
 
(987
)
 
(2,032
)
 
(2,094
)
Net income
13,594

 
7,267

 
23,874

 
12,804

Preferred stock dividends
—

 
(1,003
)
 
—

 
(2,005
)
Net income to common shareholders
$
13,594

 
$
6,264

 
$
23,874

 
$
10,799

Weighted average common shares:
 

 
 
 
 
 
 
Basic
40,333

 
15,122

 
36,763

 
14,668

Diluted
40,334

 
19,347

 
36,765

 
18,893

Net income per common share:
 

 
 

 
 

 
 

Basic
$
0.34

 
$
0.41

 
$
0.65

 
$
0.74

Diluted
$
0.34

 
$
0.38

 
$
0.65

 
$
0.68

Dividends declared per common share
$
0.27

 
$
0.23

 
$
0.54

 
$
0.46


See notes to unaudited consolidated financial statements.



2



DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
 (amounts in thousands)


 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2011
 
2010
 
2011
 
2010
Net income
$
13,594

 
$
7,267

 
$
23,874

 
$
12,804

Other comprehensive income:
 

 
 

 
 

 
 

Change in market value of available-for-sale securities
12,796

 
6,674

 
6,165

 
11,987

Reclassification adjustment for net gain on sale of available-for-sale securities
(742
)
 
(702
)
 
(742
)
 
(779
)
Net unrealized loss on cash flow hedging instruments
(11,738
)
 
(2,648
)
 
(8,781
)
 
(3,833
)
Other comprehensive income (loss)
316

 
3,324

 
(3,358
)
 
7,375

Comprehensive income
13,910

 
10,591

 
20,516

 
20,179

Dividends declared on preferred stock
—

 
(1,003
)
 
—

 
(2,005
)
Comprehensive income to common shareholders
$
13,910

 
$
9,588

 
$
20,516

 
$
18,174


See notes to unaudited consolidated financial statements.


3


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 (amounts in thousands)

 
Six Months Ended
 
June 30,
 
2011
 
2010
Operating activities:
 
 
 
Net income
$
23,874

 
$
12,804

Adjustments to reconcile net income to cash provided by operating activities:
 

 
 

Increase in accrued interest receivable
(5,275
)
 
(460
)
Increase (decrease) in accrued interest payable
358

 
(63
)
Provision for loan losses
450

 
559

Gain on sale of investments, net
(742
)
 
(794
)
Fair value adjustments, net
(5
)
 
(153
)
Amortization and depreciation
11,427

 
3,197

Stock-based compensation expense
353

 
163

Net change in other assets and other liabilities
2,840

 
(2,245
)
Net cash and cash equivalents provided by operating activities
33,280

 
13,008

Investing activities:
 

 
 

Purchase of investments
(1,244,687
)
 
(219,279
)
Principal payments received on investments
207,014

 
145,274

(Increase) decrease in principal receivable on investments
(10,663
)
 
953

Proceeds from sales of investments
35,351

 
50,883

Principal payments received on securitized mortgage loans
21,417

 
19,443

Other investing activities
(204
)
 
(97
)
Net cash and cash equivalents used in investing activities
(991,772
)
 
(2,823
)
Financing activities:
 

 
 

Borrowings under (repayment of) repurchase agreements, net
899,066

 
(47,404
)
Borrowings under non-recourse collateralized financing
—

 
50,678

Principal payments on non-recourse collateralized financing
(1,600
)
 
(15,544
)
Proceeds from issuance of common stock
95,242

 
10,859

Dividends paid
(19,077
)
 
(8,668
)
Net cash and cash equivalents provided by (used in) financing activities
973,631

 
(10,079
)
 
 
 
 
Net increase in cash and cash equivalents
15,139

 
106

Cash and cash equivalents at beginning of period
18,836

 
30,173

Cash and cash equivalents at end of period
$
33,975

 
$
30,279

Supplemental Disclosure of Cash Activities:
 

 
 

Cash paid for interest
$
9,881

 
$
8,269


See notes to unaudited consolidated financial statements.


4


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 and six months ended June 30, 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 mortgage-backed securities ("MBS").  The Company’s consolidated statements of cash flows now present separately “(increase) decrease 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 consolidated statement of cash flows for the six months ended June 30, 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.
 


5


Investments
 
The Company’s investments include Agency 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 or within twelve months of their initial reset period.

Interest rates on the adjustable-rate mortgage loans collateralizing 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 by Fannie Mae or Freddie Mac. Securities of both of these issuers are collateralized 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's Agency CMBS also include interest only securities which represent the right to receive contractual interest flows (but not principal cash flows) from the underlying unamortized principal balance of specific Agency CMBS.
 
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 June 30, 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 are 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 as unrealized gains (losses) 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 June 30, 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.



6


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 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 consolidated 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 consolidated 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

7


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 consolidated 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 consolidated statement of income.  These derivative instruments are carried at fair value on the Company’s consolidated balance sheets 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.  
 

8


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 other contingencies pending against the Company.  In accordance with ASC Topic 450, we evaluate whether to establish provisions for estimated losses from those matters.  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 Company's consolidated financial condition or liquidity.  The resolution of any such matters could, however, have a material effect on the consolidated results of operations or cash flows in a given future reporting period. Please refer to Note 12 for details on the most significant matters currently pending.
 
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, Disclosures about the Crdit Quality of Financing Receivables and the Allowance for Credit Losses, which was subsequently deferred temporarily by ASU No. 2011-01.  Management has evaluated these amendments and does not believe that they will have a material impact on the Company’s financial condition or results of operations.

In April 2011, FASB issued ASU No. 2011-03 to improve the accounting for repurchase agreements and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. ASC Topic 860 prescribes when an entity may or may not recognize a sale upon transfer of financial assets subject to repurchase agreements. That determination is based, in part, on whether the entity has maintained effective control over the transferred financial assets. Previously, under ASC Topic 860, the transferor was required to have the ability to repurchase the same or substantially the same assets in order to assert that it has maintained effective control over the transferred assets. ASU No. 2011-03 removes the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, and also removes the collateral maintenance implementation guidance related to that criterion. The FASB concluded that the assessment of effective control should focus on a transferor's contractual rights and obligations with respect to transferred financial assets, not on whether the transferor has the practical ability to perform in accordance with those rights or obligations. These amendments are effective for the first interim or annual reporting period beginning on or after December 15, 2011 and are to be applied prospectively. Management has evaluated these amendments and does not believe that they will have a material impact on the Company's financial condition or results of operations.




9



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 three and six months ended June 30, 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 was 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
 
June 30,
 
2011
 
2010
 
 
Income
 
Weighted-Average Common Shares (1)
 
 
Income
 
Weighted-
Average
Common
Shares (1)
Net income
$
13,594

 
 
 
$
7,267

 
 
Preferred stock dividends
—

 
 
 
(1,003
)
 
 
Net income to common shareholders
$
13,594

 
40,333,269

 
$
6,264

 
15,122,324

Effect of dilutive items
—

 
1,138

 
1,003

 
4,224,706

Diluted
$
13,594

 
40,334,407

 
$
7,267

 
19,347,030

Net income per common share:
 
 
 
 
 
 
 
Basic
 

 
$
0.34

 
 

 
$
0.41

Diluted (1)
 

 
$
0.34

 
 

 
$
0.38

Components of dilutive items:
 
 
 
 
 
 
 
Convertible preferred stock
$
—

 
—

 
$
1,003

 
4,221,539

Stock options
—

 
1,138

 
—

 
3,167

 
$
—

 
1,138

 
$
1,003

 
4,224,706

(1)
For the three months ended June 30, 2011 and June 30, 2010, the calculation of diluted net income per common share excludes 15,000 unexercised stock option awards because their inclusion would have been anti-dilutive.
 
Six Months Ended
 
June 30,
 
2011
 
2010
 
 
Income
 
Weighted-Average Common Shares (1)
 
 
Income
 
Weighted-Average Common Shares (1)
Net income
$
23,874

 
 
 
$
12,804

 
 
Preferred stock dividends
—

 
 
 
(2,005
)
 
 
Net income to common shareholders
23,874

 
36,762,811

 
10,799

 
14,668,489

Effect of dilutive items
—

 
2,209

 
2,005

 
4,224,438

Diluted
$
23,874

 
$
36,765,020

 
$
12,804

 
18,892,927

Net income per common share:
 
 
 
 
 
 
 
Basic
 

 
$
0.65

 
 

 
$
0.74

Diluted (1)
 

 
$
0.65

 
 

 
$
0.68

Components of dilutive items:
 
 
 
 
 
 
 
Convertible preferred stock
$
—

 
—

 
$
2,005

 
4,221,539

Stock options
—

 
2,209

 
—

 
2,899

 
$
—

 
2,209

 
$
2,005

 
4,224,438

(1)
 For the six months ended June 30, 2010, the calculation of diluted net income per common share excludes 15,000 unexercised stock option awards because their inclusion would have been anti-dilutive.


10


NOTE 3 – AGENCY MBS
 
The following table presents the components of the Company’s investment in Agency MBS as of June 30, 2011 and December 31, 2010:

 
June 30, 2011
 
December 31, 2010
 
RMBS
 
CMBS
 
Total
 
RMBS
 
CMBS
 
Total
Principal/par value
$
1,799,594

 
$
223,932

 
$
2,023,526

 
$
937,376

 
$
190,511

 
$
1,127,887

Unamortized premium
102,040

 
49,739

 
151,779

 
43,776

 
18,757

 
62,533

Unamortized discount
(1
)
 
—

 
(1
)
 
(36
)
 
—

 
(36
)
Amortized cost
1,901,633

 
273,671

 
2,175,304

 
981,116

 
209,268

 
1,190,384

Unrealized gains:
 

 
 

 
 

 
 

 
 

 
 

Available for sale
9,505

 
1,796

 
11,301

 
8,266

 
567

 
8,833

Trading
—

 
1,075

 
1,075

 
—

 
—

 
—

Unrealized losses:
 

 
 

 
 

 
 

 
 

 
 

Available for sale
(4,838
)
 
(992
)
 
(5,830
)
 
(3,371
)
 
(3,267
)
 
(6,638
)
Trading
—

 
—

 
—

 
—

 
—

 
—

Fair value
$
1,906,300

 
$
275,550

 
$
2,181,850

 
$
986,011

 
$
206,568

 
$
1,192,579

Weighted average coupon based on par value
4.57
%
 
5.39
%
 
4.66
%
 
4.46
%
 
5.41
%
 
4.62
%

During the six months ended June 30, 2011, the Company purchased $1,151,588 and $69,482 of Agency RMBS and CMBS, respectively. As of June 30, 2011, the amortized cost and fair value of Agency CMBS designated as trading securities was $24,038 and $25,113, respectively, with the remainder of the Company's Agency CMBS and Agency RMBS designated as available-for-sale. The Company did not hold any Agency CMBS or RMBS designated as trading securities as of December 31, 2010.  During the six months ended June 30, 2011, the Company did not sell any of its trading securities purchased during the three and six months ended June 30, 2011, but recognized a net unrealized gain of $956 and $1,075, respectively, related to their changes in fair value, which is included within “fair value adjustments, net” in its consolidated statement of income for the three and six months ended June 30, 2011. The Company also has derivatives designated as trading instruments, and the changes in their fair value are also included within "fair value adjustments, net". For the three and six months ended June 30, 2011, the Company recognized a net unrealized loss of $(871) and $(1,219), respectively, related to these derivatives. Please refer to Note 7 for additional information on these derivatives designated as trading instruments.

A portion of the Company's Agency CMBS as reported in the table above as of June 30, 2011 are interest only securities. The Company did not hold any Agency interest only securities as of December 31, 2010. The table below presents the Company's Agency CMBS by security type as of June 30, 2011.

 
June 30, 2011
 
Principal
 
Premium
 
Unrealized Gain (Loss)
 
Total
Principal and interest securities
$
223,932

 
$
19,658

 
$
1,798

 
$
245,388

Interest only securities (1)
—

 
30,081

 
81

 
30,162

Fair value of Agency CMBS
$
223,932

 
$
49,739

 
$
1,879

 
$
275,550

     (1)    The combined notional balance for the Agency interest only securities is $898,114 as of June 30, 2011.


11



NOTE 4 – NON-AGENCY MBS
 
The following table presents the components of the Company’s non-Agency MBS as of June 30, 2011 and December 31, 2010:
 
June 30, 2011
 
December 31, 2010
 
RMBS
 
CMBS
 
Total
 
RMBS
 
CMBS
 
Total
Principal/par value
$
11,561

 
$
250,817

 
$
262,378

 
$
16,101

 
$
247,494

 
$
263,595

Unamortized premium
—

 
14,676

 
14,676

 
138

 
5,352

 
5,490

Unamortized discount
(1,048
)
 
(11,640
)
 
(12,688
)
 
(1,115
)
 
(11,296
)
 
(12,411
)
Amortized cost
10,513

 
253,853

 
264,366

 
15,124

 
241,550

 
256,674

Unrealized gains
451

 
12,994

 
13,445

 
632

 
10,978

 
11,610

Unrealized losses
(522
)
 
(94
)
 
(616
)
 
(348
)
 
(580
)
 
(928
)
Fair value
$
10,442

 
$
266,753

 
$
277,195

 
$
15,408

 
$
251,948

 
$
267,356

Weighted average coupon based on par value
4.33
%
 
6.39
%
 
6.30
%
 
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 $272,057 and $262,234 as of June 30, 2011 and December 31, 2010, respectively.  The Company purchased $23,617 of non-Agency CMBS during the six months ended June 30, 2011, and did not purchase any non-Agency RMBS.
 
A portion of the Company's non-Agency CMBS as reported in the table above as of June 30, 2011 are interest only securities. The Company did not hold any non-Agency interest only securities as of December 31, 2010. The table below presents the Company's non-Agency CMBS by security type as of June 30, 2011.

 
June 30, 2011
 
Principal
 
Net Premium
 
Unrealized Gain (Loss)
 
Total
Principal and interest securities
$
250,817

 
$
(7,182
)
 
$
12,932

 
$
256,567

Interest only securities (1)
—

 
10,218

 
(32
)
 
10,186

Fair value of non-Agency CMBS
$
250,817

 
$
3,036

 
$
12,900

 
$
266,753

(1)    The combined notional balance for the non-Agency interest only securities is $342,968 as of June 30, 2011.

NOTE 5 – SECURITIZED MORTGAGE LOANS, NET
 
All of the Company's securitized mortgage loans are pledged as collateral for its associated securitization financing bonds, which are discussed further in Note 9. Please also refer to Note 6 for disclosures related to impaired securitized mortgage loans and the related allowance for loans losses. The following table summarizes the components of securitized mortgage loans as of June 30, 2011 and December 31, 2010:

 
June 30, 2011
 
December 31, 2010
 
Commercial
 
Single-family
 
Total
 
Commercial
 
Single-family
 
Total
Principal/par value
$
78,927

 
$
50,122

 
$
129,049

 
$
99,432

 
$
54,181

 
$
153,613

FHBT(1)
4,702

 
—

 
4,702

 
3,455

 
—

 
3,455

Unamortized premium, net
—

 
809

 
809

 
—

 
884

 
884

Unamortized discount, net
(358
)
 
—

 
(358
)
 
(520
)
 
—

 
(520
)
Amortized cost
83,271

 
50,931

 
134,202

 
102,367

 
55,065

 
157,432

Allowance for loan losses
(3,069
)
 
(208
)
 
(3,277
)
 
(4,200
)
 
(270
)
 
(4,470
)
 
$
80,202

 
$
50,723

 
$
130,925

 
$
98,167

 
$
54,795

 
$
152,962


12


 
(1)
Funds held by trustees includes $4,553 and $3,306 as of June 30, 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.

The balance of the Company's securitized commercial mortgage loans have decreased since December 31, 2010 primarily due to principal payments, including amounts received on defeased loans, of $17,419.  The Company's securitized commercial mortgage loans were originated principally in 1996 and 1997 and are collateralized by first deeds of trust on income producing properties.  Approximately 76.8% of these securitized commercial mortgage loans are secured by multifamily properties. As of June 30, 2011 and December 31, 2010, the loan-to-value ratio based on original appraisal was 42.7% and 45.0%, respectively. The unpaid principal balance of the securitized commercial mortgage loans identified as seriously delinquent (60 or more days past due) and therefore on nonaccrual status is $20,114 as of June 30, 2011. The increase of $6,025 in the balance of seriously delinquent loans, which was $14,089 as of December 31, 2010, is primarily related to a commercial mortgage loan on a property in Denver, Colorado that became seriously delinquent during the first quarter of 2011.  The estimated value of the property collateralizing the loan appears to be adequate to fully repay the loan, and thus the Company has not provided any reserves specifically for this loan. 

The balance of the Company's securitized single-family mortgage loans have decreased since December 31, 2010 due to principal payments on the loans of $3,998, of which 58% were unscheduled. These single-family mortgage loans are secured by first deeds of trust on residential real estate and were originated principally from 1992 to 1997.   As of June 30, 2011 and December 31, 2010, the loan-to-value ratio based on original appraisal was 47.8% and 48.0%, respectively. The unpaid principal balance of the Company's securitized single-family mortgage loans identified as seriously delinquent as of June 30, 2011 is $5,082. The Company continues accruing interest on any seriously delinquent securitized single-family mortgage loan so long as the primary servicer continues to advance the interest and/or principal due on the loan.

NOTE 6 – ALLOWANCE FOR LOAN LOSSES
 
As discussed in Note 1, the Company estimates for currently existing and probable losses for its mortgage loans that are considered impaired. A loan does not have to be seriously delinquent (60 or more days past due) in order to be considered impaired. The following table presents certain information on impaired securitized commercial and single-family mortgage loans as of June 30, 2011 and December 31, 2010:

 
June 30, 2011
 
December 31, 2010
 
Commercial
 
Single-family
 
Commercial
 
Single-family
Unpaid principal balance of impaired securitized loans
$
8,618

 
$
5,082

 
$
18,219

 
$
3,587

Basis adjustments related to impaired securitized loans
(22
)
 
82

 
(65
)
 
59

Amortized cost basis of impaired securitized loans
8,596

 
5,164

 
18,154

 
3,646

Allowance for loan losses
(3,069
)
 
(208
)
 
(4,200
)
 
(270
)
Investment in excess of allowance
$
5,527

 
$
4,956

 
$
13,954

 
$
3,376


The Company recognized $28 and $56 of interest income on impaired securitized commercial mortgage loans for the three and six months ended June 30, 2011 compared to $102 and $223 of interest income for the three and six months ended June 30, 2010.  The Company recognized $71 and $143 of interest income on impaired securitized single-family mortgage loans for the three and six months ended June 30, 2011 compared to $60 and $120 on impaired single-family mortgage loans for the three and six months ended June 30, 2010.

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:


13


 
Three Months Ended
 
June 30,
 
2011
 
2010
 
Commercial
 
Single-family
 
Commercial
 
Single-family
Allowance at beginning of period
$
4,237

 
$
249

 
$
4,085

 
$
277

Provision for loan losses(1)
200

 
—

 
240

 
—

Credit losses, net of recoveries
(1,368
)
 
(41
)
 
(616
)
 
(6
)
Allowance at end of period(2)
$
3,069

 
$
208

 
$
3,709

 
$
271

 
(1)
Activity shown for provision for loan losses for the three months ended June 30, 2010 excludes the reversal of $90 of provision related to the Company’s unsecuritized mortgage loan portfolio.
(2)
Balance as of June 30, 2010 excludes allowance of $265 related to the Company’s unsecuritized mortgage loan portfolio. As of June 30, 2011, the amount of allowance related to the Company's unsecuritized mortgage loan portfolio is $0.

 
Six Months Ended
 
June 30,
 
2011
 
2010
 
Commercial
 
Single-family
 
Commercial
 
Single-family
Allowance at beginning of period
$
4,200

 
$
270

 
$
3,935

 
$
277

Provision for loan losses(1)
450

 
—

 
390

 
—

Credit losses, net of recoveries
(1,581
)
 
(62
)
 
(616
)
 
(6
)
Allowance at end of period(2)
$
3,069

 
$
208

 
$
3,709

 
$
271

(1)
Activity shown for provision for loan losses for the six months ended June 30, 2010 excludes provision of $169 related to the Company’s unsecuritized mortgage loan portfolio.
(2)
Balance as of June 30, 2010 excludes allowance of $265 related to the Company’s unsecuritized mortgage loan portfolio. As of June 30, 2011, the amount of allowance related to the Company's unsecuritized mortgage loan portfolio is $0.


NOTE 7 – DERIVATIVES
 
Please see Note 1 for additional information related to the Company’s accounting policies for derivative instruments.

As of June 30, 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 its investments also designated as trading.  See Note 3 for information related to the investments designated as trading.
 

14



The tables below summarize information about the Company’s derivative financial instruments on the balance sheet as of the dates indicated:
 
As of June 30, 2011
Accounting
Designation
Balance Sheet Location
Fair Value
Cumulative Notional Amount
Weighted-average
Fixed Rate Swapped
Hedging instruments
Derivative assets
$
432

$
110,000

0.98
%
 
 
 
 

 

Hedging instruments
Derivative liabilities
$
(12,076
)
$
870,000

1.61
%
Trading instruments
Derivative liabilities
(1,219
)
27,000

2.88
%
 
 
$
(13,295
)
 

 

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

1.58
%
 
 
 
 
 


As of June 30, 2011, the Company had margin requirements with its swap counterparties for these interest rate swaps for which Agency MBS with a fair value of $19,458 have been posted as collateral.  The following table summarizes the contractual maturities remaining for the Company’s outstanding interest rate swap agreements as of June 30, 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
—

 
510,000

 
510,000

 
9

 
1.26
%
37-72 months
27,000

 
370,000

 
397,000

 
13

 
2.11
%
 
$
27,000

 
$
980,000

 
$
1,007,000

 
24

 
1.57
%


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

 
 
Amount of Loss Recognized in Net Income
For the Three Months Ended
 
Amount of Loss Recognized in Net Income
For the Six Months Ended
Type of Derivative Designated as Trading
Location of Amount Recognized in Net Income
June 30, 2011
 
June 30, 2010
 
June 30, 2011
 
June 30, 2010
Interest rate swaps
Fair value adjustments, net
$
871

 
$
—

 
$
1,219

 
$
—



15



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

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)
For the three months ended June 30, 2011:
 
Interest rate swaps
$14,810
Interest expense
$3,072
Other income, net
$25
 
 
 
 
 
 
For the three months ended June 30, 2010:
 
 
 
Interest rate swaps
$3,237
Interest expense
$589
Other income, net
$(1)
 
 
 
 
 
 
For the six months ended June 30, 2011:
 
 
 
Interest rate swaps
$13,722
Interest expense
$4,941
Other income, net
$24
 
 
 
 
 
 
For the six months ended June 30, 2010:
 
 
 
Interest rate swaps
$4,880
Interest expense
$1,047
Other income, net
$9

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
(13,722
)
 
(4,880
)
Reclassification adjustment for amounts included in statement of income
4,941

 
1,047

Balance as of June 30,
$
(11,601
)
 
$
(2,825
)

The Company estimates that an additional $11,500 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 our derivative counterparties allow those counterparties 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 June 30, 2011, the Company had derivatives in a net liability position with its derivative counterparties totaling $13,734, inclusive of accrued interest but excluding any adjustment for nonperformance risk, for which it had pledged Agency MBS with a fair value of $19,458 as collateral.  If the Company had breached any of these agreements as of June 30, 2011, it could have been required to settle those derivatives at their estimated termination value of $13,734.
 
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 June 30, 2011 and December 31, 2010 by the type of securities collateralizing the repurchase agreement:
 

16


 
June 30, 2011
Collateral Type
Balance
 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
Agency RMBS
$
1,728,495

 
0.23
%
 
$
1,799,991

Agency CMBS
192,652

 
0.34
%
 
219,778

Non-Agency RMBS
7,693

 
1.24
%
 
8,720

Non-Agency CMBS
153,304

 
1.09
%
 
177,592

Securitization financing bonds (see Note 9)
51,105

 
1.11
%
 
60,251

 
$
2,133,249

 
0.33
%
 
$
2,266,332



 
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 RMBS
12,126

 
1.29
%
 
13,628

Non-Agency CMBS
135,143

 
1.31
%
 
164,871

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 June 30, 2011 and December 31, 2010.  The following table provides a summary of the original maturity as of June 30, 2011 and December 31, 2010:

Original Maturity
June 30,
2011
 
December 31,
2010
30 days or less
$
682,112

 
$
478,848

31 to 60 days
772,995

 
372,702

61 to 90 days
265,951

 
202,569

Greater than 90 days
412,191

 
180,064

 
$
2,133,249

 
$
1,234,183


As of June 30, 2011, the maximum amount of equity at risk (equal to the fair value of the collateral pledged in excess of the amount due) under repurchase agreements with any individual counterparty is $28,461.

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 during the three and six months ended June 30, 2011. Please refer to "Liquidity and Capital Resources" within Item 2 of this Quarterly Report on Form 10-Q for additional information related to these covenants.
 

NOTE 9 – NON-RECOURSE COLLATERIZED FINANCING
 
The following table summarized information about the Company’s non-recourse collateralized financing for the periods indicated:

17


 
 
 
June 30, 2011
 
 
Interest Rate
Weighted Average
Life Remaing
Balance Outstanding
 
Value of
Collateral
Securitization financing:
 
(in years)
 
 
 
Secured by commercial mortgage loans
7.2% fixed
3.0

$
23,669

 
$
41,685

Secured by non-Agency CMBS
6.2% fixed
2.6

15,000

 
16,748

Secured by single-family mortgage loans
1-month LIBOR
plus 0.30%
3.3

19,725

 
20,621

TALF financing:(1)
 
 
 

 
 

Secured by non-Agency CMBS
2.7% fixed
1.7

50,571

 
65,004

Unamortized net bond premium and deferred costs
 
 

(2,982
)
 
n/a

 
 
 

$
105,983

 
$
144,058


 
 
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

 
$
43,440

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:(1)
 
 

 

 
 

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

 
$
146,180

(1)
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 June 30, 2011:
 
 
Collateral Type
Par Value
Outstanding
 
Fair Value
 
Repurchase
 Agreement Balance
Single-family mortgage loans
$
23,143

 
$
21,024

 
$
18,371

Commercial mortgage loans
38,381

 
39,227

 
32,734

 
$
61,524

 
$
60,251

 
$
51,105





18



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.
The following table presents the fair value of the Company’s assets and liabilities measured at fair value on a recurring basis as of June 30, 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
$
2,181,850

 
$
—

 
$
2,181,850

 
$
—

Non-Agency MBS:
 

 
 

 
 

 
 

CMBS
266,753

 
—

 
129,992

 
136,761

RMBS
10,442

 
—

 
5,720

 
4,722

Other investments
25

 
—

 
—

 
25

Derivative assets
432

 
—

 
432

 
—

Total assets carried at fair value
$
2,459,502

 
$
—

 
$
2,317,994

 
$
141,508

Liabilities:
 

 
 

 
 

 
 

Derivative liabilities
$
13,295

 
$
—

 
$
13,295

 
$
—

Total liabilities carried at fair value
$
13,295

 
$
—

 
$
13,295

 
$
—


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 activity of the instruments fair valued at Level 3 for the three and six months ended June 30, 2011:
 

19


 
Level 3 Fair Values
 
Non-Agency CMBS
 
Non-Agency RMBS
 
Other
 
Total assets
Balance as of March 31, 2011
$
138,976

 
$
8,787

 
$
25

 
$
147,788

Purchases
98

 
—

 
—

 
98

Sales
—

 
(3,765
)
 
—

 
(3,765
)
Total unrealized losses:
 

 
 

 
 

 
 

Included in other comprehensive income
1,339

 
101

 
—

 
1,440

Principal payments
(3,469
)
 
(401
)
 
—

 
(3,870
)
Amortization
(183
)
 
—

 
—

 
(183
)
Balance as of June 30, 2011
$
136,761

 
$
4,722

 
$
25

 
$
141,508


 
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

Purchases
98

 
—

 
—

 
98

Sales
—

 
(3,767
)
 
—

 
(3,767
)
Total unrealized losses:
 

 
 

 
 

 
 

Included in other comprehensive income
565

 
10

 
—

 
575

Principal payments
(10,033
)
 
(828
)
 
—

 
(10,861
)
Amortization
(540
)
 
—

 
—

 
(540
)
Balance as of June 30, 2011
$
136,761

 
$
4,722

 
$
25

 
$
141,508


The following table presents the recorded basis and estimated fair values of the Company’s financial instruments as of June 30, 2011 and December 31, 2010:
 
 
June 30, 2011
 
December 31, 2010
 
Recorded Basis
 
FairValue
 
Recorded Basis
 
FairValue
Assets:
 
 
 
 
 
 
 
Agency MBS
$
2,181,850

 
$
2,181,850

 
$
1,192,579

 
$
1,192,579

Non-Agency CMBS
266,753

 
266,753

 
251,948

 
251,948

Non-Agency RMBS
10,442

 
10,442

 
15,408

 
15,408

Securitized mortgage loans, net
130,925

 
122,318

 
152,962

 
142,177

Other investments
1,127

 
1,035

 
1,229

 
1,112

Derivative assets
432

 
432

 
692

 
692

Liabilities:
 

 
 

 
 

 
 

Repurchase agreements
$
2,133,249

 
$
2,133,249

 
$
1,234,183

 
$
1,234,183

Non-recourse collateralized financing
105,983

 
108,524

 
107,105

 
109,395

Derivative liabilities
13,295

 
13,295

 
3,532

 
3,532


There were no assets or liabilities which were measured at fair value on a non-recurring basis as of June 30, 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 June 30, 2011 and December 31, 2010:


20


 
June 30, 2011
 
December 31, 2010
 
FairValue
 
Unrealized Loss
 
FairValue
 
Unrealized Loss
Unrealized loss position for:
 
 
 
 
 
 
 
Less than one year:
 
 
 
 
 
 
 
Agency MBS
$
1,021,724

 
$
5,380

 
$
695,854

 
$
6,638

Non-Agency MBS
25,535

 
287

 
45,602

 
592

One year or more:
 

 
 

 
 

 
 

Agency MBS
24,357

 
449

 
—

 
—

Non-Agency MBS
3,368

 
329

 
3,494

 
337

 
$
1,074,984

 
$
6,445

 
$
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 June 30, 2011 are temporary.

The Company reviews any non-Agency MBS in an unrealized loss position to evaluate whether any decline in fair value represents an other-than-temporary impairment. The evaluation includes a review of the credit ratings of these MBS and the seasoning of the mortgage loans collateralizing these securities as well as the estimated future cash flows which include projected losses. The Company performed this evaluation for the non-Agency MBS in an unrealized loss position as of June 30, 2011 and has determined that there have not been any adverse changes in the timing or amount of estimated future cash flows that necessitate a recognition of other-than-temporary impairment amounts as of June 30, 2011.

NOTE 11 – SHAREHOLDERS' EQUITY
 
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 six months ended June 30, 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 June 30, 2011, has 538,147 remaining shares to be issued under the EPP.

During the six months ended June 30, 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 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:


21


 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2011
 
2010
 
2011
 
2010
Balance at beginning of period
40,318,159

 
15,037,802

 
30,342,897
 
13,931,512

Common stock issued under EPP
—

 
70,100

 
409,237
 
1,140,200

Common stock issued via public offering
—

 
—

 
9,200,000
 
—

Common stock redeemed under 2004 Stock and Incentive Plan
5,000

 
50,000

 
15,000
 
50,000

Common stock issued under 2009 Stock and Incentive Plan
20,000

 
10,840

 
376,025
 
47,030

Balance at end of period
40,343,159

 
15,168,742

 
40,343,159
 
15,168,742

 
Incentive Plans.     Pursuant to the Company’s 2009 Stock and Incentive Plan, the Company may grant stock-based compensation to eligible employees, directors or consultants or advisers 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, 2,076,945 shares remain available as of June 30, 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 June 30, 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 June 30, 2011, the fair value of the Company’s outstanding restricted stock remaining to be amortized into net income is $3,008.
 
The Company did not grant any stock options during the three and six months ended June 30, 2011 or June 30, 2010, and there were no forfeitures of its outstanding stock options for those same periods. The following tables presents a rollforward of the stock option activity for the periods presented:
 
 
Three Months Ended
 
June 30,
 
2011
 
2010
 
Number of Shares
 
Weighted-Average Exercise Price
 
Number of Shares
 
Weighted-
Average
Exercise
Price
Options outstanding at beginning of period
35,000

 
$
9.13

 
95,000

 
$
8.59

Options exercised
(5,000
)
 
7.43

 
(50,000
)
 
8.45

Options outstanding at end of period
(all vested and exercisable)
30,000

 
$
9.42

 
45,000

 
$
8.75


 
Six Months Ended
 
June 30,
 
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 exercised
(15,000
)
 
7.43

 
(50,000
)