1Q14 Form 10-Q


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC  20549
FORM 10-Q
  x
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended March 31, 2014
or
  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           x           No           o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes           x           No           o

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

Large accelerated filer
o
Accelerated filer
x
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           x

On May 2, 2014, the registrant had 54,698,963 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
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 







i


PART I.
FINANCIAL INFORMATION
ITEM 1.    FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.
CONSOLIDATED BALANCE SHEETS
(amounts in thousands except share data)
 
March 31, 2014
 
December 31, 2013
ASSETS
(unaudited)
 

Mortgage-backed securities (including pledged of $3,798,331 and
     $3,873,584, respectively)
$
3,959,852

 
$
4,018,161

Mortgage loans held for investment, net
53,804

 
55,423

Cash and cash equivalents
61,168

 
69,330

Restricted cash
18,242

 
13,385

Derivative assets
12,064

 
18,488

Principal receivable on investments
8,112

 
12,999

Accrued interest receivable
23,387

 
21,703

Other assets, net
7,653

 
7,648

Total assets
$
4,144,282

 
$
4,217,137

LIABILITIES AND SHAREHOLDERS’ EQUITY
 

 
 

Liabilities:
 

 
 

Repurchase agreements
$
3,485,544

 
$
3,580,754

Payable for unsettled mortgage-backed securities
16,086

 
10,358

Non-recourse collateralized financing
12,394

 
12,914

Derivative liabilities
11,137

 
6,681

Accrued interest payable
2,846

 
2,548

Accrued dividends payable
15,612

 
16,601

Other liabilities
1,648

 
1,405

 Total liabilities
3,545,267

 
3,631,261


 
 
 
Shareholders’ equity:
 

 
 

Preferred stock, par value $.01 per share, 8.5% Series A Cumulative Redeemable; 8,000,000 shares authorized; 2,300,000 shares issued and outstanding ($57,500 aggregate liquidation preference)
55,407

 
55,407

Preferred stock, par value $.01 per share, 7.625% Series B Cumulative Redeemable; 7,000,000 shares authorized; 2,250,000 shares issued and outstanding($56,250 aggregate liquidation preference)
54,251

 
54,251

Common stock, par value $.01 per share, 200,000,000 shares
authorized; 54,697,307 and 54,310,484 shares issued and outstanding, respectively
547

 
543

Additional paid-in capital
761,827

 
761,550

Accumulated other comprehensive loss
(4,256
)
 
(33,816
)
Accumulated deficit
(268,761
)
 
(252,059
)
 Total shareholders' equity
599,015

 
585,876

Total liabilities and shareholders’ equity
$
4,144,282

 
$
4,217,137

See notes to unaudited consolidated financial statements.

1


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
 (amounts in thousands except per share data)
 
Three Months Ended
 
March 31,
 
2014
 
2013
Interest income:
 
 
 
Mortgage-backed securities
$
26,902

 
$
32,039

Mortgage loans held for investment
738

 
943

 
27,640

 
32,982

Interest expense:
 
 
 
Repurchase agreements
7,611

 
10,218

Non-recourse collateralized financing
22

 
238

 
7,633

 
10,456

 

 
 
Net interest income
20,007

 
22,526

Provision for loan losses
—

 
(261
)
Loss on derivative instruments, net
(13,422
)
 
(17
)
(Loss) gain on sale of investments, net
(3,307
)
 
1,391

Fair value adjustments, net
32

 
(140
)
Other income (expense), net
75

 
(88
)
General and administrative expenses:
 
 
 
Compensation and benefits
(2,552
)
 
(2,358
)
Other general and administrative
(1,567
)
 
(1,450
)
Net (loss) income
(734
)
 
19,603

Preferred stock dividends
(2,294
)
 
(1,222
)
Net (loss) income to common shareholders
$
(3,028
)
 
$
18,381

 
 
 
 
Other comprehensive income:
 
 
 
Change in fair value of available-for-sale investments
23,965

 
5,897

Reclassification adjustment for (loss) gain on sale of investments, net
3,307

 
(1,391
)
Change in fair value of cash flow hedges
—

 
437

Reclassification adjustment for cash flow hedges (including de-designated hedges)
2,288

 
4,103

Total other comprehensive income
29,560

 
9,046

Comprehensive income to common shareholders
$
26,532

 
$
27,427

 
 
 
 
Weighted average common shares - basic and diluted
54,626

 
54,300

Net (loss) income per common share - basic and diluted
$
(0.06
)
 
$
0.34

See notes to unaudited consolidated financial statements.

2


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(UNAUDITED)
(amounts in thousands)
 
Preferred
Stock
 
Common
Stock
 
Additional
Paid-in
Capital
 
Accumulated Other
Comprehensive Loss
 
Accumulated
Deficit
 
Total
Balance as of
 December 31, 2013
$
109,658

 
$
543

 
$
761,550

 
$
(33,816
)
 
$
(252,059
)
 
$
585,876

Stock issuance
—

 
1

 
143

 
—

 
—

 
144

Granting and vesting of restricted stock
—

 
4

 
668

 
—

 
—

 
672

Amortization of stock issuance costs
—

 
—

 
(30
)
 
—

 
—

 
(30
)
Adjustments for tax withholding on share-based compensation
—

 
(1
)
 
(504
)
 
—

 
—

 
(505
)
Net loss
—

 
—

 
—

 
—

 
(734
)
 
(734
)
Dividends on preferred stock
—

 
—

 
—

 
—

 
(2,294
)
 
(2,294
)
Dividends on common stock
—

 
—

 
—

 
—

 
(13,674
)
 
(13,674
)
Other comprehensive income
—

 
—

 
—

 
29,560

 
—

 
29,560

Balance as of March 31, 2014
$
109,658

 
$
547

 
$
761,827

 
$
(4,256
)
 
$
(268,761
)
 
$
599,015


 
Preferred
Stock
 
Common
Stock
 
Additional
Paid-in
Capital
 
Accumulated Other
Comprehensive Income
 
Accumulated
Deficit
 
Total
Balance as of
 December 31, 2012
$
55,407

 
$
543

 
$
759,214

 
$
52,511

 
$
(250,965
)
 
$
616,710

Stock issuance
—

 
5

 
5,178

 
—

 
—

 
5,183

Granting and vesting of restricted stock
—

 
1

 
455

 
—

 
—

 
456

Amortization of stock issuance costs
—

 
—

 
(30
)
 
—

 
—

 
(30
)
Adjustments for tax withholding on share-based compensation
—

 
(1
)
 
(545
)
 
—

 
—

 
(546
)
Net income
—

 
—

 
—

 
—

 
19,603

 
19,603

Dividends on preferred stock
—

 
—

 
—

 
—

 
(1,222
)
 
(1,222
)
Dividends on common stock
—

 
—

 
—

 
—

 
(15,902
)
 
(15,902
)
Other comprehensive income
—

 
—

 
—

 
9,046

 
—

 
9,046

Balance as of March 31, 2013
$
55,407

 
$
548

 
$
764,272

 
$
61,557

 
$
(248,486
)
 
$
633,298

See notes to the unaudited consolidated financial statements.

3


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(amounts in thousands)
 
Three Months Ended
 
March 31,
 
2014
 
2013
Operating activities:
 
 
 
Net (loss) income
$
(734
)
 
$
19,603

Adjustments to reconcile net (loss) income to cash provided by operating activities:
 

 
 

Increase in accrued interest receivable
(1,684
)
 
(1,401
)
Increase (decrease) in accrued interest payable
298

 
(22
)
Provision for loan losses
—

 
261

Loss on derivative instruments, net
13,422

 
17

Loss (gain) on sale of investments, net
3,307

 
(1,391
)
Fair value adjustments, net
(32
)
 
140

Amortization and depreciation
34,829

 
32,117

Stock-based compensation expense
672

 
481

Other operating activities
(175
)
 
(4,400
)
Net cash and cash equivalents provided by operating activities
49,903

 
45,405

Investing activities:
 

 
 

Purchase of investments
(127,552
)
 
(438,376
)
Principal payments received on investments
128,676

 
215,751

Proceeds from sales of investments
59,799

 
31,158

Principal payments received on mortgage loans held for investment, net
1,605

 
5,737

Net payments on derivatives not designated as hedges
(2,542
)
 
(174
)
Other investing activities
(5
)
 
(827
)
Net cash and cash equivalents provided by (used in) investing activities
59,981

 
(186,731
)
Financing activities:
 

 
 

(Repayments of) borrowings under repurchase agreements, net
(95,314
)
 
144,023

Principal payments on non-recourse collateralized financing
(527
)
 
(2,024
)
Increase in restricted cash
(4,857
)
 
—

Proceeds from issuance of common stock, net of issuance costs
114

 
5,152

Payments related to tax withholding for share-based compensation
(505
)
 
(545
)
Dividends paid
(16,957
)
 
(16,960
)
Net cash and cash equivalents (used in) provided by financing activities
(118,046
)
 
129,646

 
 
 
 
Net decrease in cash and cash equivalents
(8,162
)
 
(11,680
)
Cash and cash equivalents at beginning of period
69,330

 
55,809

Cash and cash equivalents at end of period
$
61,168

 
$
44,129

Supplemental Disclosure of Cash Activity:
 

 
 

Cash paid for interest
$
4,935

 
$
10,381

See notes to unaudited consolidated financial statements.

4


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share and per share data)

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

Dynex Capital, Inc., ("Company”) was incorporated in the Commonwealth of Virginia on December 18, 1987 and commenced operations in February 1988. The Company primarily earns income from investing on a leveraged basis in mortgage-backed securities ("MBS") that are issued or guaranteed by the U.S. Government or U.S. Government sponsored agencies ("Agency MBS") and MBS issued by others ("non-Agency MBS").

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. The financial information included herein is unaudited; however, 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, 2014 are not necessarily indicative of the results that may be expected for any other interim periods or for the entire year ending December 31, 2014. The unaudited consolidated financial statements included herein should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC.

Reclassifications

Certain items in the prior periods' consolidated financial statements have been reclassified to conform to the current year’s presentation. The Company's consolidated balance sheet as of December 31, 2013 now presents its "securitized mortgage loans, net" and "other investments, net" together as "mortgage loans held for investment, net". In addition, the Company has combined the presentation of its consolidated statements of income and its consolidated statements of other comprehensive income together as one financial statement which is now titled "consolidated statements of comprehensive income". The Company's "interest income - securitized mortgage loans" and "interest income-other investments" on its consolidated statement of income for the three months ended March 31, 2013 is now presented together as "interest income-mortgage loans held for investment" on its consolidated statement of comprehensive income for the three months ended March 31, 2013. These presentation changes have no effect on reported total assets, total liabilities, results of operations, or cash flow activities.

Consolidation
 
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 810-10. The Company follows the equity method of accounting for investments in which it owns 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. The Company did not have any investments in which it owned less than a 50% interest in the voting equity as of March 31, 2014 or December 31, 2013.

In accordance with ASC Topic 810-10, the Company also consolidates certain trusts through which it has securitized mortgage loans held for investment. Additional information regarding the accounting policy for its securitized mortgage loans is provided below under "Mortgage Loans Held for Investment, Net".

5



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, 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.

Mortgage-Backed Securities
 
In accordance with ASC Topic 320, the Company has designated the majority of its investments in MBS as available-for-sale ("AFS"), and the remainder is designated as trading. All of the Company’s MBS are recorded at their fair value on its consolidated balance sheet. Changes in fair value for the Company's AFS securities are reported in other comprehensive income ("OCI") until the security is collected, disposed of, or determined to be other than temporarily impaired. Although the Company generally intends to hold its AFS securities until maturity, it may, from time to time, sell any of these securities as part of the overall management of its business. Upon the sale of an AFS 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. Changes in the fair value of MBS designated as trading are recognized in net income within "fair value adjustments, net". Gains and losses realized upon the sale, impairment, or other disposal of a trading security are also recognized within "fair value adjustments, net".

The Company’s MBS pledged as collateral against repurchase agreements and derivative instruments are included in MBS on the consolidated balance sheets with the fair value of the MBS pledged disclosed parenthetically.

Interest Income, Premium Amortization, and Discount Accretion. Interest income on MBS is accrued based on the outstanding principal balance (or notional balance in the case of interest-only, or "IO", securities) and their contractual terms.  Premiums and discounts on Agency MBS as well as any non-Agency MBS rated AA and higher at the time of purchase are amortized into interest income over the expected life of such securities using the effective yield method and adjustments to premium amortization are made for actual prepayment activity as well as changes in projected future cash flows in accordance with ASC Topic 310-20. The Company's projections of future cash flows are based on input and analysis received from external sources and internal models, and includes assumptions about the amount and timing of credit losses, loan prepayment rates, fluctuations in interest rates, and other factors. On at least a quarterly basis, the Company reviews and makes any necessary adjustments to its cash flow projections and updates the yield recognized on these assets.

The Company has purchased non-Agency MBS rated less than 'AA' by at least one national rating agency at discounts to their par value, and management does not believe these discounts to be substantial. The Company records the discount accretion into income over the security's expected life, which reflects management's estimate of the security's projected cash flows in accordance with ASC Topic 325-40. Future changes in the timing of projected cash flows or differences arising between projected cash flows and actual cash flows received may result in a prospective change in the effective yield on those securities.

The accrual of interest on MBS is discontinued when, in the opinion of management, it is probable that all amounts contractually due will not be collected, and in certain instances, as a result of an other-than-temporary impairment analysis (see discussion below). 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

6


the affected investment or investments qualify 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.

Determination of MBS Fair Value. In accordance with ASC Topic 820, the Company determines the fair value for the majority of its MBS based upon prices obtained from third-party pricing services and broker quotes. The remainder of the Company's MBS are valued by discounting the estimated future cash flows derived from cash flow models that utilize information such as the security's coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected losses, and credit enhancements as well as certain other relevant information. The Company's application of ASC Topic 820 guidance is discussed further in Note 7.

Other-than-Temporary Impairment. The Company evaluates all MBS in its investment portfolio for other-than-temporary impairments ("OTTI") by comparing the amortized cost of each security in an unrealized loss position against the present value of expected future cash flows of the security. If there has been a significant adverse change in the cash flow expectations for a security resulting in its amortized cost becoming greater than the present value of its expected future cash flows, an other-than-temporary credit impairment has occurred. If the Company does not intend to sell and is not more likely than not required to sell the security, the credit loss is recognized in earnings and the balance of the unrealized loss is recognized in other comprehensive income (loss). If the Company intends to sell the security or will be more likely than not required to sell the security, the full unrealized loss is recognized in earnings.

In periods after the recognition of an OTTI loss for MBS, the Company accounts for the other-than-temporarily impaired MBS as if the debt security had been purchased on the measurement date of the OTTI at an amortized cost basis equal to the previous amortized cost basis less the OTTI recognized in earnings. For MBS for which OTTIs were recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected shall be accreted into interest income using the effective interest method. The Company continues to estimate the present value of cash flows expected to be collected over the life of the MBS. If upon subsequent evaluation, there is an increase in the cash flows expected to be collected or if actual cash flows are greater than cash flows previously expected, such changes will be accounted for as a prospective adjustment to the accretable yield in accordance with ASC Topic 310-30 even if the MBS would not otherwise be within the scope of that guidance. Please see Note 3 for additional information related to the Company's evaluation for OTTI.

Mortgage Loans Held for Investment, Net

Mortgage loans held for investment consist primarily of securitized mortgage loans reported at amortized cost in accordance with ASC Topic 310-10. Securitized mortgage loans are pledged to support the repayment of securitization financing bonds issued by the Company. The associated securitization financing bonds are treated as debt of the Company and are presented as a portion of "non-recourse collateralized financing" on the consolidated balance sheet. Securitized mortgage loans can only be sold subject to the lien of the respective securitization financing indenture. Less than 2% of the Company's mortgage loans held for investment are unsecuritized; these loans are also reported at amortized cost. In accordance with ASC Topic 310-10, an allowance has been established for currently existing and probable losses on all of the Company's mortgage loans held for investment.

Repurchase Agreements
 
Repurchase agreements are treated as financings 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. Most of 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.
 



7


Derivative Instruments

The Company accounts for its derivative instruments in accordance with ASC Topic 815. ASC Topic 815 requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet and to measure those instruments at fair value.

Effective June 30, 2013, the Company discontinued cash flow hedge accounting for derivative instruments which had previously been accounted for as cash flow hedges under ASC Topic 815. Activity up to and including June 30, 2013 for those agreements previously designated as cash flow hedges was recorded in accordance with cash flow hedge accounting as prescribed by ASC Topic 815, which states that the effective portion of the hedge relationship on an instrument designated as a cash flow hedge is reported in the current period's other comprehensive income while the ineffective portion is immediately reported as a component of the current period’s net income. The balance remaining in AOCI related to the de-designated cash flow hedges is amortized into the Company's net income as a portion of "interest expense" over the remaining life of the interest rate swap agreements. Subsequent to June 30, 2013, changes in the fair value of the Company's derivative instruments, plus periodic settlements, are recorded in the Company's net income as a portion of "loss on derivative instruments, net".

The Company has Eurodollar futures, which are valued based on closing exchange prices. Variation margin is exchanged daily to settle any changes in the value of the Eurodollar futures. Gains and losses associated with purchases and short sales of futures contracts are reported in "loss on derivative instruments, net" on our consolidated statement of comprehensive income.

The Company has elected to use the portfolio exception in ASC 820-10-35-18D with respect to measuring counterparty credit risk for derivative instruments. The Company manages credit risk for its derivative positions on a counterparty-by-counterparty basis (that is, on the basis of its net portfolio exposure with each counterparty), consistent with its risk management strategy for such transactions. The Company manages credit risk by considering indicators of risk such as credit ratings, and by negotiating terms in its ISDA master netting arrangements and, if applicable, any associated Credit Support Annex documentation, with each individual counterparty. Since the effective date of ASC 820, management has monitored and measured credit risk and calculated credit valuation adjustments for its derivative transactions on the basis of its relationships at the counterparty portfolio level. Management receives reports from an independent third-party valuation specialist on a monthly basis providing the credit valuation adjustments at the counterparty portfolio level for purposes of reviewing and managing its credit risk exposures. Since the portfolio exception applies only to the fair value measurement and not to financial statement presentation, the portfolio-level adjustments are then allocated in a reasonable and consistent manner each period to the individual assets or liabilities that make up the group, in accordance with other applicable accounting guidance and the Company's accounting policy elections.

Although MBS have characteristics that meet the definition of a derivative instrument, ASC 815 specifically excludes these instruments from its scope because they are accounted for as debt securities under ASC 320.

Stock-Based Compensation

Pursuant to the Company’s 2009 Stock and Incentive Plan ("SIP"), 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. The Company's restricted stock currently issued and outstanding under this plan 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 Company does not currently have any other stock-based compensation issued or outstanding other than restricted stock. Please see Note 8 for additional disclosures regarding the Company's SIP.
 
Contingencies
 
In the normal course of business, there are various lawsuits, claims, and other contingencies pending against the Company. On a quarterly basis, we evaluate whether to establish provisions for estimated losses from those matters in accordance with ASC Topic 450, which states that a liability is recognized for a contingent loss when: (a) the underlying causal event has occurred prior to the balance sheet date; (b) it is probable that a loss has been incurred; and (c) there is a reasonable basis for estimating that loss. A liability is not recognized for a contingent loss when it is only possible or remotely possible that a loss has been incurred, however, possible contingent losses shall be disclosed. If the contingent loss (or an additional loss in excess of any accrual) is at least a reasonable possibility and material, then the Company discloses a reasonable estimate of the possible loss or

8


range of loss, if such reasonable estimate can be made. If the Company cannot make a reasonable estimate of the possible material loss, or range of loss, then that fact is disclosed. Please refer to Note 9 for information on the Company's contingencies.

Recent Accounting Pronouncements

There are no recently issued accounting pronouncements which have had or are expected to have a material impact on the Company's consolidated financial statements.


NOTE 2 – NET (LOSS) INCOME PER COMMON SHARE
 
Net (loss) income per common share is presented on both a basic and diluted basis.  Because the Company's Series A Cumulative Redeemable Preferred Stock and Series B Cumulative Redeemable Preferred Stock are redeemable at the Company's option for cash only, and may convert into shares of common stock only upon a change of control of the Company, the effect of those shares is excluded from the calculation of diluted net (loss) income per common share. For the three months ended March 31, 2013, diluted net income per common share assumes the exercise of stock options outstanding during the period using the treasury stock method. The Company did not have any stock options outstanding for the three months ended March 31, 2014. Holders of unvested shares of our issued and outstanding restricted common stock are eligible to receive non-forfeitable dividends. As such, these unvested shares are considered participating securities as per ASC 260-10 and therefore are included in the computation of basic net (loss) income per share using the two-class method. Upon vesting, restrictions on transfer expire on each share of restricted stock, and each such share of restricted is converted to one equal share of common stock.

The following table presents the calculation of the numerator and denominator for both basic and diluted net (loss) income per common share for the periods indicated:
 
For the Three Months Ended
 
March 31, 2014
 
March 31, 2013
 
Net 
Income
 
Weighted-Average Common Shares
 
Net 
Income
 
Weighted-
Average
Common
Shares
Net (loss) income
$
(734
)
 
 
 
$
19,603

 
 
Preferred stock dividends
(2,294
)
 
 
 
(1,222
)
 
 
Net (loss) income to common shareholders
(3,028
)
 
54,625,601

 
18,381

 
54,300,020

Effect of dilutive stock options
—

 
—

 
—

 
754

Diluted net (loss) income to common shareholders
$
(3,028
)
 
54,625,601

 
$
18,381

 
54,300,774

Net (loss) income per common share:
 
 
 
 
 
 
 
Basic
 

 
$
(0.06
)
 
 

 
$
0.34

Diluted (1)
 

 
$
(0.06
)
 
 

 
$
0.34

(1) The Company did not have any anti-dilutive securities outstanding during the three months ended March 31, 2014 or March 31, 2013.


NOTE 3 – MORTGAGE-BACKED SECURITIES
 
The following table presents the components and weighted average coupon ("WAC") for the portion of the Company’s MBS designated as AFS as of March 31, 2014 and December 31, 2013:

9


 
March 31, 2014
 
Par
 
Net Premium (Discount)
 
Amortized Cost
 
Gross Unrealized Gain
 
Gross Unrealized Loss
 
Fair Value
 
WAC
Agency:
 
 
 
 
 
 
 
 
 
 
 
 
 
RMBS
$
2,438,133

 
$
139,899

 
$
2,578,032

 
$
6,708

 
$
(45,438
)
 
$
2,539,302

 
3.20
%
CMBS
286,931

 
19,838

 
306,769

 
11,384

 
(509
)
 
317,644

 
5.23
%
CMBS IO (1)
—

 
461,523

 
461,523

 
11,581

 
(1,859
)
 
471,245

 
0.94
%
Total Agency AFS:
2,725,064

 
621,260

 
3,346,324

 
29,673

 
(47,806
)
 
3,328,191

 


 
 
 
 
 
 
 
 
 
 
 
 
 
 
Non-Agency:
 
 
 
 
 
 
 
 
 
 
 
 
 
RMBS
15,454

 
(7
)
 
15,447

 
209

 
(86
)
 
15,570

 
4.42
%
CMBS
375,209

 
(17,819
)
 
357,390

 
19,448

 
(842
)
 
375,996

 
5.05
%
CMBS IO (1)
—

 
209,301

 
209,301

 
3,374

 
(1,148
)
 
211,527

 
0.80
%
Total non-Agency AFS:
390,663

 
191,475

 
582,138

 
23,031

 
(2,076
)
 
603,093

 


 
 
 
 
 
 
 
 
 
 
 
 
 


Total AFS securities
$
3,115,727

 
$
812,735

 
$
3,928,462

 
$
52,704

 
$
(49,882
)
 
$
3,931,284

 
 
(1)
The notional balance for Agency CMBS IO and non-Agency CMBS IO was $10,582,484 and $5,053,884, respectively, as of March 31, 2014.

 
December 31, 2013
 
Par
 
Net Premium (Discount)
 
Amortized Cost
 
Gross Unrealized Gain
 
Gross Unrealized Loss
 
Fair Value
 
WAC
Agency:
 
 
 
 
 
 
 
 
 
 
 
 
 
RMBS
$
2,591,568

 
$
154,220

 
$
2,745,788

 
$
6,104

 
$
(59,742
)
 
$
2,692,150

 
3.22
%
CMBS
273,830

 
19,061

 
292,891

 
10,793

 
(900
)
 
302,784

 
5.07
%
CMBS IO (1)
—

 
453,766

 
453,766

 
9,895

 
(3,334
)
 
460,327

 
0.83
%
Total Agency AFS:
2,865,398

 
627,047

 
3,492,445

 
26,792

 
(63,976
)
 
3,455,261

 


 
 
 
 
 
 
 
 
 
 
 
 
 
 
Non-Agency:
 
 
 
 
 
 
 
 
 
 
 
 
 
RMBS
13,845

 
(338
)
 
13,507

 
338

 
(80
)
 
13,765

 
4.61
%
CMBS
375,703

 
(18,277
)
 
357,426

 
15,366

 
(3,511
)
 
369,281

 
5.10
%
CMBS IO (1)
—

 
150,518

 
150,518

 
2,618

 
(1,999
)
 
151,137

 
0.66
%
Total non-Agency AFS:
389,548

 
131,903

 
521,451

 
18,322

 
(5,590
)
 
534,183

 


 
 
 
 
 
 
 
 
 
 
 
 
 


Total AFS securities
$
3,254,946

 
$
758,950

 
$
4,013,896

 
$
45,114

 
$
(69,566
)
 
$
3,989,444

 
 
(1)
The notional balance for the Agency CMBS IO and non-Agency CMBS IO was $10,160,502 and $4,274,957, respectively, as of December 31, 2013.

The Company has investments in additional Agency CMBS not included in the tables above that are designated as trading securities by the Company with fair values of $28,568 and $28,717 as of March 31, 2014 and December 31, 2013, respectively. Changes in the fair value of these Agency CMBS are recognized each reporting period within "fair value adjustments, net" as a component of the Company's net income. As of March 31, 2014 and December 31, 2013, the amortized cost of these Agency CMBS designated as trading securities was $26,786 and $26,920, respectively. The Company recognized a net unrealized loss for the three months ended March 31, 2014 of $(17) compared to a net unrealized loss of $(107) for the three months ended March 31, 2013, respectively, related to changes in fair value of these Agency CMBS designated as trading securities.
   

10


The following table presents certain information for those Agency MBS in an unrealized loss position as of March 31, 2014 and December 31, 2013:
 
March 31, 2014
 
December 31, 2013
 
Fair Value
 
Gross Unrealized Losses
 
# of Securities
 
Fair Value
 
Gross Unrealized Losses
 
# of Securities
Continuous unrealized loss position for less than 12 months:
 
 
 
 
 
 
 
 
 
 
 
Agency MBS
$
1,563,078

 
$
(29,207
)
 
120

 
$
1,912,937

 
$
(43,543
)
 
150
Non-Agency MBS
126,578

 
(1,990
)
 
23

 
162,558

 
(5,435
)
 
39
 
 
 
 
 
 
 
 
 
 
 
 
Continuous unrealized loss position for 12 months or longer:
 
 
 
 
 
 
 
 
 
 
 
Agency MBS
$
767,744

 
$
(18,600
)
 
80

 
$
670,402

 
$
(20,433
)
 
67
Non-Agency MBS
1,676

 
(86
)
 
5

 
6,310

 
(155
)
 
6

Because the principal and interest related to Agency MBS are guaranteed by the government-sponsored entities Fannie Mae and Freddie Mac 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. Although the unrealized losses are not credit related, the Company assesses its ability and intent to hold any 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, 2014 and December 31, 2013 were temporary.

The Company also reviews any non-Agency MBS in an unrealized loss position to evaluate whether any decline in fair value represents an OTTI. The evaluation includes a review of the credit ratings of these non-Agency 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 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 OTTI amounts as of March 31, 2014 or December 31, 2013.

NOTE 4 – REPURCHASE AGREEMENTS
    
The following tables present the components of the Company’s repurchase agreements as of March 31, 2014 and December 31, 2013 by the fair value and type of securities pledged as collateral:
 
 
March 31, 2014
Collateral Type
 
Balance
 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
Agency RMBS
 
$
2,350,781

 
0.39
%
 
2,421,202

Agency CMBS
 
265,475

 
0.37
%
 
330,182

Agency CMBS IOs
 
382,327

 
1.14
%
 
471,173

Non-Agency RMBS
 
11,905

 
1.77
%
 
14,691

Non-Agency CMBS
 
309,398

 
1.22
%
 
371,273

Non-Agency CMBS IO
 
149,105

 
1.23
%
 
187,227

Securitization financing bonds
 
16,692

 
1.52
%
 
18,607

Deferred costs
 
(139
)
 
n/a

 
n/a

 
 
$
3,485,544

 
0.59
%
 
$
3,814,355


11



 
 
December 31, 2013
Collateral Type
 
Balance
 
Weighted
Average Rate
 
Fair Value of Collateral Pledged
Agency RMBS
 
$
2,522,503

 
0.42
%
 
2,598,158

Agency CMBS
 
246,849

 
0.39
%
 
306,318

Agency CMBS IOs
 
369,948

 
1.16
%
 
449,072

Non-Agency RMBS
 
10,569

 
1.80
%
 
12,746

Non-Agency CMBS
 
303,674

 
1.27
%
 
367,859

Non-Agency CMBS IOs
 
106,803

 
1.27
%
 
136,227

Securitization financing bonds
 
20,651

 
1.59
%
 
19,686

Deferred costs
 
(243
)
 
n/a

 
n/a

 
 
$
3,580,754

 
0.61
%
 
$
3,890,066


The combined weighted average original term to maturity for the Company’s repurchase agreements decreased to 93 days as of March 31, 2014 from 114 days as of December 31, 2013. The following table provides a summary of the original maturities as of March 31, 2014 and December 31, 2013:

Original Maturity
 
March 31,
2014
 
December 31,
2013
30 days or less
 
$
369,542

 
$
206,112

31 to 60 days
 
715,516

 
492,145

61 to 90 days
 
987,579

 
665,020

91 to 120 days
 
545,628

 
783,371

121 to 190 days
 
867,418

 
1,434,349

 
 
$
3,485,683

 
$
3,580,997


As of March 31, 2014, the Company had approximately $97,517 of its shareholders' equity at risk (defined as the excess of collateral pledged over the borrowing outstanding) with Wells Fargo Bank National Association together with its affiliate Wells Fargo Securities, LLC. The borrowings outstanding with that counterparty and its affiliates as of March 31, 2014 were $348,399 with a weighted average borrowing rate of 1.27%. Of the amount outstanding with this counterparty and its affiliate, $165,693 is under a two-year repurchase facility with Wells Fargo Bank National Association. The facility provides an aggregate maximum borrowing capacity of $250,000 and matures on August 6, 2015, subject to early termination provisions contained in the master repurchase agreement. The facility is collateralized primarily by CMBS IO, and its weighted average borrowing rate as of March 31, 2014 was 1.42%. Shareholders' equity at risk did not exceed 10% for any of the Company's other counterparties.

As of March 31, 2014, the Company had repurchase agreement amounts outstanding with 21 of its 31 available counterparties. The Company's counterparties, as set forth in the master repurchase agreement with the counterparty, require the Company to comply with various customary operating and financial covenants, including, but not limited to, minimum net worth, maximum declines in net worth in a given period, and maximum leverage requirements as well as maintaining the Company's REIT status.  In addition, some of the agreements contain cross default features, whereby default under an agreement with one lender simultaneously causes default under agreements with other lenders. To the extent that the Company fails to comply with the covenants contained in these financing agreements or is otherwise found to be in default under the terms of such agreements, the counterparty has the right to accelerate amounts due under the master repurchase agreement. The Company was in compliance with all covenants as of March 31, 2014.


12


NOTE 5 – DERIVATIVES

     The Company utilizes a variety of derivative instruments to economically hedge a portion of its exposure to market risks, primarily interest rate risk. The principal instruments used to hedge these risks are interest rate swaps and Eurodollar futures. The objective of the Company's risk management strategy is to protect the Company's earnings from rising interest rates and to mitigate declines in book value resulting from fluctuations in the fair value of the Company's assets from changing interest rates. The Company seeks to limit its exposure to changes in interest rates but does not seek to eliminate this risk. Please refer to Note 1 for information related to the Company's accounting policy for its derivative instruments.
    
The table below summarizes information about the Company’s derivative instruments on its consolidated balance sheet as of the dates indicated:  
 
 
 
 
 
 
March 31, 2014
 
December 31, 2013
Type of Derivative Instrument
 
Accounting Designation
 
Balance Sheet Location:
 
Fair Value
 
Aggregate Notional Amount
 
Fair Value
 
Aggregate Notional Amount
Interest rate swaps
 
Non-hedging
 
Derivative assets
 
$
12,064

 
$
525,000

 
$
18,488

 
$
575,000

 
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
 
Non-hedging
 
 
 
$
(1,378
)
 
$
325,000

 
$
(1,336
)
 
$
215,000

Eurodollar futures
 
Non-hedging
 
 
 
(9,759
)
 
9,000,000

 
(5,345
)
 
9,000,000

 
 
 
 
Derivative liabilities
 
$
(11,137
)
 
$
9,325,000

 
$
(6,681
)
 
$
9,215,000


The following table summarizes activity related to derivative instruments for the periods indicated:
(amounts in thousands)
Interest Rate Swaps
 
Eurodollar Futures
Notional amount as of December 31, 2013
$
790,000

 
$
9,000,000

Additions
75,000

 
—

Settlements, terminations, or expirations
(15,000
)
 
—

Notional amount as of March 31, 2014(1)
$
850,000

 
$
9,000,000

(1)
The Eurodollar futures notional amount as of March 31, 2014 represents the total notional of the 3-month contracts with expiration dates from 2016 to 2020. The maximum notional outstanding for any future 3-month period does not exceed $1,175,000.

The following table summarizes the contractual maturities remaining for the Company’s outstanding interest rate swap agreements as of March 31, 2014:
Remaining
Maturity
 
Notional Amount
 
Weighted-Average
Fixed Rate Swapped
37-48 months
 
185,000

 
0.92
%
49-60 months
 
350,000

 
1.62
%
61-72 months
 
35,000

 
1.24
%
73-84 months
 
100,000

 
2.08
%
85-108 months
 
—

 
—
%
109-127 months
 
180,000

 
2.13
%
 
 
$
850,000

 
1.61
%

The tables below summarize the effect of the Company's interest rate derivatives reported in "loss on derivative instruments, net" within the Company's net income for the periods indicated:

13


 
 
Three Months Ended
 
 
March 31,
Type of Derivative Instrument
 
2014
 
2013
Interest rate swaps
 
$
(9,008
)
 
$
(17
)
Eurodollar futures
 
(4,414
)
 
—

Loss on derivative instruments, net
 
$
(13,422
)
 
$
(17
)

Effective June 30, 2013, the Company de-designated certain interest rate swap agreements as cash flow hedges under ASC Topic 815. The net unrealized loss in AOCI of $7,077 remaining on the Company's consolidated balance sheet as of March 31, 2014 is related to these interest rate swap agreements. The amount remaining in AOCI will be recognized in the Company's net income as a portion of "interest expense" over the remaining contractual life of the agreements. All forecasted transactions associated with interest rate swap agreements previously designated as cash flow hedges are expected to occur. No amounts have been reclassified to net income in any period in connection with forecasted transactions that are no longer considered probable of occurring. The Company estimates the portion of existing net unrealized loss on discontinued cash flow hedges expected to be reclassified to net income within the next 12 months is $5,525. The Company reclassified $2,288 from AOCI to net income for the three months ended March 31, 2014 related to amortization of the net unrealized loss remaining in AOCI at the time the Company discontinued its cash flow hedge accounting. For the three months ended March 31, 2013, the Company reclassified $4,103 from AOCI to net income related to recognition of interest expense from cash flow hedging transactions.
  
Many of the Company's interest rate swaps were entered into under bilateral agreements which 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 yet been accelerated by the lender, or is declared in default of any of its covenants with any counterparty, then the Company could also be declared in default under the bilateral agreement. Additionally, these agreements allow those counterparties to require settlement of its outstanding derivative transactions if the Company fails to earn GAAP net income excluding derivative gains and losses 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. The Company was in compliance with all covenants under bilateral agreements on March 31, 2014.

NOTE 6 – OFFSETTING ASSETS AND LIABILITIES

The Company's derivatives and repurchase agreements are subject to underlying agreements with master netting or similar arrangements, which provide for the right of offset in the event of default or in the event of bankruptcy of either party to the transactions. The Company reports its assets and liabilities subject to these arrangements on a gross basis. The following tables present information regarding those assets and liabilities subject to such arrangements as if the Company had presented them on a net basis as of March 31, 2014 and December 31, 2013:
 
Offsetting of Assets
 
Gross Amount of Recognized Assets
 
Gross Amount Offset in the Balance Sheet
 
Net Amount of Assets Presented in the Balance Sheet
 
Gross Amount Not Offset in the Balance Sheet
 
Net Amount
Financial Instruments Received as Collateral
 
Cash Received as Collateral
March 31, 2014
 
 
 
 
 
 
 
 
 
 
 
Derivative assets
$
12,064

 
$
—

 
$
12,064

 
$
(395
)
 
$
(7,954
)
 
$
3,715

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2013:
 
 
 
 


 
 
 
 
 


Derivative assets
$
18,488

 
$
—

 
$
18,488

 
$
(193
)
 
$
(12,141
)
 
$
6,154



14


 
Offsetting of Liabilities
 
Gross Amount of Recognized Liabilities
 
Gross Amount Offset in the Balance Sheet
 
Net Amount of Liabilities Presented in the Balance Sheet
 
Gross Amount Not Offset in the Balance Sheet
 
Net Amount
Financial Instruments Posted as Collateral
 
Cash Posted as Collateral
March 31, 2014
 
 
 
 
 
 
 
 
 
 
 
Derivative liabilities
$
11,137

 
$
—

 
$
11,137

 
$
(1,340
)
 
$
(9,797
)
 
$
—

Repurchase agreements
3,485,544

 
—

 
3,485,544

 
(3,485,544
)
 
—

 
—

 
$
3,496,681

 
$
—

 
$
3,496,681

 
$
(3,486,884
)
 
$
(9,797
)
 
$
—

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2013:
 
 
 
 
 
 
 
 
 
 
 
Derivative liabilities
$
6,681

 
$
—

 
$
6,681

 
$
(1,299
)
 
$
(5,382
)
 
$
—

Repurchase agreements
3,580,754

 
—

 
3,580,754

 
(3,580,754
)
 
—

 
—

 
$
3,587,435

 
$
—

 
$
3,587,435

 
$
(3,582,053
)
 
$
(5,382
)
 
$
—

(1)
Amount disclosed for collateral received by or posted to the same counterparty include cash and the fair value of MBS up to and not exceeding the net amount of the asset or liability presented in the balance sheet. The fair value of the actual collateral received by or posted to the same counterparty may exceed the amounts presented.

NOTE 7 – FAIR VALUE OF FINANCIAL INSTRUMENTS
 
ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and also requires an entity to consider all aspects of nonperformance risk, including the entity's own credit standing, when measuring fair value of a liability. ASC Topic 820 established a valuation hierarchy of three levels as follows:
 
•
Level 1 – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities as of the measurement date. The fair value measurement of the Company's Eurodollar futures contracts are included in this category.
•
Level 2 – Inputs include quoted prices in active markets for similar assets or liabilities; quoted prices in inactive markets for identical or similar assets or liabilities; or inputs either directly observable or indirectly observable through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.  The Company’s assets and liabilities measured at fair value that are generally included in this category are Agency MBS, certain non-Agency MBS, and interest rate swaps.
•
Level 3 – Unobservable inputs are supported by little or no market activity. The unobservable inputs represent management’s best estimate of how market participants would price 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.  The Company’s assets and liabilities measured at fair value that are generally included in this category are certain non-Agency MBS.
The following table presents the fair value of the Company’s assets and liabilities presented on its consolidated balance sheets, segregated by the hierarchy level of the fair value estimate, that are measured at fair value on a recurring basis as of the dates indicated:

15


 
March 31, 2014
 
Fair Value
 
Level 1 - Unadjusted Quoted Prices in Active Markets
 
Level 2 - Observable Inputs
 
Level 3 - Unobservable Inputs
Assets:
 
 
 
 
 
 
 
Mortgage-backed securities
$
3,959,852

 
$
—

 
$
3,893,465

 
$
66,387

Derivative assets
12,064

 
—

 
12,064

 
—

Total assets carried at fair value
$
3,971,916

 
$
—

 
$
3,905,529

 
$
66,387

Liabilities:
 

 
 

 
 

 
 

Derivative liabilities
$
11,137

 
$
9,759

 
$
1,378

 
$
—

Total liabilities carried at fair value
$
11,137

 
$
9,759

 
$
1,378

 
$
—


 
December 31, 2013
 
Fair Value
 
Level 1 - Unadjusted Quoted Prices in Active Markets
 
Level 2 - Observable Inputs
 
Level 3 - Unobservable Inputs
Assets:
 
 
 
 
 
 
 
Mortgage-backed securities
$
4,018,161

 
$
—

 
$
3,944,681

 
$
73,480

Derivative assets
18,488

 
—

 
18,488

 
—

Total assets carried at fair value
$
4,036,649

 
$
—

 
$
3,963,169

 
$
73,480

Liabilities:
 

 
 

 
 

 
 

Derivative liabilities
$
6,681

 
$
5,345

 
$
1,336

 
$
—

Total liabilities carried at fair value
$
6,681

 
$
5,345

 
$
1,336

 
$
—


The Company did not have assets or liabilities measured at fair value on a non-recurring basis as of March 31, 2014 or December 31, 2013.

The Company’s valuation of its interest rate swaps is determined using the income approach. Derivative assets and liabilities include interest rate swaps and Eurodollar futures. The primary input into the valuation of interest rate swaps is the forward interest rate swap curve, which is considered an observable input and thus their fair values are considered Level 2 measurements. The Company's valuation of its Eurodollar futures is based on the closing exchange prices. Accordingly, these financial futures are classified as Level 1.

The Company’s Agency MBS, as well a majority of its non-Agency MBS, 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 MBS are comprised of securities for which there are not substantially similar securities that trade frequently, and their fair values are therefore considered Level 3 measurements. The Company determines the fair value of its Level 3 securities by discounting the estimated future cash flows derived from cash flow 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, and credit enhancement as well as certain other relevant information. Significant changes in any of these inputs in isolation would

16


result in a significantly different fair value measurement. Generally Level 3 assets are most sensitive to the default rate and severity assumptions.

The table below presents information about the significant unobservable inputs used in the fair value measurement for the Company's Level 3 non-Agency CMBS and RMBS as of March 31, 2014:
 
Quantitative Information about Level 3 Fair Value Measurements (1)
 
Prepayment Speed
 
Default Rate
 
Severity
 
Discount Rate
Non-Agency CMBS
20 CPY
 
2.5
%
 
35.0
%
 
8.8
%
Non-Agency RMBS
10 CPR
 
1.0
%
 
20.0
%
 
6.8
%
(1)
Data presented are weighted averages.

The following table presents the activity of the instruments fair valued at Level 3 during the three months ended March 31, 2014:
 
Three Months
 
March 31, 2014
 
Level 3 Fair Values
 
Non-Agency CMBS
 
Non-Agency RMBS
 
Total assets
Balance as of December 31, 2013
$
70,733

 
$
2,747

 
$
73,480

Change in fair value included in OCI
27

 
(126
)
 
(99
)
Principal payments
(6,993
)
 
(395
)
 
(7,388
)
Accretion
65

 
329

 
394

Balance as of March 31, 2014
$
63,832

 
$
2,555

 
$
66,387


The following table presents a summary of the recorded basis and estimated fair values of the Company’s financial instruments as of the dates indicated:
 
March 31, 2014
 
December 31, 2013
 
Recorded Basis
 
Fair Value
 
Recorded Basis
 
Fair Value
Assets:
 
 
 
 
 
 
 
Mortgage-backed securities
$
3,959,852

 
$
3,959,852

 
$
4,018,161

 
$
4,018,161

Mortgage loans held for investment, net (1)
53,804

 
45,188

 
55,423

 
46,383

Derivative assets
12,064

 
12,064

 
18,488

 
18,488

Liabilities:
 

 
 

 
 

 
 

Repurchase agreements (2)
$
3,485,544

 
$
3,485,683

 
$
3,580,754

 
$
3,580,997

Non-recourse collateralized financing (1)
12,394

 
11,915

 
12,914

 
12,414

Derivative liabilities
11,137

 
11,137

 
6,681

 
6,681

(1) The Company determines the fair value of its mortgage loans held for investment, net and its non-recourse collateralized financing using internally developed cash flow models with inputs similar to those used to estimate fair value of the Company's Level 3 non-Agency MBS.
(2) The difference between the recorded basis of repurchase agreements and their fair value is the deferred cost of the 2-year repurchase facility.


17


NOTE 8 – SHAREHOLDERS' EQUITY

Preferred Stock

The Company has 2,300,000 shares of its 8.50% Series A Cumulative Redeemable Preferred Stock and 2,250,000 shares of its 7.625% Series B Cumulative Redeemable Preferred Stock issued and outstanding as of March 31, 2014 (collectively, the "Preferred Stock"). The Preferred Stock has no maturity and will remain outstanding indefinitely unless redeemed or otherwise repurchased or converted into common stock pursuant to the terms of the Preferred Stock. Except under certain limited circumstances intended to preserve the Company's REIT status, upon the occurrence of a change in control as defined in Article IIIA, Section 7(d) of the Company’s Articles of Incorporation, or to avoid the direct or indirect imposition of a penalty tax in respect of, or to protect the tax status of, any of the Company’s real estate mortgage investment conduits (“REMIC”) interests or a REMIC in which the Company may acquire an interest (as permitted by the Company’s Articles of Incorporation), the Company may not redeem the Series A Preferred Stock prior to July 31, 2017 or the Series B Preferred Stock prior to April 30, 2018. On or after these dates, at any time and from time to time, the Preferred Stock may be redeemed in whole, or in part, at the Company's option at a cash redemption price of $25.00 per share plus any accumulated and unpaid dividends. The Series A Preferred Stock pays a cumulative cash dividend equivalent to 8.50% of the $25.00 liquidation preference per share each year and the Series B Preferred Stock pays a cumulative cash dividend equivalent to 7.625% of the $25.00 liquidation preference per share each year. Because the Preferred Stock is redeemable only at the option of the issuer, it is classified as equity on the Company's consolidated balance sheet.
    
Common Stock

The following table presents a summary of the changes in the number of common shares outstanding for the periods presented:
 
Three Months Ended
 
March 31,
 
2014
 
2013
Balance as of beginning of period
54,310,484

 
54,268,915

Common stock issued under DRIP
3,938

 
298,304

Common stock issued under ATM program
—

 
180,986

Common stock issued or redeemed under stock and incentive plans
442,035

 
139,600

Common stock forfeited for tax withholding on share-based compensation
(59,150
)
 
(52,385
)
Balance as of end of period
54,697,307

 
54,835,420


The Company had approximately 7,416,520 shares of common stock that remain available to offer and sell through its sales agent, JMP Securities LLC, under its "at the market", or "ATM" program, as of March 31, 2014.

The Company's Dividend Reinvestment and Share Purchase Plan ("DRIP") allows registered shareholders to automatically reinvest some or all of their quarterly common stock dividends in shares of the Company’s common stock and provides an opportunity for investors to purchase shares of the Company’s common stock, potentially at a discount to the prevailing market price. Of the 3,000,000 shares reserved for issuance under the Company's DRIP, there were 2,462,960 shares remaining for issuance as of March 31, 2014. The Company declared a first quarter common stock dividend of $0.25 per share payable on April 30, 2014 to shareholders of record as of April 4, 2014. There was no discount for shares purchased through the DRIP during the first quarter of 2014.

Of the $50,000 authorized by the Company's Board of Directors for the repurchase of its common stock through December 31, 2014, approximately $42,145 remains available for repurchase at the Company's option as of March 31, 2014.

2009 Stock and Incentive Plan. Of the 2,500,000 shares of common stock authorized for issuance under its 2009 Stock and Incentive Plan, the Company had 1,108,083 available for issuance as of March 31, 2014. Total stock-based compensation

18


expense recognized by the Company for the three months ended March 31, 2014 was $672 compared to $489 for the three months ended March 31, 2013.
  
The following table presents a rollforward of the restricted stock activity for the periods indicated:
 
Three Months Ended
 
March 31,
 
2014
 
2013
Restricted stock outstanding as of beginning of period
520,969

 
448,283

Restricted stock granted
428,363

 
139,600

Restricted stock vested
(188,620
)
 
(153,720
)
Restricted stock outstanding as of end of period
760,712

 
434,163


 The restricted stock granted during the three months ended March 31, 2014 and March 31, 2013 had combined fair values of $3,453 and $1,491, respectively, at their grant dates. As of March 31, 2014, the balance of the Company’s outstanding restricted stock remaining to be amortized into compensation expense is $6,092 of which $1,902 is expected to be amortized in the remaining nine months of 2014, $2,161 in 2015, $1,452 in 2016, $541 in 2017, and $36 in 2018. The Company did not have any other type of stock-based compensation issued or outstanding as of March 31, 2014 or December 31, 2013 other than its restricted stock.


NOTE 9 – COMMITMENTS AND CONTINGENCIES
 
The Company and its subsidiaries are parties to various legal proceedings. Although the ultimate outcome of those 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 will not have a material effect on the Company’s consolidated financial condition or liquidity. However, the resolution of any of those proceedings could have a material impact on consolidated results of operations or cash flows in a given future reporting period as the proceedings are resolved. Please refer to Note 1 for information on the Company's accounting policy with respect to accrual for loss contingencies. There have been no material changes during the three months ended March 31, 2014 for the legal proceedings discussed in our Annual Report on Form 10-K for the year ended December 31, 2013.

NOTE 10 – 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 has determined that there have been no significant events or circumstances that qualify as a "recognized" or "nonrecognized" subsequent event as defined by ASC Topic 855.

19


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our unaudited financial statements and the accompanying notes included in Item 1. “Financial Statements” in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2013. 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 mortgage real estate investment trust, or mortgage REIT, which invests in mortgage assets on a leveraged basis. Our common stock is traded on the New York Stock Exchange ("NYSE") under the symbol "DX". We also have two series of Preferred Stock outstanding, our 8.50% Series A Cumulative Redeemable Preferred Stock (the "Series A Preferred Stock") which is traded on the NYSE under the symbol "DXPRA", and our 7.625% Series B Cumulative Redeemable Preferred Stock (the "Series B Preferred Stock") which is traded on the NYSE under the symbol "DXPRB". 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 investing in Agency and non-Agency mortgage-backed securities (“MBS”), and we are no longer originating or securitizing mortgage loans. MBS consist of residential MBS (“RMBS”) and commercial MBS (“CMBS”), including CMBS interest-only ("IO") securities. Agency MBS have a guaranty of principal payment by an agency of the U.S. government or a U.S. government-sponsored entity ("GSE") such as Fannie Mae and Freddie Mac. Non-Agency MBS have no such guaranty of payment.

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. We invest our capital pursuant to our Operating Policies as approved by our Board of Directors which include an Investment Policy and Investment Risk Policy as discussed in Part I, Item 1, "Business" under "Company Overview-Operating Policies and Restrictions" in our annual Report on Form 10-K for the year ended December 31, 2013. Our investment policy permits investments in any type of Agency MBS and investment grade non-Agency MBS, legacy securitized mortgage loans, and legacy whole loans.

Since 2008 we have invested primarily in higher credit quality and shorter duration investments. When we have purchased longer duration investments, we have generally reduced the duration risk on these investments through our hedging strategy as discussed further below.

RMBS. Our Agency RMBS investments include MBS collateralized by adjustable-rate mortgage loans ("ARMS"), which have interest rates that generally will adjust at least annually to an increment over a specified interest rate index, and hybrid adjustable-rate mortgage loans ("hybrid ARMs"), which are loans that have a fixed rate of interest for a specified period (typically three to ten years) and then adjust their interest rate at least annually to an increment over a specified interest rate index as further discussed below. Agency ARMs also include hybrid Agency ARMs that are past their fixed-rate periods or within twelve months of their initial reset period. We may also invest in fixed-rate Agency RMBS from time to time. Additionally, we invest in non-Agency RMBS which generally resemble similar types of Agency ARMs, but lack a guaranty of principal payment by an agency of the U.S. government or a U.S. government-sponsored entity.

20



Interest rates on loans collateralizing Agency and non-Agency ARMs are based on specific index rates, such as the London Interbank Offered Rate, or LIBOR, the one-year constant maturity treasury rate, or CMT, 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.

CMBS. Our Agency and non-Agency CMBS are collateralized by first mortgage loans and are substantially comprised of fixed-rate securities. The majority of the loans collateralizing our CMBS are secured by multifamily properties. Typically these loans have some form of prepayment protection provisions (such as prepayment lock-out) or prepayment compensation provisions (such as yield maintenance or prepayment penalty). Yield maintenance and prepayment penalty requirements are intended to create an economic disincentive for the loans to prepay.

CMBS IO. A portion of our Agency and non-Agency CMBS also include IO securities which represent the right to receive excess interest payments (but not principal cash flows) based on the underlying unpaid principal balance of the underlying pool of mortgage loans. As these securities have no principal associated with them, the interest payments received are based on the unpaid principal balance (often referred to as the notional amount) of the underlying pool of mortgage loans. CMBS IO securities generally have some level of prepayment protection in the form of lock-outs, prepayment penalties, or yield maintenance associated with the underlying loans similar to CMBS described above.


Factors that Affect Our Results of Operations and Financial Condition

The performance of our investment portfolio, including the amount of net interest income we earn and fluctuations in investment values, will depend on multiple factors, many of which are beyond our control. These factors include, but are not limited to, the absolute level of interest rates, trends of interest rates, the relative 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 (including multifamily, residential and commercial mortgage markets), and market required yields as reflected by market credit spreads. In addition, the performance of our investment portfolio, the cost and availability of financing and the availability of investments at acceptable return levels could be influenced by actions and policy measures of the U.S. government including the Federal Housing Finance Administration, the U. S. Department of the Treasury (the "Treasury"), and the Board of Governors of the Federal Reserve System (the "Federal Reserve").

Our business model may also be impacted by other factors such as the availability and cost of financing and the state of the overall credit markets. 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, potentially at losses or at amounts below their true fair value. Other factors also impacting our business include changes in regulatory requirements, including requirements to qualify for registration under the Investment Company Act of 1940 and REIT requirements.

Investing in mortgage-related securities while using leverage to increase our return on shareholders' capital subjects us to a number of risks including interest rate risk, prepayment and reinvestment risk, credit risk, market value risk and liquidity risk, which are discussed in "Liquidity and Capital Resources" within this Item 2 and Part I, Item 3 of this Quarterly Report on Form 10-Q as well as in Item 1A, "Risk Factors" of Part I, and in Item 7A, "Quantitative and Qualitative Disclosures about Market Risk" of Part II of our Annual Report on Form 10-K for the year ended December 31, 2013. Please see these Items for a detailed discussion of these risks and the potential impact on our results of operations and financial condition.


Non-GAAP Financial Measures

In addition to our operating results presented in accordance with GAAP, this Quarterly Report on Form 10-Q contains certain non-GAAP financial measures. The following descriptions are for the non-GAAP measures contained herein which management has included because we believe these measures may be important to investors and present useful information about the Company's performance:


21


•Core net operating income to common shareholders equals GAAP net income to common shareholders adjusted for amortization of accumulated other comprehensive loss on de-designated cash flow hedges included in GAAP interest expense, net change in fair value of derivative instruments which includes gains and losses on terminated derivative instruments (if applicable), gains and losses on sales of investments, and fair value adjustments on investments not classified as available for sale.
•Effective borrowing costs equals GAAP interest expense excluding the amortization of accumulated other comprehensive loss on interest rate swaps de-designated as cash flow hedges on June 30, 2013 plus net periodic interest costs on derivative instruments (including accrued amounts) which are not already included in GAAP interest expense.
•Adjusted net interest income equals GAAP net interest income less effective borrowing costs.
•Adjusted net interest spread equals average annualized yields on investments less effective borrowing costs.

Schedules reconciling these non-GAAP financial measures to GAAP financial measures are provided in "Results of Operations" within Part 1, Item 2 of this Quarterly Report on Form 10-Q. Management believes these non-GAAP financial measures are useful because they provide investors greater transparency to the information we use in our financial and operational decision-making processes. Management also believes the presentation of these measures, when analyzed in conjunction with the our GAAP operating results, allows investors to more effectively evaluate and compare our performance to that of our peers, particularly those competitors that continue to use cash flow hedge accounting in reporting their financial results, as well as to our performance in periods prior to discontinuing cash flow hedge accounting. However, because these non-GAAP financial measures exclude certain items used to compute GAAP net (loss) income to common shareholders and GAAP interest expense, these non-GAAP measures should be considered as a supplement to, and not as a substitute for, our GAAP results as reported in our consolidated statements of comprehensive income. In addition, because not all companies use identical calculations, our presentation of core net operating income, effective borrowing costs, adjusted net interest income, and adjusted net interest spread may not be comparable to other similarly-titled measures of other companies.


Highlights of the First Quarter of 2014

During the first quarter of 2014, credit spreads tightened across fixed income markets and the U.S Treasury curve flattened as markets seemed to adjust to Janet Yellen as the new Chair of the Federal Reserve and as a result of somewhat tepid economic data. The combination of tighter credit spreads and lower rates helped increase our book value per common share by $0.18, or slightly more than 2%, to $8.87 from $8.69. We also earned $0.25 per common share on a core net operating income basis (a non-GAAP measure) versus $0.29 per common share in the fourth quarter of 2013, as general and administrative expenses in the fourth quarter reflected the reversal of $1.4 million in incentive compensation accruals. We declared a dividend of $0.25, slightly lower than our fourth quarter dividend of $0.27. In addition, we continued to reduce the overall leverage on our balance sheet as we maintained a cautious stance with respect to reinvestments of principal and interest received on our portfolio.

Our adjusted net interest spread (a non-GAAP measure) increased 0.11% for the first quarter of 2014 compared to fourth quarter of 2013. This increase in adjusted net interest spread resulted from a 0.02% increase in average annualized effective yields on our assets as well as a 0.09% decline in the effective borrowing rate (a non-GAAP measure) of financing our assets. We continue to maintain a modeled duration gap (a measure of the sensitivity of our investments and derivative instruments to changes in interest rates) at the higher end of our 0.5-1.5 years targeted range. Our duration gap exposure is generally in the one-to-three year maturities, which are generally more sensitive to actual or expected changes in the targeted federal funds rate.

The following table summarizes the average annualized effective yield by type of MBS investment for the first quarter of 2014 and for each of the preceding four quarters:

22


 
Three Months Ended
 
March 31, 2014
 
December 31, 2013
 
September 30, 2013
 
June 30, 2013
 
March 31, 2013
Average annualized effective yield:
 
 
 
 
 
 
 
 
 
RMBS
1.87%
 
1.85%
 
1.99%
 
1.91%
 
2.05%
CMBS
4.61%
 
4.65%
 
4.78%
 
4.75%
 
4.73%
CMBS IO
4.21%
 
4.47%
 
4.41%
 
4.53%
 
4.61%
All other investments
5.17%
 
5.26%
 
5.36%
 
5.44%
 
5.36%
Total average annualized effective yield
2.74%
 
2.72%
 
2.82%
 
2.86%
 
3.04%
Costs of financing
(0.87)%
 
(0.90)%
 
(0.88)%
 
(1.11)%
 
(1.15)%
Net interest spread
1.87%
 
1.82%
 
1.94%
 
1.75%
 
1.89%
 
 
 
 
 
 
 
 
 
 
Effective borrowing cost (1)
(0.86)%
 
(0.95)%
 
(1.17)%
 
(1.14)%
 
(1.17)%
Adjusted net interest spread (1)
1.88%
 
1.77%
 
1.65%
 
1.72%
 
1.87%
(1) Represents a non-GAAP financial measure. Please refer to the discussion above regarding the use of non-GAAP financial measures and to the corresponding reconciliations of GAAP to non-GAAP financial measures provided in "Results of Operations" within this Item 2.


Trends and Recent Market Impacts

There are certain conditions and prospective trends in the marketplace that have impacted our current financial condition and results of operations and which may continue to impact us in the future. The following provides a discussion of conditions and trends that had significant developments during the first quarter of 2014 or are new conditions and trends that are important to our financial condition and results of operations.

Federal Reserve Monetary Policy

The Federal Open Market Committee ("FOMC") continues its purchase of U.S. Treasury and fixed-rate Agency MBS under its asset purchase program known as "QE3". The FOMC beginning in May 2014 will be purchasing $45 billion per month in securities down from a high of $85 billion per month in 2013. The FOMC has reduced its targeted purchases of Treasury and Agency MBS by $10 billion per month as announced at its regularly scheduled meetings. The FOMC has indicated that improvements in the underlying strength of the broader economy as evidenced by continued improvement in economic activity and labor market conditions support the reduction in the purchases of securities despite the negative impact on growth from adverse winter weather conditions in the first quarter of 2014. In its March 2014 meeting, the FOMC shifted its guidance on the future path of interest rate policy. Previously, the FOMC had set targets for inflation and unemployment that were intended to communicate to the markets the economic conditions in which the FOMC may change its policy with respect to the federal funds target rate. The Committee revised its guidance at its March 2014 meeting, removing the targeted inflation and unemployment rate. The FOMC further noted that it will continue to monitor income information on economic and financial developments and will continue its purchases of Treasury securities and Agency MBS, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. In its latest statement, the FOMC reiterated its commitment to maintaining a highly accommodative stance of monetary policy for a considerable time after the asset purchase program ends. In determining how long to maintain the current 0% to 0.25% target range for the federal funds rate, the FOMC noted that it will assess progress--both realized and expected--toward its objectives of maximum employment and 2% inflation. It was noted that this assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The FOMC noted that when it decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2%. Market participants are currently forecasting an end to asset purchases by the FOMC in 2014 and the highest probability of an increase in the targeted federal funds rate sometime in the second quarter of 2015.



23


Asset Credit Spreads and Competition for Assets

Asset credit spreads are defined as the difference between the yields on securities with credit risk and yields on benchmark securities, and that reflects the relative riskiness of the securities versus the benchmark. Changes in asset credit spreads result from the expansion or contraction of the perceived riskiness of an investment versus its benchmark. As noted in the table shown below, asset credit spreads widened dramatically in the second quarter of 2013, but have tightened since, in part due to Federal Reserve policy, supply considerations, and overall market liquidity. Spreads continued to tighten in the first quarter of 2014 for the same reasons and also from perceived dovish commentary from FOMC officials. The following table provides various estimated market credit spreads on categories of assets owned by the Company at the end of each of the last four quarters:
(amounts in basis points)
March 31, 2014
 
December 31, 2013
 
September 30, 2013
 
June 30, 2013
Hybrid ARM 5/1 (2.0% coupon) spread to Treasuries
 
21

 
 
 
30

 
 
 
40

 
 
 
45

 
Hybrid ARM 10/1 (2.5% coupon) spread to Treasuries
 
57

 
 
 
76

 
 
 
80

 
 
 
75

 
Agency CMBS spread to interest rate swaps
 
50

 
 
 
58

 
 
 
72

 
 
 
92

 
'A'-rated CMBS spread to interest rate swaps
 
190

 
 
 
220

 
 
 
255

 
 
 
287

 
Agency CMBS IO spread to Treasuries
 
155

 
 
 
165

 
 
 
200

 
 
 
200

 


GSE Reform

Policy makers in Washington DC continue to debate the future of Fannie Mae and Freddie Mac's participation in the U.S. mortgage market. Several bills have been introduced in the U.S. Senate and the U.S. House of Representatives regarding the reform and/or dissolution of the GSEs. Any changes to the structure of the GSEs, or the revocations of their charters, if enacted, may have broad adverse implications for the MBS market and our business, results of 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. While we expect GSE reform to be a multi-year process, it is possible that new types of Agency MBS could be proposed and sold by Fannie Mae and Freddie Mac in the near term that are structured differently from current Agency MBS. This may have the effect of reducing the amount of available investment opportunities for the Company. For further discussion of the uncertainties and risks related to GSE reform, please refer to "Risk Factors" contained within Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2013.

Regulatory Uncertainty and Reform

Certain rules recently adopted or proposed by regulators of financial institutions require such financial institutions to maintain minimum amounts of capital relative to their assets. Final rules were adopted on May 1, 2014 by the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency to strengthen the leverage ratio standards for the largest, most systemically significant U.S. banking organizations defined as bank holding companies with more than $700 billion in consolidated total assets or $10 trillion in assets under custody. Under the proposal, these entities would be required to maintain a tier 1 capital leverage buffer of at least 2 percent above the minimum supplementary leverage ratio requirement of 3 percent, for a total of 5 percent. Such amount is in excess of current required capital levels for these institutions and could force reductions in overall leverage, including repurchase agreement financing, by these institutions in order to comply with the supplemental leverage ratio requirement, which could in turn limit the amount available for us to borrow or could increase our overall cost of financing. There are various other recently adopted or proposed rules that could impact all regulated financial institutions in ways that may impact our ability to access financing.

In addition, the Federal Reserve has expressed concern over the generally unregulated nature of short-term wholesale funding markets including the repurchase agreement markets. In a speech to the Federal Reserve Bank of Atlanta Financial Markets Conference on April 15, 2014, Ms. Yellen, Chair of the Federal Reserve, noted that the Federal Reserve is actively considering additional measures that could address risks in the short-term wholesale funding markets in the event of a crisis such as was experienced in 2008 and 2009. Various other suggestions have been made including imposing capital surcharges and guarantees as well as money market mutual fund reform (money market mutual funds are a large supplier of liquidity to the repurchase

24


markets). The outcome of any of these suggestions are uncertain but any capital surcharges (including to fund guarantees for certain types of financing transactions) or other reductions in repurchase agreement availability could have a material effect on the availability and cost of financing. In response to these regulatory efforts, we are maintaining a diverse counterparty funding base and also seeking to diversify our investment funding.


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 our consolidated 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. The discussion and analysis of our financial condition and results of operations also consider certain non-GAAP measures as described in "Executive Overview".
Critical accounting policies are defined as those that require management's most difficult, subjective or complex judgments, and which may result in materially different results under different assumptions and conditions. Our accounting policies that require the most significant management estimates, judgments, or assumptions, or that management believes includes the most significant uncertainties, and are considered most critical to our results of operations or financial position relate to fair value measurements, amortization of investment premiums, and other-than-temporary impairments. Our critical accounting policies are discussed in our Annual Report on Form 10-K for the year ended December 31, 2013 under “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies”. There have been no significant changes in our critical accounting policies during the three months ended March 31, 2014.


FINANCIAL CONDITION

We invest primarily in Agency and non-Agency MBS, including RMBS, CMBS and CMBS IO securities. The following tables outline our asset allocation based on fair value as of March 31, 2014 and as of the end of each of the four preceding quarters:
 
March 31, 2014
 
December 31, 2013
 
September 30, 2013
 
June 30, 2013
 
March 31, 2013
Agency MBS
83.6%
 
85.5%
 
86.3%
 
85.9%
 
84.9%
Non-Agency MBS
15.0%
 
13.1%
 
12.3%
 
12.6%
 
13.6%
Other investments
1.4%
 
1.4%
 
1.5%
 
1.5%
 
1.5%
 
 
March 31, 2014
 
December 31, 2013
 
September 30, 2013
 
June 30, 2013
 
March 31, 2013
RMBS
64.5%
 
67.3%
 
68.5%
 
67.9%
 
65.0%
CMBS
18.5%
 
17.7%
 
17.2%
 
17.4%
 
19.3%
CMBS IO
17.0%
 
15.0%
 
14.3%
 
14.7%
 
15.7%

As shown above, our asset allocation is more heavily weighted toward Agency MBS which have a guaranty of principal payment by an agency of the U.S. government or a GSE such as Fannie Mae and Freddie Mac, and therefore carry less credit risk than our non-Agency MBS which have no such guaranty of payment. The majority of our Agency MBS investments are RMBS predominantly collateralized by variable-rate mortgage loans. Agency MBS also includes CMBS IO securities rated 'AAA' which are issued by securitization trusts sponsored by Fannie Mae, Freddie Mac and Ginnie Mae. The majority of our non-Agency MBS investments are fixed-rate CMBS and CMBS IO. During the first quarter of 2014, we conservatively managed our investment portfolio and leverage and retained a portion of our portfolio paydowns; we invested the remainder of our portfolio paydowns primarily in non-Agency CMBS and CMBS IO. These investments provided more attractive risk-adjusted returns during the first quarter, and we anticipate that trend continuing into the second quarter.

25



Agency MBS

Our investments in Agency RMBS are collateralized primarily by ARMs and hybrid ARMs. Our investments in Agency CMBS and CMBS IO are collateralized by fixed rate mortgage loans which generally have some form of prepayment protection provisions (such as prepayment lock-outs) or prepayment compensation provisions (such as yield maintenance or prepayment penalties).
    
Activity related to our Agency MBS for the three months ended March 31, 2014 is as follows:
($ in thousands)
RMBS
 
CMBS
 
CMBS IO (1)
 
Total
Balance as of January 1, 2014
$
2,692,150

 
$
331,501

 
$
460,327

 
$
3,483,978

Purchases
10,247

 
16,171

 
25,389

 
51,807

Principal payments
(113,207
)
 
(1,399
)
 
—

 
(114,606
)
Sales
(56,801
)
 
—

 
(326
)
 
(57,127
)
Change in net unrealized gain
14,908

 
966

 
3,160

 
19,034

Net premium amortization
(7,995
)
 
(1,027
)
 
(17,305
)
 
(26,327
)
Balance as of March 31, 2014
$
2,539,302

 
$
346,212

 
$
471,245

 
$
3,356,759

(1) Amounts shown for CMBS IO represent premium only and exclude underlying notional values.

Our investment in Agency MBS as of March 31, 2014 has decreased slightly since December 31, 2013 as our principal payments and sales have outpaced our purchases. In recent quarters, our purchases of Agency RMBS have slowed due to a lower supply of attractive purchases at premiums acceptable to us while our purchases of Agency CMBS and CMBS IO have increased quarter over quarter due to their better absolute return and value relative to Agency RMBS in the current market environment. Unlike Agency RMBS, Agency CMBS and CMBS IO generally have prepayment protection provisions, therefore management views these MBS as having lower prepayment risk. Please refer to "Prepayment Risk" within Item 3, "Quantitative and Qualitative Disclosures About Market Risk" contained within this Quarterly Report on Form 10-Q for further discussion.

As of March 31, 2014, 75% of our Agency MBS issued securities are variable-rate MBS with the remainder fixed