10-Q 1 d311982d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 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, 2012

OR

 

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

For the transition period from              to             .

Commission file number 001-33740

 

 

 

LOGO

CYS Investments, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Maryland   20-4072657

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

Identification No.)

890 Winter Street, Suite 200

Waltham, Massachusetts

  02451
(Address of principal executive offices)   (Zip Code)

(617) 639-0440

(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  ¨

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

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

 

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

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

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

 

Class

  

Outstanding at April 17, 2012

Common Stock ($0.01 par value)    116,145,923

 

 

 


Table of Contents

 

Table of Contents

 

          Page  

PART I.

  

Financial Information

     1   

Item 1.

  

Financial Statements

     1   

Item 2.

  

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

     20   

Item 3.

  

Quantitative and Qualitative Disclosures about Market Risk

     35   

Item 4.

  

Controls and Procedures

     38   

PART II.

  

Other Information

     38   

Item 1.

  

Legal Proceedings

     38   

Item 1A.

  

Risk Factors

     38   

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

     38   

Item 3.

  

Defaults Upon Senior Securities

     38   

Item 4.

  

Mine Safety Disclosures.

     39   

Item 5.

  

Other Information

     39   

Item 6.

  

Exhibits

     39   
  

SIGNATURES

     40   


Table of Contents

PART I. Financial Information

 

Item 1. Financial Statements

CYS INVESTMENTS, INC.

CONDENSED STATEMENTS OF ASSETS AND LIABILITIES (UNAUDITED)

 

(In thousands, except per share numbers)    March 31, 2012      December 31, 2011*  

ASSETS:

     

Investments in securities, at fair value (including pledged assets of $8,806,898 and $8,412,295, respectively)

   $ 13,388,839       $ 9,466,128   

Interest rate cap contracts, at fair value

     4,548         5,966   

Cash and cash equivalents

     10,643         11,508   

Receivable for securities sold and principal repayments

     116,918         5,550   

Interest receivable

     34,152         27,815   

Other assets

     805         1,090   
  

 

 

    

 

 

 

Total assets

     13,555,905         9,518,057   
  

 

 

    

 

 

 

LIABILITIES:

     

Repurchase agreements

     8,234,669         7,880,814   

Interest rate swap contracts, at fair value

     84,941         79,476   

Payable for securities purchased

     3,634,983         463,302   

Distribution payable

     58,069         —     

Accrued interest payable (including accrued interest on repurchase agreements of $2,425 and $3,747, respectively)

     15,564         15,617   

Accrued expenses and other liabilities

     1,887         1,390   
  

 

 

    

 

 

 

Total liabilities

     12,030,113         8,440,599   
  

 

 

    

 

 

 

Contingencies (note 6)

     
  

 

 

    

 

 

 

NET ASSETS

   $ 1,525,792       $ 1,077,458   
  

 

 

    

 

 

 

Net assets consist of:

     

Common Stock, $0.01 par value, 500,000 shares authorized (116,139 and 82,753 shares issued and outstanding, respectively)

   $ 1,161       $ 828   

Additional paid in capital

     1,434,836         997,884   

Retained earnings

     89,795         78,746   
  

 

 

    

 

 

 

NET ASSETS

   $ 1,525,792       $ 1,077,458   
  

 

 

    

 

 

 

NET ASSET VALUE PER SHARE

   $ 13.14       $ 13.02   
  

 

 

    

 

 

 

 

* Derived from audited financial statements.

See notes to condensed financial statements.

 

1


Table of Contents

CYS INVESTMENTS, INC.

CONDENSED SCHEDULES OF INVESTMENTS

MARCH 31, 2012 (UNAUDITED)

INVESTMENTS IN SECURITIES – UNITED STATES OF AMERICA

 

(In thousands)    Face Amount      Fair Value  

Fixed Income Securities - 877.5%(c)

     

Mortgage Pass-Through Agency RMBS - 872.2%(c)

     

Fannie Mae Pools - 780.2%(c)

     

2.700%, due 5/1/2042(b)

   $ 35,000       $ 36,323   

2.720%, due 5/1/2042(b)

     25,000         25,859   

2.797%, due 3/1/2042(b)

     50,190         52,147   

2.799%, due 1/1/2042(b)

     48,949         50,842   

2.800%, due 5/1/2042(b)

     200,000         208,500   

2.801%, due 2/1/2042(a)(b)

     57,186         59,402   

2.817%, due 2/1/2042(b)

     30,023         31,219   

2.820%, due 5/1/2042(b)

     67,343         70,289   

2.823%, due 4/1/2042(b)

     57,851         60,273   

2.843%, due 2/1/2042(a)(b)

     38,892         40,489   

2.866%, due 1/1/2042(a)(b)

     66,708         69,494   

2.869%, due 12/1/2041(a)(b)

     62,516         65,131   

2.889%, due 2/1/2042(a)(b)

     49,178         51,147   

2.999%, due 1/1/2041(a)(b)

     38,688         40,307   

3.000%, due 2/1/2027 - 6/1/2037

     1,941,543         2,007,118   

3.015%, due 12/1/2040(a)(b)

     131,638         137,234   

3.049%, due 9/1/2041(a)(b)

     47,609         49,895   

3.050%, due 9/1/2041(a)(b)

     46,119         48,313   

3.160%, due 9/1/2041(a)(b)

     37,412         39,340   

3.171%, due 11/1/2041(a)(b)

     34,125         35,712   

3.177%, due 7/1/2041(a)(b)

     32,991         34,478   

3.179%, due 10/1/2041(a)(b)

     49,089         51,860   

3.194%, due 6/1/2041(a)(b)

     169,386         177,138   

3.228%, due 9/1/2041(a)(b)

     105,252         110,200   

3.232%, due 7/1/2040(a)(b)

     38,728         40,518   

3.240%, due 3/1/2041(a)(b)

     17,621         18,453   

3.250%, due 4/1/2041(a)(b)

     53,513         56,005   

3.251%, due 11/1/2040(a)(b)

     39,426         41,491   

3.253%, due 10/1/2041(a)(b)

     96,441         101,203   

3.258%, due 6/1/2041(a)(b)

     48,709         50,955   

3.271%, due 12/1/2040(a)(b)

     58,438         61,011   

3.285%, due 6/1/2041(a)(b)

     107,917         112,892   

3.291%, due 5/1/2041(a)(b)

     38,858         40,652   

3.292%, due 9/1/2041(a)(b)

     83,666         87,723   

3.301%, due 6/1/2041(a)(b)

     30,121         31,583   

3.303%, due 10/1/2041(a)(b)

     136,794         143,469   

3.358%, due 8/1/2041(a)(b)

     30,724         32,269   

3.368%, due 5/1/2041(a)(b)

     20,800         21,735   

3.377%, due 4/1/2041(a)(b)

     44,612         46,802   

3.389%, due 4/1/2041(a)(b)

     50,006         52,437   

3.392%, due 6/1/2041(a)(b)

     103,826         108,906   

3.500%, due 7/1/2021(a)

     256,373         269,227   

3.500%, due 12/1/2025 - 2/1/2027(a)

     2,979,306         3,127,733   

3.549%, due 8/1/2040(a)(b)

     35,894         37,753   

3.567%, due 7/1/2040(a)(b)

     15,848         16,670   

3.572%, due 8/1/2040(a)(b)

     32,957         34,679   

3.576%, due 7/1/2040(a)(b)

     11,359         11,953   

3.601%, due 6/1/2041(a)(b)

     57,892         60,967   

3.619%, due 6/1/2041(a)(b)

     59,812         62,971   

 

See notes to condensed financial statements.

 

2


Table of Contents

CYS INVESTMENTS, INC.

CONDENSED SCHEDULES OF INVESTMENTS – (Continued)

MARCH 31, 2012 (UNAUDITED)

 

     Face Amount      Fair Value  

3.659%, due 8/1/2040(a)(b)

     33,059         34,832   

3.676%, due 7/1/2040(a)(b)

     37,351         39,162   

3.702%, due 5/1/2040(a)(b)

     30,311         31,939   

3.702%, due 8/1/2040(a)(b)

     9,035         9,530   

3.813%, due 7/1/2040(a)(b)

     30,399         32,124   

3.952%, due 9/1/2039(a)(b)

     14,042         14,805   

3.960%, due 10/1/2039(a)(b)

     28,060         29,674   

4.000%, due 10/1/2024 - 6/1/2026(a)

     1,589,828         1,687,804   

4.000%, due 9/1/2030 - 12/1/2030(a)

     312,312         331,419   

4.500%, due 8/1/2024 - 3/1/2026(a)

     294,942         315,889   

4.500%, due 4/1/2030 - 11/1/2030(a)

     148,625         158,243   

5.000%, due 4/1/2041 - 5/1/2041(a)

     221,805         239,707   

5.000%, due 4/1/2042

     700,000         756,104   
  

 

 

    

 

 

 

Total Fannie Mae Pools

     11,322,098         11,903,999   
  

 

 

    

 

 

 

Freddie Mac Pools - 82.6%(c)

     

2.614%, due 3/1/2042(a)(b)

     40,055         41,508   

2.798%, due 12/1/2041(b)

     49,432         51,274   

2.977%, due 9/1/2041(a)(b)

     45,722         47,704   

3.025%, due 9/1/2041(a)(b)

     43,584         45,464   

3.137%, due 11/1/2041(a)(b)

     49,467         51,722   

3.226%, due 2/1/2041(a)(b)

     37,539         39,422   

3.242%, due 12/1/2040(a)(b)

     39,985         41,941   

3.248%, due 1/1/2041(a)(b)

     43,435         45,617   

3.267%, due 6/1/2041(b)

     40,095         41,920   

3.421%, due 9/1/2041(a)(b)

     46,876         49,369   

3.500%, due 4/1/2026 - 2/1/2027(a)

     231,789         242,354   

3.649%, due 6/1/2041(a)(b)

     44,396         46,815   

4.000%, due 10/1/2025 - 5/1/2026(a)

     153,035         161,814   

4.500%, due 7/1/2024 - 5/1/2025(a)

     115,750         123,552   

5.500%, due 8/1/2038

     210,439         229,377   
  

 

 

    

 

 

 

Total Freddie Mac Pools

     1,191,599         1,259,853   
  

 

 

    

 

 

 

Ginnie Mae Pools - 9.4%(c)

     

3.500%, due 7/20/2040(a)(b)

     119,432         126,385   

4.000%, due 1/20/2040(a)(b)

     16,251         17,206   
  

 

 

    

 

 

 

Total Ginnie Mae Pools

     135,683         143,591   
  

 

 

    

 

 

 

Total Mortgage Pass-Through Agency RMBS (Cost - $13,059,534)

     12,649,380         13,307,443   
  

 

 

    

 

 

 

U.S. Treasury Bills - 3.9%(c)

     

0.060%, due 8/2/2012(d)

     60,000         59,981   
  

 

 

    

 

 

 

Total U.S. Treasury Bills (Cost - $59,982)

     60,000         59,981   
  

 

 

    

 

 

 

Other investments (Cost - $14,261)(e) - 1.4%(c)

     27,944         21,415   
  

 

 

    

 

 

 

Total Investments in Securities (Cost - $13,133,777)

   $ 12,737,324       $ 13,388,839   
  

 

 

    

 

 

 

Interest Rate Cap Contracts - 0.3%(c)

     

 

Expiration

   Cap Rate     Notional Amount      Fair Value  

12/30/2014

     2.073   $ 200,000       $ 401   

10/15/2015

     1.428     300,000         2,376   

11/8/2015

     1.360     200,000         1,771   
    

 

 

    

 

 

 

Total Interest Rate Cap Contracts (Cost, $12,762)

  

  $ 700,000       $ 4,548   
    

 

 

    

 

 

 

Interest Rate Swap Contracts - (5.6%)(c)(f)

       

 

Expiration

   Pay Rate     Notional Amount      Fair Value  

5/26/2013

     1.600   $ 100,000       $ (1,263

6/30/2013

     1.378     300,000         (3,238

7/15/2013

     1.365     300,000         (3,281

 

See notes to condensed financial statements.

 

3


Table of Contents

CYS INVESTMENTS, INC.

CONDENSED SCHEDULES OF INVESTMENTS – (Continued)

MARCH 31, 2012 (UNAUDITED)

 

Expiration

   Pay Rate     Notional Amount      Fair Value  

12/15/2013

     1.309     400,000         (5,182

12/16/2013

     1.264     400,000         (4,876

12/16/2013

     1.281     500,000         (6,235

12/17/2013

     1.323     400,000         (5,285

7/1/2014

     1.720     100,000         (2,468

7/16/2014

     1.733     250,000         (6,340

8/16/2014

     1.353     200,000         (3,396

9/23/2014

     1.312     500,000         (8,086

10/6/2014

     1.173     240,000         (3,069

2/14/2015

     2.145     500,000         (20,194

6/2/2016

     1.940     300,000         (11,021

(g)12/19/2016

     1.426     250,000         (1,007
    

 

 

    

 

 

 

Interest Rate Swap Contracts (Cost, $0)

  

  $ 4,740,000       $ (84,941
    

 

 

    

 

 

 

 

LEGEND

 

(a)

Securities or a portion of the securities are pledged as collateral for repurchase agreements or interest rate swap contracts.

(b)

The coupon rate shown on floating or adjustable rate securities represents the rate at March 31, 2012.

(c)

Percentage of net assets.

(d)

Zero coupon bond, rate shown represents purchase yield.

(e)

Comprised of investments that were individually less than 1% of net assets.

(f)

The Company’s interest rate swap contracts receive a floating rate set quarterly to three month LIBOR.

(g)

The interest rate swap effective date is December 19, 2012 and does not accrue any income or expense until that date.

See notes to condensed financial statements.

 

4


Table of Contents

CYS INVESTMENTS, INC.

CONDENSED SCHEDULES OF INVESTMENTS – (Continued)

DECEMBER 31, 2011 (UNAUDITED)*

INVESTMENTS IN SECURITIES – UNITED STATES OF AMERICA

 

(In thousands)    Face Amount      Fair Value  

Fixed Income Securities - 878.6% (c)

     

Mortgage Pass-Through Agency RMBS - 869.9% (c)

     

Fannie Mae Pools - 785.0% (c)

     

2.820%, due 3/1/2042(b)

   $ 20,000       $ 20,627   

2.840%, due 1/1/2042(b)

     36,000         37,288   

2.850%, due 1/1/2042(b)

     16,000         16,575   

2.880%, due 12/1/2041(b)

     63,081         65,342   

2.900%, due 2/1/2042(b)

     50,000         51,750   

2.940%, due 1/1/2042(b)

     15,000         15,572   

2.979%, due 10/1/2040(a)(b)

     43,981         45,730   

3.005%, due 1/1/2041(a)(b)

     40,986         42,804   

3.028%, due 12/1/2040(a)(b)

     150,737         157,242   

3.050%, due 9/1/2041(a)(b)

     48,486         50,252   

3.054%, due 9/1/2041(a)(b)

     48,199         50,255   

3.120%, due 1/1/2042(b)

     50,000         52,016   

3.168%, due 9/1/2041(a)(b)

     39,736         41,366   

3.176%, due 1/1/2042(b)

     36,000         37,530   

3.178%, due 10/1/2041(a)(b)

     50,099         52,153   

3.179%, due 7/1/2041(a)(b)

     36,737         38,265   

3.200%, due 6/1/2041(a)(b)

     180,296         187,753   

3.214%, due 11/1/2040(a)(b)

     37,557         39,183   

3.224%, due 7/1/2040(a)(b)

     41,581         43,485   

3.238%, due 9/1/2041(a)(b)

     110,829         115,419   

3.239%, due 3/1/2041(a)(b)

     17,931         18,644   

3.246%, due 4/1/2041(a)(b)

     59,124         61,544   

3.251%, due 10/1/2041(a)(b)

     101,419         105,830   

3.255%, due 11/1/2040(a)(b)

     42,699         44,561   

3.258%, due 12/1/2040(a)(b)

     62,487         65,219   

3.263%, due 6/1/2041(a)(b)

     51,090         53,186   

3.282%, due 5/1/2041(a)(b)

     41,835         43,569   

3.284%, due 9/1/2041(a)(b)

     89,046         92,760   

3.287%, due 6/1/2041(a)(b)

     115,948         120,770   

3.308%, due 6/1/2041(a)(b)

     33,112         34,480   

3.308%, due 10/1/2041(a)(b)

     145,746         151,824   

3.356%, due 8/1/2041(a)(b)

     31,291         32,620   

3.366%, due 5/1/2041(a)(b)

     22,685         23,661   

3.387%, due 4/1/2041(a)(b)

     52,425         54,583   

3.391%, due 4/1/2041(a)(b)

     46,394         48,322   

3.396%, due 6/1/2041(a)(b)

     109,987         114,549   

3.500%, due 7/1/2021 (a)

     272,115         284,948   

3.500%, due 12/1/2025 - 1/1/2027(a)

     2,337,971         2,446,851   

3.546%, due 8/1/2040(a)(b)

     37,780         39,569   

3.564%, due 7/1/2040(a)(b)

     13,746         14,405   

3.574%, due 7/1/2040(a)(b)

     16,592         17,388   

3.577%, due 8/1/2040(a)(b)

     37,002         38,791   

3.599%, due 6/1/2041(a)(b)

     64,248         67,400   

3.616%, due 6/1/2041(a)(b)

     62,636         65,703   

 

See notes to condensed financial statements.

 

5


Table of Contents

CYS INVESTMENTS, INC.

CONDENSED SCHEDULES OF INVESTMENTS – (Continued)

DECEMBER 31, 2011 (UNAUDITED)*

 

     Face Amount      Fair Value  

3.677%, due 7/1/2040(a)(b)

     39,283         41,115   

3.682%, due 8/1/2040(a)(b)

     37,852         39,770   

3.699%, due 5/1/2040(a)(b)

     31,975         33,665   

3.701%, due 8/1/2040(a)(b)

     9,420         9,902   

3.734%, due 9/1/2039(a)(b)

     25,442         26,734   

3.811%, due 7/1/2040(a)(b)

     33,941         35,739   

3.951%, due 9/1/2039(a)(b)

     14,578         15,410   

3.965%, due 10/1/2039(a)(b)

     30,165         31,831   

4.000%, due 10/1/2024 - 6/1/2026(a)

     1,689,232         1,783,467   

4.000%, due 9/1/2030 - 12/1/2030(a)

     392,940         415,235   

4.500%, due 5/1/2023 - 3/1/2026(a)

     369,311         393,873   

4.500%, due 4/1/2030 - 11/1/2030(a)

     158,827         169,867   

5.000%, due 4/1/2041 - 5/1/2041(a)

     239,747         259,123   
  

 

 

    

 

 

 

Total Fannie Mae Pools

     8,053,327         8,457,515   
  

 

 

    

 

 

 

Freddie Mac Pools - 71.2% (c)

     

2.983%, due 9/1/2041(a)(b)

     48,696         50,838   

3.025%, due 9/1/2041(a)(b)

     49,029         51,159   

3.236%, due 12/1/2040(a)(b)

     42,661         44,466   

3.240%, due 2/1/2041(a)(b)

     39,068         40,779   

3.246%, due 1/1/2041(a)(b)

     46,017         48,037   

3.272%, due 6/1/2041(a)(b)

     45,131         46,984   

3.423%, due 9/1/2041(a)(b)

     48,337         50,535   

3.500%, due 4/1/2026(a)

     180,607         188,414   

3.645%, due 6/1/2041(a)(b)

     46,075         48,390   

4.000%, due 10/1/2025(a)

     57,327         60,183   

4.500%, due 7/1/2024 - 5/1/2025(a)

     129,517         137,334   
  

 

 

    

 

 

 

Total Freddie Mac Pools

     732,465         767,119   
  

 

 

    

 

 

 

Ginnie Mae Pools - 13.7% (c)

     

3.500%, due 7/20/2040(a)(b)

     78,468         82,891   

3.500%, due 7/20/2040(a)(b)

     44,331         46,830   

4.000%, due 1/20/2040(a)(b)

     17,026         18,099   
  

 

 

    

 

 

 

Total Ginnie Mae Pools

     139,825         147,820   
  

 

 

    

 

 

 

Total Mortgage Pass-Through Agency RMBS (Cost - $9,148,730)

     8,925,617         9,372,454   
  

 

 

    

 

 

 

U.S. Treasury Bills - 7.0% (c)

     

0.060%, due 2/9/2012(d)

     75,000         74,999   
  

 

 

    

 

 

 

Total U.S. Treasury Bills (Cost - $74,995)

     75,000         74,999   
  

 

 

    

 

 

 

Other investments (Cost - $15,318)(e) - 1.7%(c)

     27,944         18,675   
  

 

 

    

 

 

 

Total Investments in Securities (Cost - $9,239,043)

   $ 9,028,561       $ 9,466,128   
  

 

 

    

 

 

 

Interest Rate Cap Contracts - 0.6%(c)

     

 

Expiration

   Cap Rate     Notional Amount      Fair Value  

12/30/2014

     2.073   $ 200,000       $ 656   

10/15/2015

     1.428     300,000         3,062   

11/8/2015

     1.360     200,000         2,248   
    

 

 

    

 

 

 

Total Interest Rate Cap Contracts (Cost, $13,722)

  

  $ 700,000       $ 5,966   
    

 

 

    

 

 

 

Interest Rate Swap Contracts - (7.4%)(c)(f)

       

 

Expiration

   Pay Rate     Notional Amount      Fair Value  

5/26/2013

     1.600   $ 100,000       $ (1,266

6/30/2013

     1.378     300,000         (3,000

 

See notes to condensed financial statements.

 

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CYS INVESTMENTS, INC.

CONDENSED SCHEDULES OF INVESTMENTS – (Continued)

DECEMBER 31, 2011 (UNAUDITED)*

 

Expiration

   Pay Rate     Notional Amount      Fair Value  

7/15/2013

     1.365     300,000         (3,034

12/15/2013

     1.309     400,000         (4,587

12/16/2013

     1.264     400,000         (4,230

12/16/2013

     1.281     500,000         (5,421

12/17/2013

     1.323     400,000         (4,695

7/1/2014

     1.720     100,000         (2,375

7/16/2014

     1.733     250,000         (6,149

8/16/2014

     1.353     200,000         (3,059

9/23/2014

     1.312     500,000         (7,115

10/6/2014

     1.173     240,000         (2,520

2/14/2015

     2.145     500,000         (20,274

6/2/2016

     1.940     300,000         (11,027

(g)12/19/2016

     1.426     250,000         (724
    

 

 

    

 

 

 

Interest Rate Swap Contracts (Cost, $0)

  

  $ 4,740,000       $ (79,476
    

 

 

    

 

 

 

 

LEGEND

 

*

Derived from audited financial statements.

(a)

Securities or a portion of the securities are pledged as collateral for repurchase agreements or interest rate swap contracts.

(b)

The coupon rate shown on floating or adjustable rate securities represents the rate at December 31, 2011.

(c)

Percentage of net assets.

(d)

Zero coupon bond, rate shown represents purchase yield.

(e)

Comprised of investments that were individually less than 1% of net assets.

(f)

The Company’s interest rate swap contracts receive a floating rate set quarterly to three month LIBOR.

(g)

The interest rate swap effective date is December 19, 2012 and does not accrue any income or expense until that date.

See notes to condensed financial statements.

 

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CYS INVESTMENTS, INC.

CONDENSED STATEMENTS OF OPERATIONS (UNAUDITED)

 

     Three Months Ended March 31,  
(In thousands, except per share numbers)    2012     2011  

INVESTMENT INCOME - Interest income

   $ 65,369      $ 40,980   
  

 

 

   

 

 

 

EXPENSES:

    

Interest

     6,853        3,104   

Management fees

     —          2,840   

Compensation and benefits

     3,164        544   

General, administrative and other

     1,955        1,034   
  

 

 

   

 

 

 

Total expenses

     11,972        7,522   
  

 

 

   

 

 

 

Net investment income

     53,397        33,458   
  

 

 

   

 

 

 

GAINS AND (LOSSES) FROM INVESTMENTS:

    

Net realized gain (loss) on investments

     5,173        5,909   

Net unrealized appreciation (depreciation) on investments

     27,977        13,911   
  

 

 

   

 

 

 

Net gain (loss) from investments

     33,150        19,820   
  

 

 

   

 

 

 

GAINS AND (LOSSES) FROM SWAP AND CAP CONTRACTS:

    

Net swap and cap interest income (expense)

     (11,506     (11,859

Net unrealized appreciation (depreciation) on swap and cap contracts

     (5,923     10,678   
  

 

 

   

 

 

 

Net gain (loss) from swap and cap contracts

     (17,429     (1,181
  

 

 

   

 

 

 

NET INCOME

   $ 69,118      $ 52,097   
  

 

 

   

 

 

 

NET INCOME PER COMMON SHARE BASIC & DILUTED

   $ 0.66      $ 0.74   
  

 

 

   

 

 

 

See notes to condensed financial statements.

 

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CYS INVESTMENTS, INC.

CONDENSED STATEMENT OF CHANGES IN NET ASSETS (UNAUDITED)

 

(In thousands)    Three Months Ended
March 31, 2012
 

Net income:

  

Net investment income

   $ 53,397   

Net realized gain (loss) on investments

     5,173   

Net unrealized appreciation (depreciation) on investments

     27,977   

Net gain (loss) on swap and cap contracts

     (17,429
  

 

 

 

Net income

     69,118   
  

 

 

 

Capital transactions:

  

Net proceeds from issuance of common shares

     436,592   

Distributions to shareholders

     (58,069

Amortization of share based compensation

     693   
  

 

 

 

Increase in net assets from capital transactions

     379,216   
  

 

 

 

Total increase in net assets

     448,334   

Net assets:

  

Beginning of period

     1,077,458   
  

 

 

 

End of period

   $ 1,525,792   
  

 

 

 

See notes to condensed financial statements.

 

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CYS INVESTMENTS, INC.

CONDENSED STATEMENTS OF CASH FLOWS (UNAUDITED)

 

     Three Months Ended March 31,  
(In thousands)    2012     2011  

CASH FLOWS FROM OPERATING ACTIVITIES:

    

Net income

   $ 69,118      $ 52,097   

Adjustments to reconcile net income to net cash used in operating activities:

    

Purchase of investment securities

     (4,764,173     (2,755,907

Proceeds from disposition of investment securities

     314,522        402,841   

Proceeds from paydowns of investment securities

     543,180        184,984   

Amortization of share based compensation

     693        544   

Amortization of premiums and discounts on investment securities

     16,910        5,804   

Amortization of premiums on interest rate cap contracts

     960        960   

Net realized (gain) loss on investments

     (5,173     (5,909

Net unrealized (appreciation) depreciation on investments

     (27,977     (13,911

Net unrealized (appreciation) depreciation on swap and cap contracts

     5,923        (10,678

Change in assets and liabilities:

    

Receivable for securities sold and principal repayments

     (111,368     (200,461

Interest receivable

     (6,337     (7,012

Other assets

     285        281   

Payable for securities purchased

     3,171,681        150,590   

Accrued interest payable

     (53     4,150   

Related party management fee payable

     —          232   

Accrued expenses and other liabilities

     497        (122
  

 

 

   

 

 

 

Net cash used in operating activities

     (791,312     (2,191,517
  

 

 

   

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

    

Proceeds from repurchase agreements

     17,917,781        7,963,285   

Repayments of repurchase agreements

     (17,563,926     (6,043,099

Net proceeds from issuance of common shares

     436,592        275,822   
  

 

 

   

 

 

 

Net cash provided by financing activities

     790,447        2,196,008   
  

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     (865     4,491   

CASH AND CASH EQUIVALENTS - Beginning of period

     11,508        1,510   
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS - End of period

   $ 10,643      $ 6,001   
  

 

 

   

 

 

 

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:

    

Interest paid

   $ 21,037      $ 11,616   
  

 

 

   

 

 

 

SUPPLEMENTAL DISCLOSURES OF NONCASH FLOW INFORMATION:

    

Distributions declared, not yet paid

   $ 58,069      $ 49,536   
  

 

 

   

 

 

 

See notes to condensed financial statements.

 

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CYS INVESTMENTS, INC.

CONDENSED NOTES TO FINANCIAL STATEMENTS (UNAUDITED)

1. ORGANIZATION

CYS Investments, Inc. (the “Company”) was formed as a Maryland corporation on January 3, 2006, and commenced operations on February 10, 2006. The Company has elected to be taxed and intends to continue to qualify as a real estate investment trust (“REIT”) and is required to comply with the provisions of the Internal Revenue Code of 1986, as amended (the “Code”), with respect thereto. Since March 2008, the Company has exclusively purchased residential mortgage-backed securities that are issued and the principal and interest of which are guaranteed by a federally chartered corporation (“Agency RMBS”), such as the Federal National Mortgage Association (“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”), or an agency of the U.S. government such as the Government National Mortgage Association (“Ginnie Mae”), or U.S. Treasuries securities. The Company’s common stock trades on the New York Stock Exchange under the symbol “CYS.”

2. SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying interim unaudited condensed financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and the instructions to Form 10-Q and Article 10, Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The interim unaudited condensed financial statements should be read in conjunction with the Company’s audited financial statements as of and for the year ended December 31, 2011, included in the annual report on Form 10-K. The results for interim periods are not necessarily indicative of the results to be expected for the fiscal year.

The Company adopted Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 946, Clarification of the Scope of Audit and Accounting Guide Investment Companies (“ASC 946”), prior to its deferral in February 2008. Under ASC 946, the Company uses financial reporting for investment companies.

Segment Reporting

The Company operates as a single segment reporting to the Chief Executive Officer, who manages the entire investment portfolio.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those management estimates.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand, cash held in banks and highly liquid investments with original maturities of three months or less. Interest income earned on cash and cash equivalents is recorded in interest income.

Interest Rate Swap and Cap Contracts

The Company utilizes interest rate swaps and caps to hedge the interest rate risk associated with the financing of its portfolio. Specifically, the Company seeks to hedge the exposure to potential interest rate mismatches between the interest earned on investments and the borrowing costs caused by fluctuations in short term interest rates. In a simple interest rate swap, one investor pays a floating rate of interest on a notional principal amount and receives a fixed rate of interest on the same notional principal amount for a specified period of time. Alternatively, an investor may pay a fixed rate and receive a floating rate. In a simple interest rate cap, one investor pays a premium for a notional principal amount based on a capped interest rate (the “cap rate”). If the floating interest rate (the “floating rate”) exceeds the cap rate, the investor receives a payment from the cap counterparty equal to the difference between the floating rate and the cap rate on the same notional principal amount for a specified period of time. Alternatively, an investor may receive a premium and pay the difference in cap rate and floating rate. Interest rate swaps and caps are asset/liability management tools.

During the term of the interest rate swap or cap, the Company makes or receives periodic payments and unrealized gains or losses are recorded as a result of marking the swap and cap to their fair value. When the swap or cap is terminated, the Company records a realized gain or loss equal to the difference between the proceeds from (or cost of) the closing transaction and the

 

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Company’s cost basis in the contract, if any. The periodic payments, amortization of premiums on cap contracts and any realized or unrealized gains or losses are reported under gains and losses from swap and cap contracts in the statements of operations. Swaps involve a risk that interest rates will move contrary to the Company’s expectations, thereby increasing the Company’s payment obligation.

Because the Company uses financial reporting for investment companies, its investments, including its interest rate swap and cap contracts, are carried at fair value with changes in fair value included in earnings. Consequently, there would be no impact to designating interest rate swaps and caps as cash flow or fair value hedges under GAAP.

The Company is exposed to credit loss in the event of nonperformance by the counterparty to the swap or cap limited to the amount of collateral posted that exceeds the fair value of the contract. However, as of March 31, 2012 and December 31, 2011 the Company did not anticipate nonperformance by any counterparty. Should interest rates move unexpectedly, the Company may not achieve the anticipated benefits of the interest rate swap or cap and may realize a loss.

Investment Valuation

The Company has established a pricing committee responsible for establishing valuation policies and procedures as well as approving valuations on a monthly basis at a pricing meeting. The pricing committee is made up of individuals from the accounting team, the investment team and senior management.

Agency RMBS and U.S. Treasury securities are generally valued on the basis of valuations provided by third party pricing services, as derived from such services’ pricing models. Inputs to the models may include, but are not limited to, reported trades, executable bid and asked prices, broker quotations, prices or yields of securities with similar characteristics, benchmark curves or information pertaining to the issuer, as well as industry and economic events. The pricing services may use a matrix approach, which considers information regarding securities with similar characteristics to determine the valuation for a security.

Interest rate swaps and caps are generally valued using valuations provided by broker quotations. Such broker quotations are based on the present value of fixed and projected floating rate cash flows over the term of the swap contract. Future cash flows are discounted to their present value using swap rates provided by electronic data services or by broker.

CLOs are generally valued using valuations provided by broker quotations, as derived from such brokers’ pricing models. Inputs to the models may include, but are not limited to, reported trades, executable bid and asked prices, prices or yields of securities with similar characteristics, default rates, recovery rates, prepayment rates, reinvestment rates, and information pertaining to the issuer, as well as industry and economic events.

All valuations received from third party pricing services or broker quotes are non-binding. The Company does not adjust any of the prices received from third party pricing services, and all prices are reviewed by the Company. This review includes comparisons of similar market transactions, alternative third party pricing services and broker quotes, or comparisons to a pricing model. To ensure the proper fair value hierarchy, the Company reviews the third party pricing service’s methodology to understand whether observable or unobservable inputs are being used.

Agency RMBS

The Company’s investments in Agency RMBS consist of whole-pool pass-through certificates backed by fixed rate, monthly reset adjustable-rate loans (“ARMs”) and hybrid ARMs, the principal and interest of which are guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. Hybrid ARMs have interest rates that have an initial fixed period (typically three, five, seven or ten years) and thereafter reset at regular intervals in a manner similar to ARMs.

Forward Settling Transactions

The Company may engage in forward settling transactions. The Company records forward settling transactions on the trade date and maintains security positions such that sufficient liquid assets will be available to make payment on the settlement date for the securities purchased. Securities purchased on a forward settling basis are carried at fair value and begin earning interest on the settlement date. Losses may occur on these transactions due to changes in market conditions or the failure of counterparties to perform under the contract. Among other forward settling transactions, the Company may transact in to-be-announced Securities (“TBAs”). As with other forward settling transactions, a seller agrees to issue TBAs at a future date. However, the seller does not specify the particular securities to be delivered. Instead, the Company agrees to accept any security that meets specified terms such as issuer, interest rate and terms of underlying mortgages. The Company records TBAs on the trade date utilizing information associated with the specified terms of the transaction as opposed to the specific mortgages. TBAs are carried at fair value and begin earning interest on the settlement date. Losses may occur due to the fact that the actual underlying mortgages received may be less favorable than those

 

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anticipated by the Company. As of March 31, 2012 the Company had pledged Agency RMBS with a fair value of $11.5 million on its open forward settling and TBAs. The Company did not have any pledged Agency RMBS on its open forward settling transactions as of December 31, 2011.

Repurchase Agreements

Repurchase agreements are borrowings that are collateralized by the Company’s Agency RMBS and are carried at their amortized cost, which approximates their fair value due to their short term nature, generally 30-90 days. The Company’s repurchase agreement counterparties are large institutional dealers in fixed income securities. Collateral is valued daily and counterparties may require additional collateral when appropriate. At March 31, 2012 and December 31, 2011, Agency RMBS owned with a fair value of approximately $8,655.2 million and $8,284.4 million, respectively, have been pledged as collateral for repurchase agreements for which the counterparty has the right to sell or repledge.

Investment Transactions and Income

The Company records its transactions in securities on a trade date basis. Realized gains and losses on securities transactions are recorded on an identified cost basis. Interest income and expense are recorded on the accrual basis. Interest income on Agency RMBS is accrued based on outstanding principal amount of the securities and their contractual terms. Interest on CLOs is accrued at a rate determined based on estimated future cash flows and adjusted prospectively as future cash flow amounts are recast. For CLOs placed on nonaccrual status or when the Company cannot reliably estimate cash flows, the cost recovery method is used. Amortization of premium and accretion of discount are recorded using the yield to maturity method, and are included in interest income in the statements of operations. The Company does not estimate prepayments when calculating the yield to maturity. The amount of premium or discount associated with a prepayment is recorded through interest income on the statements of operations as they occur.

Reclassification and Presentation

The statements of operations for the three months ended March 31, 2011 had previously provided separate disclosure of related party management compensation, which included the expense relating to restricted stock granted to non-employees (prior to the Company’s internalization of management (the “Internalization”)). The related party management compensation for the three months ended March 31, 2011 of $544 thousand, was reclassified to compensation and benefits in the presentation herein. The statements of changes in net assets and statements of cash flows for the three months ended March 31, 2011 had previously provided disclosure of amortization of related party management compensation which has been changed to amortization of share based compensation.

Compensation and Benefits

Included in the Company’s compensation and benefits are salaries, incentive compensation, benefits, share based compensation and the expense relating to restricted stock granted to non-employees (prior to the Internalization). The Company accounts for share based compensation using the fair value based methodology prescribed by ASC 718, Share-Based Payment (“ASC 718”). Compensation cost related to restricted common stock issued is measured at its estimated fair value at the grant date and recognized as expense over the vesting period. Prior to the Internalization, which became effective on September 1, 2011, compensation cost related to restricted common stock and common stock options issued to the Company’s executive officers, certain employees of its Manager and its sub-advisors and other individuals who provide services to the Company was initially measured at estimated fair value at the grant date and was remeasured on subsequent dates to the extent the awards were unvested.

Income Taxes

The Company has elected to be taxed as a REIT and intends to continue to comply with provisions of the Code with respect thereto. As a REIT, the Company generally will not be subject to federal or state income tax. To maintain its qualification as a REIT, the Company must distribute at least 90% of its REIT taxable income to its stockholders and meet certain other tests relating to assets and income.

Earnings Per Share (“EPS”)

Basic EPS is computed using the two class method by dividing net income (loss), after adjusting for the impact of unvested stock awards deemed to be participating securities, by the weighted average number of common shares outstanding calculated excluding unvested stock awards. Diluted EPS is computed by dividing net income (loss), after adjusting for the impact of unvested stock awards deemed to be participating securities, by the weighted average number of common shares outstanding calculated excluding unvested stock awards, giving effect to common stock options and warrants, if they are not anti-dilutive. See note 3 for EPS computations.

 

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Recent Accounting Pronouncements

In April 2011, the FASB issued Accounting Standards Update (“ASU”) 2011-03, Reconsideration of Effective Control for Repurchase Agreements (Topic 860), Transfers and Servicing. In a typical repurchase agreement transaction, an entity transfers financial assets to a counterparty in exchange for cash with an agreement for the counterparty to return the same or equivalent financial assets for a fixed price in the future. Prior to this update, one of the factors in determining whether sale treatment could be used was whether the transferor maintained effective control of the transferred assets by having the ability to repurchase such assets. Based on this update, the FASB concluded that the assessment of effective control should focus on a transferor’s contractual rights and obligations with respect to transferred financial assets rather than whether the transferor has the practical ability to perform in accordance with those rights or obligations. Therefore, this update removes the transferor’s ability criterion from consideration of effective control. This update was effective for the first interim or annual period beginning on or after December 15, 2011 and did not have a material effect on the Company’s financial statements.

In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, (Topic 820), Fair Value Measurements. ASU 2011-04 changes the wording used to describe many of the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements to ensure consistency between GAAP and International Financial Reporting Standards (“IFRS”). ASU 2011-04 also expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. This update was effective for the first interim or annual period beginning on or after December 15, 2011 and did not have a material effect on the Company’s financial statements.

In December 2011, the FASB issued ASU 2011-11, Disclosures about Offsetting Assets and Liabilities (Topic 210), Balance Sheet. The update requires new disclosures about balance sheet offsetting and related arrangements. For derivatives and financial assets and liabilities, the amendments require disclosure of gross asset and liability amounts, amounts offset on the balance sheet, and amounts subject to the offsetting requirements but not offset on the balance sheet. The guidance is effective December 1, 2013 and is to be applied retrospectively. This guidance does not amend the existing guidance on when it is appropriate to offset. As a result, we do not expect this guidance to have a material effect on the Company’s financial statements.

3. EARNINGS PER SHARE

Components of the computation of basic and diluted EPS were as follows (in thousands, except per share numbers):

 

     Three Months Ended March 31,  
     2012     2011  

Net income

   $ 69,118      $ 52,097   

Less dividends paid:

    

Common shares

     (57,691     (49,068

Unvested shares

     (378     (468
  

 

 

   

 

 

 

Undistributed earnings

     11,049        2,561   
  

 

 

   

 

 

 

Basic weighted average shares outstanding:

    

Common shares

     103,952        70,153   
  

 

 

   

 

 

 

Basic earnings per common share:

    

Distributed earnings

   $ 0.55      $ 0.70   

Undistributed earnings

     0.11        0.04   
  

 

 

   

 

 

 

Basic earnings per common share

   $ 0.66      $ 0.74   
  

 

 

   

 

 

 

Diluted weighted average shares outstanding:

    

Common shares

     103,952        70,153   

Net effect of dilutive warrants (1)

     —          2   
  

 

 

   

 

 

 
     103,952        70,155   
  

 

 

   

 

 

 

Diluted earnings per common share:

    

Distributed earnings

   $ 0.55      $ 0.70   

Undistributed earnings

     0.11        0.04   
  

 

 

   

 

 

 

Diluted earnings per common share

   $ 0.66      $ 0.74   
  

 

 

   

 

 

 

 

(1) 

The impact of equity instruments is not included in the computation of EPS for periods in which their inclusion would be anti-dilutive. For the three months ended March 31, 2012 and 2011, the Company had an aggregate of 131,000 stock options outstanding with a weighted average exercise price of $30.00 that were not included in the calculation of EPS for the three months ended March 31, 2012 and 2011, as their inclusion would have been anti-dilutive. These equity instruments may have a dilutive impact on future EPS.

 

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4. INVESTMENTS IN SECURITIES AND INTEREST RATE SWAP AND CAP CONTRACTS

The Company’s valuation techniques are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect the Company’s market assumptions. ASC 820 classifies these inputs into the following hierarchy:

Level 1 Inputs—Quoted prices for identical instruments in active markets.

Level 2 Inputs—Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

Level 3 Inputs—Instruments with primarily unobservable value drivers.

Excluded from the tables below are financial instruments carried on the accompanying financial statements at cost basis, which is deemed to approximate fair value, primarily due to the short duration of these instruments, including cash and cash equivalents, receivables, payables and borrowings under repurchase arrangements with initial terms of 120 days or less. The fair value of these instruments is determined using level two inputs. The following tables provide a summary of the Company’s assets and liabilities that are measured at fair value on a recurring basis as of March 31, 2012 and December 31, 2011:

March 31, 2012

 

000,000,000 000,000,000 000,000,000 000,000,000
     Fair Value Measurements Using  
     Level 1      Level 2      Level 3      Total  
     (in thousands)  

Assets

           

Agency RMBS

   $ —         $ 13,307,443       $ —         $ 13,307,443   

U.S. Treasury Bills

     59,981         —           —           59,981   

CLOs

     —           —           21,415         21,415   

Interest rate cap contracts

     —           4,548         —           4,548   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 59,981      $ 13,311,991       $ 21,415       $ 13,393,387   
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities

           

Interest rate swap contracts

   $ —         $ 84,941       $ —         $ 84,941   
  

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2011

 

000,000,000 000,000,000 000,000,000 000,000,000
     Fair Value Measurements Using  
     Level 1      Level 2      Level 3      Total  
     (in thousands)  

Assets

           

Agency RMBS

   $ —         $ 9,372,454       $ —         $ 9,372,454   

U.S. Treasury Bills

     74,999         —           —           74,999   

CLOs

     —           —           18,675         18,675   

Interest rate cap contracts

     —           5,966         —           5,966   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 74,999       $ 9,378,420       $ 18,675       $ 9,472,094   
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities

           

Interest rate swap contracts

   $ —         $ 79,476         —         $ 79,476   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

The table below presents a reconciliation of changes in assets classified as Level 3 in the Company’s financial statements for the three months ended March 31, 2012 and 2011. A discussion of the method of fair valuing these assets is included above in “Investment Valuation.” CLOs are generally valued using valuations provided by broker quotations. The Company validates the broker quotations using internal discounted cash flow models. The significant unobservable inputs used in the fair value measurement of the Company’s CLOs are prepayment rates, probability of default, and recovery rate in the event of default. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates. The weighted average inputs to the models were:

 

     Constant Prepayment Rate     Default Rate     Recovery Rate     Recovery Lag  

Weighted Average

     20     2     60     6 Months   

 

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Fair Value Reconciliation, Level 3

(in thousands)

 

     Three Months Ended March 31,  
     2012     2011  

CLOs

    

Beginning balance Level 3 assets

   $ 18,675      $ 20,478   

Change in net unrealized appreciation (depreciation)

     3,797        4,577   

Cash payments recorded as a reduction of cost basis

     (1,057     (1,108

Transfers into (out of) Level 3

     —          —     
  

 

 

   

 

 

 

Ending balance Level 3 assets

   $ 21,415      $ 23,947   
  

 

 

   

 

 

 

The Agency RMBS portfolio consisted of Agency RMBS as follows:

March 31, 2012

 

     Par Value      Fair Value      Weighted Average  

Asset Type

   (in thousands)      Cost/Par      Fair
Value/Par
     MTR(1)     Coupon     CPR(2)  

10 Year Fixed Rate

   $ 256,373       $ 269,227       $ 103.88       $ 105.01         N/A        3.50     13.8

15 Year Fixed Rate

     7,306,193         7,666,261         103.05         104.93         N/A        3.54     14.8

20 Year Fixed Rate

     460,938         489,662         102.36         106.23         N/A        4.16     21.8

30 Year Fixed Rate

     1,132,244         1,225,193         106.90         108.21         N/A        5.09     26.5

Hybrid ARMs

     3,493,632         3,657,100         102.54         104.68         65.9        3.19     20.1
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total/Weighted Average

   $ 12,649,380       $ 13,307,443       $ 103.24       $ 105.20         65.9 (3)      3.61     17.3
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

 

December 31, 2011

 

     Par Value      Fair Value      Weighted Average  

Asset Type

   (in thousands)      Cost/Par      Fair
Value/Par
     MTR(1)     Coupon     CPR(2)  

10 Year Fixed Rate

   $ 272,115       $ 284,948       $ 103.96       $ 104.72         N/A        3.50     13.6

15 Year Fixed Rate

     4,763,965         5,010,121         102.53         105.17         N/A        3.79     17.8

20 Year Fixed Rate

     551,766         585,103         102.32         106.04         N/A        4.14     28.1

30 Year Fixed Rate

     239,747         259,123         103.09         108.08         N/A        5.00     26.3

Hybrid ARMs

     3,098,024         3,233,159         102.31         104.36         64.0        3.29     20.3
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total/Weighted Average

   $ 8,925,617       $ 9,372,454       $ 102.50       $ 105.01         64.0 (3)      3.66     19.5
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

 

(1) 

MTR, or “Months to Reset” is the number of months remaining before the fixed rate on a hybrid ARM becomes a variable rate. At the end of the fixed period, the variable rate will be determined by the margin and the pre-specified caps of the ARM. After the fixed period, 100% of the hybrid ARMS in the portfolio reset annually.

(2) 

CPR, or “Constant Prepayment Rate,” is a method of expressing the prepayment rate for a mortgage pool that assumes that a constant fraction of the remaining principal is prepaid each month or year. Specifically, the constant prepayment rate is an annualized version of the prior three month prepayment rate. Securities with no prepayment history are excluded from this calculation.

(3) 

Weighted average months to reset of our Hybrid ARM portfolio.

As of March 31, 2012 and December 31, 2011, the Company’s Agency RMBS were purchased at a net premium to their par value due to the average interest rates on these investments being higher than prevailing market rates. As of March 31, 2012 and December 31, 2011, approximately $410.5 million and $223.5 million, respectively, of unamortized premium was included in the cost basis of the securities.

Actual maturities of Agency RMBS are generally shorter than stated contractual maturities (which range up to 30 years), as they are affected by the contractual lives of the underlying mortgages, periodic payments and prepayments of principal. As of March 31,

 

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2012 and December 31, 2011, the average final contractual maturity of the Company’s Agency RMBS portfolio is in year 2032 and 2031, respectively. Interest income on Agency RMBS for the three months ended March 31, 2012 and 2011, was $64.1 million and $40.0 million, respectively.

In order to mitigate its interest rate exposure, the Company enters into interest rate swap and cap contracts. The Company did not enter into any swap and cap contract transactions during the three months ended March 31, 2012. The Company had the following interest rate swap and cap transactions during the three months ended March 31, 2011 (in thousands):

 

Three Months Ended March 31, 2011

 

Trade Date

   Transaction    Notional  

February 2011

   Opened    $ 500,000   

March 2011

   Opened      250,000   
     

 

 

 

Net Increase

      $ 750,000   
     

 

 

 

As of March 31, 2012 and December 31, 2011, the Company had net pledged Agency RMBS and U.S Treasury securities with a fair value of $140.2 million and $127.9 million, respectively, as collateral on interest rate swap and cap contracts. Below is a summary of our interest rate swap and cap contracts open as of March 31, 2012 and December 31, 2011 and for the three months ended March 31, 2012 and 2011 (in thousands):

 

Derivatives not designated as hedging instruments under ASC 815(a)

Interest Rate Swap Contracts

   Notional Amount      Fair Value     Statement of Assets and Liabilities Location

March 31, 2012

   $ 4,740,000       $ (84,941   Liabilities

December 31, 2011

     4,740,000         (79,476   Liabilities

Interest Rate Cap Contracts

   Notional Amount      Fair Value     Statement of Assets and Liabilities Location

March 31, 2012

   $ 700,000       $ 4,548      Assets

December 31, 2011

     700,000         5,966      Assets

 

          Amount of Gain or (Loss)
Recognized in Income on Derivative
 
Derivatives not designated as hedging    Location of Gain or (Loss) Recognized in    Three Months Ended March 31,  

Instruments under ASC 815(a)

  

Income on Derivative

   2012     2011  

Interest rate swap and cap contracts

  

Net gain (loss) from swap and cap contracts

   $ (17,429   $ (1,181
     

 

 

   

 

 

 

 

(a) 

See note 2 for additional information on the Company’s purpose for entering into interest rate swaps and caps and the decision not to designate them as hedging instruments.

Credit Risk

At March 31, 2012 and December 31, 2011, the Company continued to have minimal exposure to credit losses on its mortgage assets by owning principally Agency RMBS. The payment of principal and interest on Agency RMBS is guaranteed by Freddie Mac, Fannie Mae or Ginnie Mae. In September 2008, both Freddie Mac and Fannie Mae were placed in the conservatorship of the United States government. While it is hoped that the conservatorship will help stabilize Freddie Mac’s and Fannie Mae’s losses and overall financial position, there can be no assurance that it will succeed or that, if necessary, Freddie Mac or Fannie Mae will be able to satisfy their guarantees of Agency RMBS.

On August 5, 2011, Standard & Poor’s downgraded the U.S.’s credit rating to AA+ for the first time. Because Fannie Mae and Freddie Mac are in conservatorship of the U.S. Government, the implied credit ratings of Agency RMBS guaranteed by Freddie Mac, Fannie Mae or Ginnie Mae were also downgraded to AA+. While this downgrade did not have a significant impact on the fair value of the Agency RMBS in the Company’s portfolio, it has increased the uncertainty regarding the credit risk of Agency RMBS.

The Company’s CLOs do not have the backing of Fannie Mae, Freddie Mac or Ginnie Mae. Payment of principal and interest is dependent on the performance of the underlying loans, which are subject to borrower default and possible losses.

 

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5. BORROWINGS

The Company leverages its Agency RMBS portfolio through the use of repurchase agreements. Each of the borrowing vehicles used by the Company bears interest at floating rates based on a spread above or below the LIBOR. The fair value of borrowings under repurchase agreements approximates their carrying amount due to the short term nature of these financial instruments.

Certain information with respect to the Company’s borrowings is summarized in the following tables. Each of the borrowings listed is contractually due in one year or less (dollars in thousands).

 

March 31, 2012

 

Outstanding borrowings

   $ 8,234,669   

Interest accrued thereon

   $ 2,425   

Weighted average borrowing rate

     0.34

Weighted average remaining maturity (in days)

     37.2   

Fair value of the collateral(1)

   $ 8,655,219   

 

December 31, 2011

 

Outstanding borrowings

   $ 7,880,814   

Interest accrued thereon

   $ 3,747   

Weighted average borrowing rate

     0.36

Weighted average remaining maturity (in days)

     27.6   

Fair value of the collateral(1)

   $ 8,284,423   

 

(1) 

Collateral for borrowings consists of Agency RMBS.

At March 31, 2012 and December 31, 2011, the Company did not have any repurchase agreements where the amount at risk exceeded 10% of net assets.

6. CONTINGENCIES

The Company enters into certain contracts that contain a variety of indemnifications, principally with brokers. The maximum potential amount of future payment the Company could be required to make under these indemnification provisions is unknown. The Company has not incurred any costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of March 31, 2012 and December 31, 2011.

7. SHARE CAPITAL

The Company has authorized 500,000,000 shares of common stock having par value of $0.01 per share. As of March 31, 2012 and December 31, 2011, the Company had issued and outstanding 116,138,501 and 82,753,036 shares of common stock, respectively. The Company’s common stock transactions during the three months ended March 31, 2012 and 2011 are as follows:

 

     Three months ended March 31, 2012      Three Months ended March 31, 2011  
     Shares      Amount      Shares      Amount  

Shares sold in public offerings or issued as restricted stock

     33,385,465       $ 437,285,499         23,008,643       $ 276,365,388   

The Company has authorized 50,000,000 shares of preferred stock having a par value of $0.01 per share. As of March 31, 2012 and December 31, 2011, no such shares were issued or outstanding.

Equity Offerings

On February 1, 2012, the Company closed a public offering of 28,750,000 shares of its common stock at a public offering price of $13.28 per share for total net proceeds of approximately $377.3 million, after the underwriting discount and commissions and expenses.

Dividend Reinvestment and Direct Stock Purchase Plan (“DSPP”)

The Company sponsors a dividend reinvestment and direct stock purchase plan through which stockholders may purchase additional shares of common stock by reinvesting some or all of the cash dividends received on shares of common stock.

 

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Stockholders may also make optional cash purchases of shares of common stock subject to certain limitations detailed in the plan prospectus. For the three months ended March 31, 2012 and 2011 the Company issued 1,486,699 and 1,659 shares under the plan, respectively, raising approximately $19.9 million and $21,076 of net proceeds, respectively. As of March 31, 2012 and December 31, 2011, there were approximately 7.9 million and 9.4 million shares, respectively, available for issuance under this plan.

Restricted Stock Awards

For the three months ended March 31, 2012 and 2011 the Company granted 189,034 and 6,984 shares of restricted stock, respectively to certain of its directors, officers and employees.

Equity Placement Program (“EPP”)

On June 7, 2011, the Company entered into a sales agreement with JMP Securities LLC whereby the Company may, from time to time, publicly offer and sell up to 15,000,000 shares of the Company’s common stock through at-the-market transactions and/or privately negotiated transactions. For the three months ended March 31, 2012, the Company issued 2,959,732 shares under the plan raising approximately $39.7 million. As of March 31, 2012 and December 31, 2011, 12,040,268 and 15,000,000 shares of common stock, respectively, remained available for issuance to be sold under the sales agreement.

8. FINANCIAL HIGHLIGHTS

In accordance with financial reporting requirements applicable to investment companies, the Company has included below certain financial highlight information for the three months ended March 31, 2012 and 2011:

 

     Per Share  
     Three months ended March 31,  
     2012     2011  

Net asset value, beginning of period

   $ 13.02      $ 11.59   

Net income:

    

Net investment income

     0.51  (a)      0.47  (a) 

Net gain from investments and swap and cap contracts

     0.15  (a)      0.26  (a) 
  

 

 

   

 

 

 

Net income

     0.66        0.73   
  

 

 

   

 

 

 

Capital transactions:

    

Distributions to shareholders

     (0.50     (0.70

Issuance of common shares and amortization of share based compensation

     (0.04 ) (a)      0.12  (a) 
  

 

 

   

 

 

 

Net decrease in net asset value from capital transactions

     (0.54     (0.58
  

 

 

   

 

 

 

Net asset value, end of period

   $ 13.14      $ 11.74   
  

 

 

   

 

 

 

Net asset value total return (%)

     4.76 % (b)      7.33 % (b) 

Market value total return (%)

     3.41 % (b)      (1.78 )% (b) 

Ratios to Average Net Assets

    

Expenses before interest expense

     1.46 % (c)      2.11 % (c) 

Total expenses

     3.41 % (c)      3.64 % (c) 

Net investment income

     15.19 % (c)      16.18 % (c) 

 

(a) Calculated based on average shares outstanding during the period. Average shares outstanding include vested and unvested restricted shares and differs from weighted average shares outstanding used in calculating EPS (see note 3).
(b) Not computed on an annualized basis.
(c) Computed on an annualized basis.

9. SUBSEQUENT EVENTS

On April 1, 2012, an aggregate of 7,422 shares of restricted common stock were granted to certain directors as a portion of their compensation for serving on the Company’s board of directors.

The CPR of the Company’s Agency RMBS portfolio was approximately 20.6% for the month of April 2011.

 

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

In this Quarterly Report on Form 10-Q, we refer to CYS Investments, Inc. as “we,” “us,” “our company,” or “our,” unless we specifically state otherwise or the context indicates otherwise. The following defines certain of the commonly used terms in this quarterly report on Form 10-Q: RMBS refers to residential mortgage-backed securities; agency securities or Agency RMBS refers to our RMBS that are issued or whose principal and interest payments are guaranteed by a federally chartered corporation, such as the Federal National Mortgage Association (“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”), or an agency of the U.S. government, such as the Government National Mortgage Association (“Ginnie Mae”); ARMs refers to adjustable-rate mortgage loans that typically have interest rates that adjust annually to an increment over a specified interest rate index; and hybrids refers to ARMs that have interest rates that are fixed for a specified period of time and, thereafter, generally adjust annually to an increment over a specified interest rate index.

The following discussion should be read in conjunction with our financial statements and accompanying notes included in Item 1 of this Quarterly Report on Form 10-Q as well as our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 filed on February 13, 2012.

Forward Looking Statements

When used in this Quarterly Report on Form 10-Q, in future filings with the Securities and Exchange Commission (“SEC”) or in press releases or other written or oral communications, statements which are not historical in nature, including those containing words such as “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” or similar expressions, are intended to identify “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and, as such, may involve known and unknown risks, uncertainties and assumptions. The forward-looking statements we make in this Quarterly Report on Form 10-Q include, but are not limited to, statements about the following:

 

   

the effect of movements in interest rates on our assets and liabilities (including our hedging instruments) and our net income;

 

   

our investment, financing and hedging strategy and the success of these strategies;

 

   

the effect of increased prepayment rates on our portfolio;

 

   

our ability to convert our assets into cash or extend the financing terms related to our assets;

 

   

the effect of widening credit spreads on the value of our assets and investment strategy;

 

   

the types of indebtedness we may incur;

 

   

our ability to quantify risks based on historical experience;

 

   

our ability to be taxed as a real estate investment trust (“REIT”) and to maintain an exemption from registration under the Investment Company Act of 1940, as amended (the “Investment Company Act”);

 

   

our assessment of counterparty risk;

 

   

our ability to meet short term liquidity requirements with our cash flow from operations and borrowings

 

   

our liquidity;

 

   

our asset valuation policies;

 

   

our distribution policy; and

 

   

the effect of recent U.S. Government actions on interest rates and the housing and credit markets.

Forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. The following factors could cause actual results to vary from our forward-looking statements:

 

   

the factors referenced in this Quarterly Report on Form 10-Q, including those set forth under the section captioned “Risk Factors;”

 

   

changes in our investment, financing and hedging strategy;

 

   

the adequacy of our cash flow from operations and borrowings to meet our short term liquidity requirements;

 

   

the liquidity of our portfolio;

 

   

unanticipated changes in our industry, interest rates, the credit markets, the general economy or the real estate market;

 

   

changes in interest rates and the market value of our Agency RMBS;

 

   

changes in the prepayment rates on the mortgage loans underlying our Agency RMBS;

 

   

our ability to borrow to finance our assets;

 

   

changes in government regulations affecting our business;

 

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our ability to maintain our qualification as a REIT for federal income tax purposes;

 

   

our ability to maintain our exemption from registration under the Investment Company Act and the availability of such exemption in the future; and

 

   

risks associated with investing in real estate assets, including changes in business conditions and the general economy.

These and other risks, uncertainties and factors, including those described elsewhere in this report, could cause our actual results to differ materially from those projected in any forward-looking statements we make. All forward-looking statements speak only as of the date on which they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Overview

We are a specialty finance company created with the objective of achieving consistent risk-adjusted investment income. We seek to achieve this objective by investing, on a leveraged basis, in Agency RMBS. In addition, our investment guidelines permit investments in collateralized mortgage obligations issued by a government agency or government sponsored entity that are collateralized by Agency RMBS (“CMOs”), although we had not invested in any CMOs as of March 31, 2012. We commenced operations in February 2006 and completed our initial public offering in June 2009. Our common stock is traded on the New York Stock Exchange under the symbol “CYS”.

We earn investment income from our investment portfolio, and we use leverage to seek to enhance our returns. Our net investment income is generated primarily from the difference, or net spread, between the interest income we earn on our investment portfolio and the cost of our borrowings and hedging activities. The amount of net investment income we earn on our investments depends in part on our ability to control our financing costs, which comprise a significant portion of our operating expenses. Although we leverage our portfolio investments in Agency RMBS to seek to enhance our potential returns, leverage also may exacerbate losses.

While we use hedging to mitigate some of our interest rate risk, we do not hedge all of our exposure to changes in interest rates. This is because there are practical limitations on our ability to insulate our portfolio from all potential negative consequences associated with changes in short term interest rates in a manner that will allow us to achieve attractive spreads on our portfolio.

In addition to investing in issued pools of Agency RMBS, we regularly utilize forward settling transactions, including forward-settling purchases of Agency RMBS where the pool is “to-be-announced” (“TBAs”). Pursuant to these TBAs, we agree to purchase, for future delivery, Agency RMBS with certain principal and interest terms and certain types of underlying collateral, but the particular Agency RMBS to be delivered is not identified until shortly before the TBA settlement date. For our other forward settling transactions, we agree to purchase, for future delivery, Agency RMBS. However, unlike our TBAs, these forward settling transactions reference an identified Agency RMBS.

We have elected to be taxed as a REIT and have complied, and intend to continue to comply, with the provisions of the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”) with respect thereto. Accordingly, we generally do not expect to be subject to federal income tax on our REIT taxable income that we currently distribute to our stockholders if certain asset, income and ownership tests and recordkeeping requirements are fulfilled. Even if we maintain our qualification as a REIT, we may be subject to some federal, state and local taxes on our income.

Factors that Affect our Results of Operations and Financial Condition

A variety of industry and economic factors may impact our results of operations and financial condition. These factors include:

 

   

interest rate trends;

 

   

prepayment rates on mortgages underlying our Agency RMBS, and credit trends insofar as they affect prepayment rates;

 

   

competition for investments in Agency RMBS;

 

   

actions taken by the U.S. Government, including the U.S. Federal Reserve and the U.S. Treasury;

 

   

credit rating downgrades of the United States’ and certain European countries’ sovereign debt; and

 

   

other market developments.

In addition, a variety of factors relating to our business may also impact our results of operations and financial condition. These factors include:

 

   

our degree of leverage;

 

   

our access to funding and borrowing capacity;

 

   

our borrowing costs;

 

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our hedging activities;

 

   

the market value of our investments; and

 

   

the REIT requirements and the requirements to qualify for a registration exemption under the Investment Company Act.

We anticipate that, for any period during which changes in the interest rates earned on our assets do not coincide with interest rate changes on the corresponding liabilities, such assets will likely change in value more slowly than the corresponding liabilities. Consequently, changes in interest rates, particularly short term interest rates, may significantly influence our net investment income.

Our net investment income may be affected by a difference between actual prepayment rates and our projections. Prepayments on loans and securities may be influenced by changes in market interest rates and homeowners’ ability and desire to refinance their mortgages. To the extent we have acquired assets at a premium or discount to par value, changes in prepayment rates may impact our anticipated yield.

Trends and Recent Market Impacts

The volatility in the U.S. interest rate markets in 2011 and early 2012 has produced opportunities in our markets. While the performance of the U.S. economy in 2011 turned out to be disappointing primarily due to a lack of significant job growth, the first quarter of 2012 has shown some improvement in job growth and U.S. real gross domestic project growth. The U.S. Federal Reserve (“the Fed”) announced in March 2012 that it intended to keep the Federal Funds Target Rate near zero through late-2014 which has had a positive effect on the markets for Agency RMBS. However, in its March 13, 2012 press release, the Fed reaffirmed current economic conditions likely warranted keeping exceptionally low levels for the Federal Funds Target Rate through at least late 2014 despite the improved labor market conditions. The U.S. unemployment rate has declined in recent months from 8.5% in December 2011 to 8.2% in March 2012, however, this downward trend may not necessarily represent the longer-term pace of job creation. The residential construction sector remains depressed, though sales of existing home sales have picked up recently.

Overall inflation and wage pressures have remained muted in recent months but prices of crude oil and gasoline have increased. This environment and the $400 billion maturity extension program described below in “—Government Activity” have created strong demand for U.S. government guaranteed assets, and valuations of Agency RMBS have increased due to such demand.

The following trends and recent market impacts may also affect our business:

Interest Rates

During the three months ended March 31, 2012, long term interest rates started to rise with the 10 Year U.S. Treasury rate (the “10 Year”) increasing from 1.88% at December 31, 2011 to 2.21% at March 31, 2012. This contrasts with long term interest rate movements during 2011, when rates on the 10 Year fell from 3.29% at the beginning of 2011 to 1.88% at December 31, 2011. The main drivers of the increase in long term interest rates are the improved prospects for economic growth and the increased probability the Fed will have to tighten monetary policy sooner rather than later.

The demand for consumer credit, specifically mortgage loans has been strong. This demand has come primarily from banks because of the favorable treatment of Agency RMBS under bank risk based capital guidelines. In addition to banks, demand for mortgage loans has come from the Fed, which in September 2011 announced it would reinvest principal and interest received from its holdings of Agency RMBS. Conversely, supply of mortgage loans has been subdued.

While we have recently seen a slightly more positive trend in U.S. employment and housing data, the U.S. economy still appears to be in a period of slow growth with little inflationary pressure. The U.S. Federal Funds Target Rate remains at 0-0.25%, with no change since mid-December 2008. Since December 2010, 30-Day LIBOR has also remained low with a rate of 0.24% at March 31, 2012, similar to a year ago. However, the rate declined from 0.295% at December 31, 2011, and 3-Month LIBOR also decreased during the first quarter of 2012 from 0.58% at December 31, 2011 to 0.47% at March 31, 2012. The availability of repurchase agreement financing is stable with interest rates between 0.30% and 0.40% for 30-90 day repurchase agreements at March 31, 2012. The following table presents 30-Day LIBOR, 3-Month LIBOR and the U.S. Federal Funds Target Rate at the end of each respective fiscal quarter:

 

Date

   30-Day LIBOR     3-Month LIBOR     Federal Funds Target Rate  

March 31, 2012

     0.241     0.468     0.25

December 31, 2011

     0.295     0.581     0.25

September 30, 2011

     0.239     0.374     0.25

June 30, 2011

     0.186     0.246     0.25

March 31, 2011

     0.243     0.303     0.25

December 31, 2010

     0.261     0.303     0.25

Source: Bloomberg

 

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Longer-term interest rates fell sharply in 2011, but increased in the three months ended March 31, 2012. The yield on five year U.S. Treasury notes was 2.006% at the beginning of 2011 and 0.832% at December 31, 2011. However, during the three months ended March 31, 2012, yields on mortgages diverged from the yield on five year U.S. Treasury notes. During the three months ended March 31, 2012, the yield on five year U.S. Treasury notes increased 21 basis points while the yield on par-priced Fannie Mae Agency RMBS backed by 15 year fixed rate mortgage loans decreased 10 basis points. Rates on three year interest rate swaps, currently one of our primary hedging vehicles, decreased by six and 46 basis points during the three months ended March 31, 2012 and year ended December 31, 2011, respectively. Meanwhile, the 3-Month LIBOR, which is the rate used to calculate the interest payments we receive on interest rate swaps and interest rate caps, if any, decreased by five basis points during the three months ended March 31, 2012, to 0.468%. During the three months ended March 31, 2012, the Company purchased $4,786.4 million of Agency RMBS with a weighted average yield of 2.33%.

The following table illustrates this market environment by comparing market levels for three benchmark securities or rates, the yield on five year U.S. Treasury Notes, the three year interest rate swap rate and the price of 15 year Fannie Mae 3.5% Agency RMBS:

 

Date

   Five Year U.S.
Treasury Note
    Three Year Interest
Rate Swap Rates
    Market Prices of 15
Year Fannie Mae
3.5% Agency RMBS
 

March 31, 2012

     1.039     0.758   $ 104.922   

December 31, 2011

     0.832     0.820   $ 104.578   

September 30, 2011

     0.952     0.736   $ 104.422   

June 30, 2011

     1.761     1.147   $ 101.828   

March 31, 2011

     2.277     1.571   $ 100.078   

December 31, 2010

     2.006     1.279   $ 100.328   

Source: Bloomberg

The increase in market prices of Agency RMBS during 2011 and the first three months of 2012 was impacted by the various programs of the U.S. Federal Reserve, including the September 2011 announcement of the $400 billion maturity extension program described below in “—Government Activity.” However, in 2012 the yield curve has started to steepen. Below is a graph of the yield curve at March 31, 2012, December 31, 2011 and December 31, 2010.

 

LOGO

 

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Prepayment Rates and Loan Buy-back Programs

Prepayment rates were very low in the summer of 2011 but have begun to increase as mortgages rates continue to push against historical lows. However, the continued weak U.S. housing market and high unemployment have reduced many U.S. homeowners’ ability to refinance their mortgages. The following table presents the prepayment rates for Fannie Mae Agency RMBS backed by 15 year and 30 year fixed rate mortgages:

 

     Jan-11     Feb-11     Mar-11     Apr-11     May-11     Jun-11     Jul-11     Aug-11     Sep-11     Oct-11     Nov-11     Dec-11  

15 Year

     17.8     13.6     13.7     12.2     12.2     14.7     15.6     18.4     23.0     25.2     23.2     20.8

30 Year

     19.5     15.5     15.4     13.4     13.0     14.9     14.9     16.8     21.4     24.4     25.2     23.6

 

     Jan-12     Feb-12     Mar-12  

15 Year

     18.8     20.9     21.6

30 Year

     21.6     25.0     25.8

 

LOGO

Source: eMBS

The CPR of the Company’s Agency RMBS portfolio was approximately 20.6% for the month of April 2011.

Government Activity

On January 4, 2012, the U.S. Federal Reserve released a report titled “The U.S. Housing Market: Current Conditions and Policy Considerations” to Congress, which provided a framework for thinking about certain issues and tradeoffs that policy makers might consider. It is unclear how future legislation may impact the housing finance market and the investing environment for Agency RMBS as the method of reform is undecided and has not yet been defined by the regulators.

On September 21, 2011, the U.S. Federal Reserve announced its maturity extension program whereby it intends to sell $400 billion of shorter-term U.S. Treasury securities by the end of June 2012 and use the proceeds to buy longer-term U.S. Treasury securities. This program is intended to extend the average maturity of the securities in the Federal Reserve’s portfolio. By reducing the supply of longer-term U.S. Treasury securities in the market, this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term U.S. Treasury securities, like certain types of Agency RMBS. The reduction in longer-term interest rates, in turn, may contribute to a broad easing in financial market conditions that the U.S. Federal Reserve hopes will provide additional stimulus to support the economic recovery.

In September 2011, the White House announced they are working on a major plan to allow some of the 11 million homeowners who owe more on their mortgages than their homes are worth to refinance. Consequently, in October 2011 the FHFA announced

 

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changes to the Home Affordable Refinance Program (“HARP”) to expand access to refinancing for qualified individuals and families whose homes have lost value. One such change is to increase the HARP loan-to-value ceiling above 125%. However, this would only apply to mortgages guaranteed by the Fannie Mae, Freddie Mac or Ginnie Mae. There are many challenging issues to this proposal, notably the question as to whether a loan with a 125% or greater loan-to-value ratio qualifies as a mortgage or an unsecured consumer loan. The chances of this initiative’s success and other ideas proposed by the U.S. Federal Reserve’s white paper, have created additional uncertainty in the RMBS market, particularly with respect to possible increases in prepayment rates.

In February 2011, the U.S. Department of the Treasury along with the U.S. Department of Housing and Urban Development released a report titled “Reforming America’s Housing Finance Market” to Congress outlining recommendations for reforming the U.S. housing system, specifically Fannie Mae and Freddie Mac, and transforming the government’s involvement in the housing market. It is unclear how future legislation may impact the housing finance market and the investing environment for Agency RMBS as the method of reform is undecided and has not yet been defined by the regulators.

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) into law. The Dodd-Frank Act is extensive, complicated and comprehensive legislation that impacts practically all aspects of banking and represents a significant overhaul of many aspects of the regulation of the financial services industry. Although many provisions remain subject to further rulemaking, the Dodd-Frank Act implements numerous and far-reaching regulation changes that affect financial companies, including our Company, and other banks and institutions which are important to our business model. Certain notable rules are, among other things:

 

   

Requiring regulation and oversight of large, systemically important financial institutions by establishing an interagency council on systemic risk and implementation of heightened prudential standards and regulation by the Board of Governors of the U.S. Federal Reserve for systemically important financial institutions (including nonbank financial companies), as well as the implementation of the Federal Deposit Insurance Corporation (“FDIC”) resolution procedures for liquidation of large financial companies to avoid market disruption;

 

   

applying the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies, savings and loan holding companies and systemically important nonbank financial companies;

 

   

limiting the U.S. Federal Reserve’s emergency authority to lend to nondepository institutions to facilities with broad-based eligibility, and authorizing the FDIC to establish an emergency financial stabilization fund for solvent depository institutions and their holding companies, subject to the approval of Congress, the Secretary of the U.S. Treasury and the U.S. Federal Reserve;

 

   

creating regimes for regulation of over-the-counter derivatives and non-admitted property and casualty insurers and reinsurers;

 

   

implementing regulation of hedge fund and private equity advisers by requiring such advisers to register with the SEC;

 

   

providing for the implementation of corporate governance provisions for all public companies concerning proxy access and executive compensation; and

 

   

reforming regulation of credit rating agencies.

Many of the provisions of the Dodd-Frank Act, including certain provisions described above are subject to further study, rulemaking, and the discretion of regulatory bodies. As the hundreds of regulations called for by the Dodd-Frank Act are promulgated, we will continue to evaluate the impact of any such regulations. It is unclear how this legislation may impact the borrowing environment, investing environment for Agency RMBS and interest rate swaps as much of the bill’s implementation has not yet been defined by the regulators.

Certain programs initiated by the U.S. Government, through the Federal Housing Administration (“FHA”) and the FDIC, to provide homeowners with assistance in avoiding residential mortgage loan foreclosures are currently in effect. The programs may involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans or the rate of interest payable on the loans, or to extend the payment terms of the loans. While the effect of these programs has not been as extensive as originally expected, the effect of such programs for holders of Agency RMBS could be that such holders would experience changes in the anticipated yields of their Agency RMBS due to (i) increased prepayment rates on their Agency RMBS and (ii) lower interest and principal payments on their Agency RMBS.

Credit Spreads

Over the past few years, the credit markets generally experienced tightening credit spreads (specifically, spreads between U.S. Treasury securities and other securities that are identical in all respects except for ratings) mainly due to the strong demand for lending opportunities. Generally, when credit spreads tighten, the value of Agency RMBS increases, which results in an increase in our book value. Due to these tightening credit spreads our book value has increased. If credit spreads were to widen, we expect the market value of Agency RMBS would decrease, which could reduce our book value, but also create an attractive opportunity to reinvest principal and interest from our existing portfolio as well as deploy new capital into higher-yielding Agency RMBS.

 

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For a discussion of additional risks relating to our business see “Risk Factors” disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 filed on February 13, 2012.

Financial Condition

As of March 31, 2012 and December 31, 2011, the Agency RMBS in our portfolio were purchased at a net premium to their par value due to the average interest rates on these investments being higher than the prevailing market rates at the time of purchase. As of March 31, 2012 and December 31, 2011, we had approximately $410.5 million and $223.5 million, respectively, of unamortized premium included in the cost basis of our investments.

As of March 31, 2012 and December 31, 2011, our Agency RMBS portfolio consisted of the following assets:

March 31, 2012

 

      Par Value      Fair Value      Weighted Average  
                    Fair                     

Asset Type

   (in thousands)      Cost/Par      Value/Par      MTR(1)     Coupon     CPR(2)  

10 Year Fixed Rate

   $ 256,373       $ 269,227       $ 103.88       $ 105.01         N/A        3.50     13.8

15 Year Fixed Rate

     7,306,193         7,666,261         103.05         104.93         N/A        3.54     14.8

20 Year Fixed Rate

     460,938         489,662         102.36         106.23         N/A        4.16     21.8

30 Year Fixed Rate

     1,132,244         1,225,193         106.90         108.21         N/A        5.09     26.5

Hybrid ARMs

     3,493,632         3,657,100         102.54         104.68         65.9        3.19     20.1
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total/Weighted Average

   $ 12,649,380       $ 13,307,443       $ 103.24       $ 105.20         65.9 (3)      3.61     17.3
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

 

December 31, 2011

 

     Par Value      Fair Value      Weighted Average  
                    Fair                     

Asset Type

   (in thousands)      Cost/Par      Value/Par      MTR(1)     Coupon     CPR(2)  

10 Year Fixed Rate

   $ 272,115       $ 284,948       $ 103.96       $ 104.72         N/A        3.50     13.6

15 Year Fixed Rate

     4,763,965         5,010,121         102.53         105.17         N/A        3.79     17.8

20 Year Fixed Rate

     551,766         585,103         102.32         106.04         N/A        4.14     28.1

30 Year Fixed Rate

     239,747         259,123         103.09         108.08         N/A        5.00     26.3

Hybrid ARMs

     3,098,024         3,233,159         102.31         104.36         64.0        3.29     20.3
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total/Weighted Average

   $ 8,925,617       $ 9,372,454       $ 102.50       $ 105.01         64.0 (3)      3.66     19.5
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

 

(1) 

MTR, or “Months to Reset” is the number of months remaining before the fixed rate on a hybrid ARM becomes a variable rate. At the end of the fixed period, the variable rate will be determined by the margin and the pre-specified caps of the ARM. After the fixed period, 100% of the hybrid ARMS in the portfolio reset annually.

(2) 

CPR, or “Constant Prepayment Rate” is a method of expressing the prepayment rate for a mortgage pool that assumes that a constant fraction of the remaining principal is prepaid each month or year. Specifically, the constant prepayment rate is an annualized version of the prior three month prepayment rate. Securities with no prepayment history are excluded from this calculation.

(3) 

Weighted average months to reset of our ARM portfolio.

Actual maturities of Agency RMBS are generally shorter than stated contractual maturities (which range up to 30 years), as they are affected by the contractual lives of the underlying mortgages, periodic payments and prepayments of principal. As of March 31, 2012 and December 31, 2011, the average final contractual maturity of the mortgage portfolio is in year 2032 and 2031 respectively. The average expected life of our Agency RMBS reflects the estimated average period of time the securities in the portfolio will remain outstanding. The average expected lives of our Agency RMBS do not exceed five years, based upon the prepayment model obtained through subscription-based financial information service providers. The prepayment model considers current yield, forward yield, the steepness of the yield curve, current mortgage rates, the mortgage rate of the outstanding loan, loan age, margin and volatility. The actual lives of the Agency RMBS in our investment portfolio could be longer or shorter than those estimates depending on the actual prepayment rates experienced over the lives of the applicable securities.

As of March 31, 2012 and December 31, 2011, we had CLOs with a fair value of $21.4 million and $18.7 million, respectively.

 

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Hedging Instruments

We seek to hedge as much of the interest rate risk we determine is in the best interests of our stockholders. Our policies do not contain specific requirements as to the percentages or amount of interest rate risk we are required to hedge. No assurance can be given that our hedging activities will have the desired beneficial impact on our results of operations or financial condition.

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

 

   

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

 

   

available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;

 

   

due to prepayments on assets and repayments of debt securing such assets, the duration of the hedge may not match the duration of the related liability or asset;

 

   

the credit quality of the hedging counterparty may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and

 

   

the hedging counterparty may default on its obligation to pay.

We engage in interest rate swaps and caps as a means of mitigating our interest rate risk on forecasted interest expense associated with repurchase agreements for the term of the swap contract. An interest rate swap is a contractual agreement entered into by two counterparties under which each agrees to make periodic payments to the other for an agreed period of time based upon a notional amount of principal. Under the most common form of interest rate swap, commonly known as a fixed-floating interest rate swap, a series of fixed interest rate payments on a notional amount of principal is exchanged for a series of floating interest rate payments on such notional amount. In a simple interest rate cap, one investor pays a premium for a notional principal amount based on a capped interest rate (the “cap rate”). When the floating interest rate (the “floating rate”) exceeds the cap rate, the investor receives a payment from the cap counterparty equal to the difference between the floating rate and the cap rate on the same notional principal amount for a specified period of time. Alternatively, an investor may receive a premium and pay the difference in cap rate and floating rate.

At March 31, 2012, we were a party to 15 interest rate swaps and three interest rate caps (whereby we will receive interest payments when three-month LIBOR exceeds the cap rate) with maturities between May 2013 and December 2016, aggregate notional amount of $5,440.0 million and a fair value of approximately $(80.4) million. At December 31, 2011, we were a party to 15 interest rate swaps and three interest rate caps with maturities between May 2013 and December 2016, aggregate notional amount of $5,440.0 million and a fair value of approximately $(73.5) million. As of March 31, 2012 and December 31, 2011, the weighted average fixed rate on our interest rate swaps was 1.478%. As of March 31, 2012 and December 31, 2011, the weighted average cap rate on our interest rate caps was 1.593%.

The current fair value of interest rate swaps and caps is heavily dependent on the prevailing market fixed rate, the corresponding term structure of floating rates (known as the yield curve) as well as the expectation of changes in future floating rates.

Liabilities

We have entered into repurchase agreements to finance some of our purchases of Agency RMBS. These agreements are secured by our Agency RMBS and bear interest at rates that have historically moved in close relationship to LIBOR. At March 31, 2012, we had approximately $8,234.7 million of liabilities pursuant to repurchase agreements with 24 counterparties that had weighted average interest rates of approximately 0.34%, and a weighted average maturity of 37.2 days. In addition, as of March 31, 2012, we had approximately $3,635.0 million in payable for securities purchased, a portion of which will be financed through repurchase agreements. At December 31, 2011, we had approximately $7,880.8 million of liabilities pursuant to repurchase agreements with 24 counterparties that had weighted average interest rates of approximately 0.36%, and a weighted average maturity of 27.6 days. In addition, as of December 31, 2011 we had approximately $463.3 million in payable for securities purchased, a portion of which was financed through repurchase agreements. Below is a summary of our payable for securities purchased as of March 31, 2012 and December 31, 2011 (in thousands).

 

March 31, 2012                     

Forward Settling Purchases

   Settle Date      Par Value      Payable  

FHLMC - 30 Year 5.5% Fixed

     04/12/2012       $ 210,439       $ 228,515   

FNMA - 30 Year 5.0% Fixed

     04/12/2012         600,000         647,073   

FNMA - 15 Year 3.0% Fixed

     04/17/2012         1,019,092         1,056,759   

FNMA - 15 Year 3.5% Fixed

     04/17/2012         45,221         47,530   

FHLMC - 15 Year 4.0% Fixed

     04/17/2012         100,707         106,897   

FNMA - 30 Year 5.0% Fixed

     04/17/2012         200,000         215,694   

FNMA - 30 Year 2.7% Hybrid ARM

     04/24/2012         35,000         36,373   

FNMA - 30 Year 2.82% Hybrid ARM

     04/24/2012         67,343         69,695   

FNMA - 30 Year 2.8% Hybrid ARM

     04/25/2012         200,000         207,483   

FNMA - 15 Year 3.0% Fixed

     05/17/2012         700,000         724,642   

FNMA - 15 Year 3.0% Fixed

     06/18/2012         200,000         205,572   

FHLMC - 15 Year 3.5% Fixed

     06/18/2012         60,104         62,908   

FNMA - 30 Year 2.72% Hybrid ARM

     06/21/2012         25,000         25,842   
     

 

 

    

 

 

 
      $ 3,462,906       $ 3,634,983   
     

 

 

    

 

 

 

 

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December 31, 2011                     

Forward Settling Purchases

   Settle Date      Par Value      Payable  

FNMA - 15 Year 3.5% Fixed

     1/18/2012       $ 225,000       $ 232,977   

FNMA - 30 Year 2.84% Hybrid ARM

     1/24/2012         21,000         21,478   

FNMA - 30 Year 2.85% Hybrid ARM

     1/24/2012         16,000         16,579   

FNMA - 30 Year 2.94% Hybrid ARM

     1/24/2012         15,000         15,499   

FNMA - 30 Year 3.12% Hybrid ARM

     1/24/2012         50,000         51,807   

FNMA - 30 Year 2.84% Hybrid ARM

     1/24/2012         15,000         15,452   

FNMA - 30 Year 3.17% Hybrid ARM

     1/27/2012         36,000         37,389   

FNMA - 30 Year 2.90% Hybrid ARM

     2/23/2012         50,000         51,479   

FNMA - 30 Year 2.82% Hybrid ARM

     3/22/2012         20,000         20,642   
     

 

 

    

 

 

 
      $ 448,000       $ 463,302   
     

 

 

    

 

 

 

Summary Financial Data

 

     Three Months Ended March 31,  
(In thousands, except per share numbers)    2012     2011  

Investment income - Interest income

    

Interest Income - Agency RMBS

   $ 64,147      $ 40,033   

Interest Income - CLOs and Cash Equivalents

     1,222        947   
  

 

 

   

 

 

 

Total interest income

     65,369        40,980   
  

 

 

   

 

 

 

EXPENSES:

    

Interest expense

     6,853        3,104   

Operating expenses

     5,119        4,418   
  

 

 

   

 

 

 

Total expenses

     11,972        7,522   
  

 

 

   

 

 

 

Net investment income

     53,397        33,458   
  

 

 

   

 

 

 

Net gain (loss) from investments

     33,150        19,820   
  

 

 

   

 

 

 

GAINS AND (LOSSES) FROM SWAP AND CAP CONTRACTS:

    

Net swap and cap interest income (expense)

     (11,506     (11,859

Net unrealized appreciation (depreciation) on swap and cap contracts

     (5,923     10,678   
  

 

 

   

 

 

 

Net gain (loss) from swap and cap contracts

     (17,429     (1,181
  

 

 

   

 

 

 

NET INCOME

   $ 69,118      $ 52,097   
  

 

 

   

 

 

 

Net income per common share (diluted)

   $ 0.66      $ 0.74   
  

 

 

   

 

 

 

Distributions per common share

   $ 0.50      $ 0.60   
  

 

 

   

 

 

 

Key Portfolio Statistics*

    

Average Agency RMBS(1)

   $ 9,238,905      $ 4,962,719   

Average repurchase agreements (2)

     8,194,067        4,207,234   

Average net assets (3)

     1,406,049        838,593   

Average yield on Agency RMBS (4)

     2.78     3.27

Average cost of funds and hedge (5)

     0.90     1.44

Interest rate spread net of hedge (6)

     1.88     1.83

Operating expense ratio (7)

     1.46     2.11

Leverage ratio (at period end) (8)

     7.7:1        8.1:1   

 

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(1) Our average Agency RMBS for the period was calculated by averaging the month end cost basis of our settled Agency RMBS during the period.
(2) Our average repurchase agreements for the period were calculated by averaging the month end repurchase agreement balance during the period.
(3) Our average net assets for the period were calculated by averaging the month end net assets during the period.
(4) Our average yield on Agency RMBS for the period was calculated by dividing our interest income from Agency RMBS by our average Agency RMBS.
(5) Our average cost of funds and hedge for the period was calculated by dividing our total interest expense, including our net swap and cap interest income (expense), by our average repurchase agreements.
(6) Our interest rate spread net of hedge for the period was calculated by subtracting our average cost of funds and hedge from our average yield on Agency RMBS.
(7) Our operating expense ratio is calculated by dividing operating expenses by average net assets.
(8) Our leverage ratio was calculated by dividing (i) our repurchase agreements plus payable for securities purchased minus receivable for securities sold by (ii) net assets.
* All percentages are annualized.

Core Earnings:

Core Earnings represents a non-GAAP financial measure and is defined as net income (loss) excluding net gain (loss) from investments, net gain (loss) on termination of swap contracts and net unrealized appreciation (depreciation) on swap and cap contracts. In order to evaluate the effective yield of the portfolio, management uses Core Earnings to reflect the net investment income of our portfolio as adjusted to reflect the net swap and cap interest income (expense). Core Earnings allows management to isolate the interest income (expense) associated with our swaps and caps in order to monitor and project our borrowing costs and interest rate spread. In addition, management utilizes Core Earnings as a key metric in conjunction with other portfolio and market factors to determine the appropriate leverage and hedging ratios, as well as the overall structure of the portfolio.

We adopted Accounting Standards Codification (“ASC”) 946, Clarification of the Scope of Audit and Accounting Guide Investment Companies (“ASC 946”), prior to its deferral in February 2008, while most, if not all, other public companies that invest only in Agency RMBS have not adopted ASC 946. Under ASC 946, we use the financial reporting specified for investment companies, and accordingly, our investments are carried at fair value with changes in fair value included in earnings. Most other public companies that invest only in Agency RMBS include most changes in the fair value of their investments within shareholders’ equity, not in earnings. As a result, investors are not able to readily compare our results of operations to those of most of our competitors. We believe that the presentation of our Core Earnings is useful to investors because it provides a means of comparing our Core Earnings to those of our competitors. In addition, because Core Earnings isolates the net swap and cap interest income (expense), it provides investors with an additional metric to identify trends in our portfolio as they relate to the interest rate environment.

The primary limitation associated with Core Earnings as a measure of our financial performance over any period is that it excludes the effects of net realized gain (loss) from investments. In addition, our presentation of Core Earnings may not be comparable to similarly-titled measures of other companies, who may use different calculations. As a result, Core Earnings should not be considered as a substitute for our GAAP net income (loss) as a measure of our financial performance or any measure of our liquidity under GAAP.

 

(In thousands)    Three Months Ended March 31,  
Non-GAAP Reconciliation:    2012     2011  

NET INCOME

   $ 69,118      $ 52,097   

Net (gain) loss from investments

     (33,150     (19,820

Net unrealized (appreciation) depreciation on swap and cap contracts

     5,923        (10,678
  

 

 

   

 

 

 

Core Earnings

   $ 41,891      $ 21,599   
  

 

 

   

 

 

 

 

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Results of Operations

Three Months Ended March 31, 2012 Compared to the Three Months Ended March 31, 2011

Net Income. Net income increased $17.0 million to $69.1 million for the three months ended March 31, 2012, compared to net income of $52.1 million for the three months ended March 31, 2011. The major components of this increase are detailed below.

Interest Income. Interest income, which consists of interest income on Agency RMBS, subordinated tranches of CLOs and short term investments, increased by $24.4 million to $65.4 million for the three months ended March 31, 2012, as compared to $41.0 million for the three months ended March 31, 2011. The change in interest income was primarily due to the increased size of our portfolio. During the three months ended March 31, 2012, our average Agency RMBS portfolio was $9,238.9 million, compared to $4,962.7 million during the three months ended March 31, 2011. However, the increased income due to the size of our portfolio was partially offset by the decrease in the average yield on Agency RMBS. During the three months ended March 31, 2012 and 2011, our average yield on Agency RMBS was 2.78% and 3.27%, respectively.

Interest Expense. Interest expense increased $3.8 million to $6.9 million for the three months ended March 31, 2012, as compared to $3.1 million for the three months ended March 31, 2011. The increase was due to the increase in our average amounts outstanding under our repurchase agreements. During the three months ended March 31, 2012 and 2011, our average repurchase agreements were $8,194.1 million and $4,207.2 million, respectively. In addition, we had an average rate on our repurchase agreements of 0.33% and 0.30% during the three months ended March 31, 2012 and 2011, respectively.

Operating Expenses. For the three months ended March 31, 2012, operating expenses increased by $0.7 million to $5.1 million compared to $4.4 million for the three months ended March 31, 2011. However, expenses as a percentage of net assets decreased significantly during the three months ended March 31, 2012 to 1.46% compared to 2.11% during the three months ended March 31, 2011. The primary reason for the decrease in expenses as a percentage of net assets was that we had a larger asset base. Our average net assets were $1,406.1 million and $838.6 million during the three months ended March 31, 2012 and 2011, respectively.

Net Gain (Loss) From Investments. Net gain from investments increased by $13.4 million to $33.2 million for the three months ended March 31, 2012, compared to $19.8 million for the three months ended March 31, 2011. This increase was the result of the change in the price of Agency RMBS and the increase in our average Agency RMBS portfolio. During the three months ended March 31, 2012 and 2011, the price of Agency RMBS backed by 15 year 3.5% mortgages changed by $0.344 and $(0.250), respectively. During the three months ended March 31, 2012 and 2011, our average Agency RMBS was $9,238.9 million and $4,962.7 million, respectively.

Net Gain (Loss) from Swap and Cap Contracts. Net loss from swap and cap contracts increased by $16.2 million to a loss of $17.4 million for the three months ended March 31, 2012, compared to a loss of $1.2 million for the three months ended March 31, 2011. The increase in net loss on swap contracts was primarily due to the change in swap rates combined with the change in the size of our interest rate swap and cap portfolio. During the three months ended March 31, 2012 and 2011, our average interest rate swap and cap notional amount was $5,440.0 million and $4,702.5 million, respectively. During the three months ended March 31, 2012 and 2011, three year swap rates decreased by 6 basis points and increased by 29 basis points, respectively.

Contractual Obligations and Commitments

The following table summarizes our contractual obligations for repurchase agreements, interest expense on repurchase agreements and the office lease at March 31, 2012 (dollars in thousands).

 

March 31, 2012    Within One
Year
     One to three
Years
     Three to
Five Years
     Total  

Repurchase agreements

   $ 8,234,669       $ —         $ —         $ 8,234,669   

Interest expense on repurchase agreements, based on rates at March 31, 2012

     5,324         —           —           5,324   

Long term operating lease obligation

     315         403         —           718   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 8,240,308       $ 403       $ —         $ 8,240,711   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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December 31, 2011    Within One
Year
     One to three
Years
     Three to
Five Years
     Total  

Repurchase agreements

   $ 7,880,814       $ —         $ —         $ 7,880,814   

Interest expense on repurchase agreements, based on rates at December 31, 2011

     5,852         —           —           5,852   

Long term operating lease obligation

     313         482         —           795   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 7,886,979       $ 482       $ —         $ 7,887,461   
  

 

 

    

 

 

    

 

 

    

 

 

 

We enter into interest rate swap and cap contracts as a means of mitigating our interest rate risk on forecasted interest expense associated with repurchase agreements for the term of the swap or cap contract. At March 31, 2012 and December 31, 2011, we had the following interest rate swap and cap contracts (dollars in thousands):

As of March 31, 2012

 

Counterparty

   Total
Notional
     Fair
Value
    Accrued
Interest
    Amount
At Risk  (1)
     Weighted
Average
Maturity
in Years
 

Deutsche Bank

   $ 840,000       $ (11,750   $ (2,678   $ 13,291         2.1   

Goldman Sachs

     1,800,000         (38,337     (3,999     20,056         2.2   

Morgan Stanley Capital Markets

     250,000         (1,007     —          1,542         4.7   

Nomura Global Financial Products, Inc.

     550,000         (17,362     (2,398     5,733         3.3   

The Royal Bank of Scotland plc

     2,000,000         (11,937     (4,065     6,322         2.1   
  

 

 

    

 

 

   

 

 

   

 

 

    

Total

   $ 5,440,000       $ (80,393   $ (13,140   $ 46,944      
  

 

 

    

 

 

   

 

 

   

 

 

    

As of December 31, 2011

 

Counterparty

   Total
Notional
     Fair
Value
    Accrued
Interest
    Amount
At Risk  (1)
     Weighted
Average
Maturity
in Years
 

Deutsche Bank

   $ 840,000       $ (10,275   $ (1,436   $ 11,846         2.4   

Goldman Sachs

     1,800,000         (36,205     (5,705     18,025         2.5   

Morgan Stanley Capital Markets

     250,000         (723     —          1,236         5.0   

Nomura Global Financial Products, Inc.

     550,000         (17,176     (2,085     4,679         3.6   

The Royal Bank of Scotland plc

     2,000,000         (9,131     (2,644     6,965         2.4   
  

 

 

    

 

 

   

 

 

   

 

 

    

Total

   $ 5,440,000       $ (73,510   $ (11,870   $ 42,751      
  

 

 

    

 

 

   

 

 

   

 

 

    

 

(1) 

Equal to the fair value of pledged securities plus accrued interest income, minus the fair value of the interest rate swap and cap and accrued interest income and expense.

We enter into certain contracts that contain a variety of indemnification obligations, principally with our brokers and counterparties to interest rate swap contracts and repurchase agreements. The maximum potential future payment amount we could be required to pay under these indemnification obligations is unlimited. We have not incurred any costs to defend lawsuits or settle claims related to these indemnification obligations. As a result, the estimated fair value of these agreements is minimal. Accordingly, we recorded no liabilities for these agreements as of March 31, 2012 and December 31, 2011. In addition, as of March 31, 2012 and December 31, 2011, we had a $3,635.0 million and $463.3 million payable for securities purchased, respectively, a portion of which either was or will be financed through repurchase agreements. A summary of our payable for securities purchased as of March 31, 2012 and December 31, 2011 is included in the “Financial Condition—Liabilities” section.

Off-Balance Sheet Arrangements

As of March 31, 2012 and December 31, 2011, we did not maintain any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, special purpose or variable interest entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, as of March 31, 2012 and December 31, 2011, we had not guaranteed any obligations of unconsolidated entities or entered into any commitment or had any intent to provide funding to any such entities.

 

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Table of Contents

Liquidity and Capital Resources

Our primary sources of funds are borrowings under repurchase arrangements and monthly principal repayments and interest payments on our investments. Other sources of funds may include proceeds from debt and equity offerings and asset sales. As of March 31, 2012 and December 31, 2011, we had repurchase agreements totaling $8,234.7 million and $7,880.8 million, respectively, with a weighted average borrowing rate of 0.34% and 0.36%, respectively. In addition, during the three months ended March 31, 2012 and 2011, we received $543.2 million and $185.0 million of principal repayments and $59.0 million and $34.0 million of interest payments, respectively. We held cash and cash equivalents of $10.6 million and $11.5 million at March 31, 2012 and December 31, 2011, respectively.

During the three months ended March 31, 2012 and 2011, our operations used net cash of $791.3 million and $2,191.5 million, respectively. During the three months ended March 31, 2012 and 2011, we had net purchases of securities (net of purchases, sales and principal repayments) of $3,906.5 million and $2,168.1 million, respectively. The increase in net purchases of securities was the result of investing the $436.6 million of total net proceeds from the (i) February 1, 2012 public offering when we issued and sold 28,750,000 shares of common stock, raising approximately $377.3 million of net proceeds, and (ii) the issuances of shares under the dividend reinvestment and direct stock purchase plan (“DSPP”) and Equity Placement Program (“EPP”), while maintaining our leverage ratio.

Through the DSPP, stockholders may purchase additional shares of common stock by reinvesting some or all of the cash dividends received on shares of common stock. Stockholders may also make optional cash purchases of shares of common stock subject to certain limitations detailed in the plan prospectus. For the three months ended March 31, 2012 and 2011 we issued 1,486,699 and 1,659 shares under the plan, respectively, raising approximately $19.9 million and $21,076 of net proceeds, respectively. As of March 31, 2012 and December 31, 2011, there were approximately 7.9 million and 9.4 million shares, respectively available for issuance under the DSPP.

On June 7, 2011 we established the EPP whereby, from time to time, we may publicly offer and sell up to 15,000,000 shares of our common stock in at-the-market transactions and/or privately negotiated transactions with JMP Securities LLC acting as sales agent. For the three months ended March 31, 2012 the Company issued 2,959,732 shares under the plan raising approximately $39.7 million. As of March 31, 2012 and December 31, 2011, there were approximately 12.0 million and 15.0 million shares of common stock, respectively, remained available for issuance to be sold under the EPP.

The following tables present certain information regarding our risk exposure on our repurchase agreements as of March 31, 2012 and December 31, 2011 (dollars in thousands):

March 31, 2012

 

Counterparty

   Total
Outstanding
Borrowings
     % of
Total
    Amount
At Risk  (1)
     Weighted
Average
Maturity in
Days
 

Bank of America Securities LLC

   $ 409,774         5.0   $ 22,897         23   

Bank of Nova Scotia

     475,356         5.8        16,355         68   

Barclays Capital, Inc.

     418,760         5.1        22,182         51   

BNP Paribas Securities Corp

     281,426         3.4        15,273         44   

Cantor Fitzgerald & Co.

     339,358         4.1        18,836         18   

Citigroup Global Markets, Inc.

     325,948         4.0        18,300         23   

Credit Suisse Securities (USA) LLC

     346,421         4.2        16,916         16   

Daiwa Securities America, Inc.

     256,072         3.1        14,658         52   

Deutsche Bank Securities, Inc.

     521,035         6.3        30,001         10   

Goldman Sachs & Co.

     510,083         6.2        31,208         45   

Guggenheim Liquidity Services, LLC

     142,280         1.7        7,820         53   

Industrial and Commercial Bank of China Financial Services LLC

     396,459         4.8        21,111         59   

ING Financial Markets LLC

     376,629         4.6        21,667         68   

Jefferies & Company, Inc.

     95,215         1.2        5,116         46   

LBBW Securities LLC

     199,000         2.4        11,446         51   

Mitsubishi UFJ Securities (USA), Inc.

     496,061         6.0        27,207         33   

 

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Table of Contents

Counterparty

   Total
Outstanding
Borrowings
     % of
Total
    Amount
At Risk  (1)
     Weighted
Average
Maturity in
Days
 

Mizuho Securities USA, Inc.

     272,747         3.3        15,537         24   

Morgan Stanley & Co. Inc.

     313,475         3.8        17,935         56   

Nomura Securities International, Inc.

     260,097         3.2        16,655         51   

RBC Capital Markets, LLC

     259,284         3.2        15,439         52   

South Street Securities LLC

     314,533         3.8        16,958         19   

The Royal Bank of Scotland PLC

     132,496         1.6        7,932         9   

UBS Securities LLC

     611,930         7.4        34,954         34   

Wells Fargo Securities, LLC

     480,230         5.8        16,677         9   
  

 

 

    

 

 

   

 

 

    
   $ 8,234,669         100.0   $ 443,080      
  

 

 

    

 

 

   

 

 

    

December 31, 2011

 

Counterparty

   Total
Outstanding
Borrowings
     % of
Total
    Amount at
Risk (1)
     Weighted
Average
Maturity in
Days
 

Bank of America Securities LLC

   $ 242,641         3.1   $ 13,845         19   

Bank of Nova Scotia

     416,381         5.3        13,927         33   

Barclays Capital, Inc.

     414,103         5.3        22,235         52   

BNP Paribas Securities Corp

     282,544         3.6        15,142         13   

Cantor Fitzgerald & Co.

     411,499         5.2        23,156         36   

Citigroup Global Markets, Inc.

     244,284         3.1        14,065         20   

Credit Suisse Securities (USA) LLC

     414,021         5.2        20,060         47   

Daiwa Securities America, Inc.

     288,960         3.6        16,082         30   

Deutsche Bank Securities, Inc.

     557,902         7.1        32,141         11   

Goldman Sachs & Co.

     543,768         6.9        30,168         22   

Guggenheim Liquidity Services, LLC

     151,530         1.9        8,472         23   

Industrial and Commercial Bank of China Financial Services LLC

     415,863         5.3        24,429         30   

ING Financial Markets LLC

     419,837         5.3        23,858         19   

Jefferies & Company, Inc.

     101,235         1.3        5,851         17   

LBBW Securities LLC

     206,734         2.6        11,257         45   

Mitsubishi UFJ Securities (USA), Inc.

     482,404         6.1        26,354         35   

Mizuho Securities USA, Inc.

     297,917         3.8        16,528         20   

Morgan Stanley & Co. Inc.

     172,063         2.2        10,320         45   

Nomura Securities International, Inc.

     281,998         3.6        15,257         41   

RBC Capital Markets, LLC

     223,831         2.8        14,008         12   

South Street Securities LLC

     336,394         4.3        22,261         18   

The Royal Bank of Scotland PLC

     143,628         1.8        7,746         10   

UBS Securities LLC

     328,368         4.2        18,683         47   

Wells Fargo Securities, LLC

     502,909         6.4        18,302         10   
  

 

 

    

 

 

   

 

 

    

Total

   $ 7,880,814         100.0   $ 424,147      
  

 

 

    

 

 

   

 

 

    

 

(1) 

Equal to the fair value of pledged securities plus accrued interest income, minus the sum of repurchase agreement liabilities and accrued interest expense.

Our repurchase agreements contain typical provisions and covenants as set forth in the standard master repurchase agreement published by the Securities Industry and Financial Markets Association. Our repurchase agreements generally require us to transfer additional securities to the counterparty in the event the value of the securities then held by the counterparty in the margin account falls below specified levels and contain events of default in cases where we or the counterparty breaches our respective obligations under the agreement.

 

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Table of Contents

We receive margin calls from our repurchase agreement counterparties from time to time in the ordinary course of business similar to other entities in the specialty finance business. We receive two types of margin calls under our repurchase agreements. The first type, which are known as “factor calls,” are margin calls that occur each month and relate to the timing difference between the reduction of principal balances of our Agency RMBS, due to monthly principal payments on the underlying mortgages, and the receipt of the corresponding cash. The second type of margin call we may receive is a “valuation call”, which occurs due to market and interest rate movements. Both factor and valuation margin calls occur if the total value of our assets pledged as collateral to a counterparty drops beyond a threshold level, typically between $100,000 and $500,000. Both types of margin calls require a dollar for dollar restoration of the margin shortfall. Conversely, we may initiate margin calls to our counterparties when the value of our assets pledged as collateral with a counterparty increases above the threshold level, thereby increasing our liquidity. All unrestricted cash and cash equivalents, plus any unpledged securities, are available to satisfy margin calls

As of March 31, 2012 and December 31, 2011, we had approximately $1,044.2 million and $580.0 million, respectively, in Agency RMBS, U.S. Treasury securities and cash and cash equivalents available to satisfy future margin calls. To date, we have maintained sufficient liquidity to meet margin calls, and we have never been unable to satisfy a margin call, although no assurance can be given that we will be able to satisfy requests from our lenders to post additional collateral in the future.

An event of default or termination event under the standard master repurchase agreement would give our counterparty the option to terminate all repurchase transactions existing with us and make any amount due by us to the counterparty to be payable immediately.

We have made and intend to continue to make regular quarterly distributions of all or substantially all of our REIT taxable income to holders of our common stock. On March 8, 2012, we declared a quarterly dividend of $0.50 per share of common stock for the first quarter of 2012, which was paid on April 18, 2012 to stockholders of record on March 23, 2012. In order to qualify as a REIT and to avoid federal corporate income tax on the income that we distribute to our stockholders, we are required to distribute at least 90% of our REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gain, on an annual basis. This requirement can impact our liquidity and capital resources.

For our short term (one year or less) and long term liquidity and capital resource requirements, we also rely on the cash flow from operations, primarily monthly principal and interest payments to be received on our Agency RMBS, as well as any securities offerings authorized by our board of directors.

Based on our current portfolio, leverage rate and available borrowing arrangements, we believe that our cash flow from operations and the utilization of borrowings will be sufficient to enable us to meet anticipated short term (one year or less) liquidity requirements such as funding our investment activities, funding our distributions to stockholders and for general corporate expenses. However, an increase in prepayment rates substantially above our expectations could cause a temporary liquidity shortfall due to the timing of the necessary margin calls on the financing arrangements and the actual receipt of the cash related to principal paydowns. If our cash resources are at any time insufficient to satisfy our liquidity requirements, we may have to issue debt or additional equity securities or sell Agency RMBS in our portfolio. If required, the sale of Agency RMBS at prices lower than their amortized cost would result in realized losses. We believe that we have additional capacity through repurchase agreements to leverage our equity further should the need for additional short term (one year or less) liquidity arise.

We may increase our capital resources by obtaining long term credit facilities or making public or private offerings of equity or debt securities. Such financing will depend on market conditions for capital raises and for the investment of any proceeds. If we are unable to renew, replace or expand our sources of financing on substantially similar terms, it may have an adverse effect on our business and results of operations.

Qualitative and Quantitative Disclosures about Short Term Borrowings

The following table discloses quantitative data about our short term borrowings under repurchase agreements during the three months ended March 31, 2012 and 2011.

 

     Three Months Ended March 31,  
(In millions)    2012     2011  

Outstanding at period end

   $ 8,234.7      $ 5,364.0   

Weighted average rate at period end

     0.34     0.29

Average outstanding during period (1)

   $ 8,194.1      $ 4,207.2   

Weighted average rate during period

     0.33     0.30

Largest month end balance during period

   $ 8,343.9      $ 5,364.0   

 

(1) 

Calculated based on the average month end balance during the period.

 

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Table of Contents

During the three months ended March 31, 2012, our repurchase agreement balance increased due to our February 1, 2012 public offering that allowed us to finance additional asset purchases. Our net assets as of March 31, 2012 were $1,525.8 million compared to the average during the three months ended March 31, 2012 of $1,406.0 million. During the three months ended March 31, 2012, the rate on our repurchase agreements remained relatively stable. During the three months ended March 31, 2011, our repurchase agreement balance increased due to our February 15, 2011 public offering that allowed us to finance additional asset purchases. Our net assets as of March 31, 2011 were $969.2 million compared to the average during the three months ended March 31, 2011 of $838.6 million. During the three months ended March 31, 2011, the rate on our repurchase agreements remained relatively stable.

Inflation

Virtually all of our assets and liabilities are interest rate sensitive in nature. As a result, interest rates and other factors influence our performance far more than inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our financial statements are prepared in accordance with GAAP and our distributions are determined by our board of directors based in part on our REIT taxable income as calculated according to the requirements of the Internal Revenue Code. In each case, our activities and balance sheet are measured with reference to fair value without considering inflation.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

As of March 31, 2012 and December 31, 2011, the primary component of our market risk was interest rate risk, as described below. While we do not seek to avoid risk completely, we do believe that risk can be quantified from historical experience and seek to actively manage risk, to earn sufficient compensation to justify taking risks and to maintain capital levels consistent with the risks we undertake. Our board of directors exercises oversight of risk management in many ways, including overseeing our senior management’s risk-related responsibilities and reviewing management and investment policies and performance against these policies and related benchmarks. See “BusinessRisk Management” in our annual report on Form 10-K for the fiscal year ended December 31, 2011 for a further discussion of our risk mitigation practices.

Interest Rate Risk

We are subject to interest rate risk in connection with our investments in Agency RMBS collateralized by ARMs, hybrid ARMs and fixed rate mortgage loans and our related debt obligations, which are generally repurchase agreements of limited duration that are periodically refinanced at current market rates. We seek to mitigate this risk through utilization of derivative contracts, primarily interest rate swap and cap agreements.

Effect on Net Investment Income. We fund our investments in long term Agency RMBS collateralized by ARMs, hybrid ARMs and fixed rate mortgage loans with short term borrowings under repurchase agreements. During periods of rising interest rates, the borrowing costs associated with those Agency RMBS tend to increase while the income earned on such Agency RMBS (during the fixed rate component of such securities) may remain substantially unchanged. This results in a narrowing of the net interest spread between the related assets and borrowings and may even result in losses.

We are a party to the interest rate swap and contracts as of March 31, 2012 and December 31, 2011 described in detail under Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of OperationsContractual Obligations and Commitments” in this quarterly report on Form 10-Q.

Hedging techniques are partly based on assumed levels of prepayments of our Agency RMBS. If prepayments are slower or faster than assumed, the life of the Agency RMBS will be longer or shorter, which would reduce the effectiveness of any hedging strategies we may use and may cause losses on such transactions.

Occasionally we invest in Agency RMBS collateralized by ARMs which are based on mortgages whose coupon rates reset monthly based on the Monthly Treasury Average (“MTA”). However, our borrowing costs pursuant to our repurchase agreements are generally based on 30-day LIBOR, which may change more quickly than the MTA index. Hence, in a rapidly rising interest rate environment, we would expect our net interest margin to decrease, temporarily. In a falling interest rate environment, we would expect our net interest margin to rise temporarily. For a discussion of the effects of interest rate changes on our Agency RMBS collateralized by hybrid ARMs and fixed-rate mortgages, see “—Extension Risk.

Effect on Fair Value. Another component of interest rate risk is the effect changes in interest rates will have on the fair value of our assets. We face the risk that the fair value of our assets will increase or decrease at different rates than that of our liabilities, including our hedging instruments.

 

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We primarily assess our interest rate risk by estimating the duration of our assets and the duration of our liabilities. Duration essentially measures the market price volatility of financial instruments as interest rates change. We generally calculate duration using various third-party financial models and empirical data. Different models and methodologies can produce different duration numbers for the same securities.

Extension Risk. We invest in Agency RMBS collateralized by hybrid ARMs, which have interest rates that are fixed for the first few years of the loan (typically three, five, seven or 10 years) and thereafter reset periodically on the same basis as Agency RMBS collateralized by ARMs. We compute the projected weighted average life of our Agency RMBS collateralized by hybrid ARMs based on assumptions regarding the rate at which the borrowers will prepay the underlying mortgages. In general, when Agency RMBS collateralized by fixed rate or hybrid ARMs is acquired with borrowings, we may, but are not required to, enter into an interest rate swap agreement or other hedging instrument that effectively fixes our borrowing costs for a period close to the anticipated weighted average life of the fixed rate portion of the related Agency RMBS. This strategy is designed to protect us from rising interest rates by fixing our borrowing costs for the duration of the fixed rate period of the collateral underlying the related Agency RMBS.

We have structured our swaps to expire in conjunction with the estimated weighted average life of the fixed period of the mortgages underlying our Agency RMBS portfolio. However, in a rising interest rate environment, the weighted average life of the fixed rate mortgages underlying our Agency RMBS could extend beyond the term of the swap agreement or other hedging instrument. This could have a negative impact on our results from operations, as borrowing costs would no longer be fixed after the term of the hedging instrument while the income earned on the remaining Agency RMBS would remain fixed for a period of time. This situation may also cause the market value of our Agency RMBS to decline with little or no offsetting gain from the related hedging transactions. In extreme situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses.

Interest Rate Cap Risk. Both the ARMs and hybrid ARMs that collateralize our Agency RMBS are typically subject to periodic and lifetime interest rate caps and floors, which limit the amount by which the security’s interest yield may change during any given period. However, our borrowing costs will not be subject to similar restrictions. Therefore, in a period of increasing interest rates, the interest costs on our borrowings could increase without limitation by caps while the interest rate yields on our Agency RMBS would effectively be limited by caps. This problem will be magnified to the extent that we acquire Agency RMBS that are collateralized by hybrid ARMs that are not fully indexed. In addition, the underlying mortgages may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. This could result in our receipt of less cash income on our Agency RMBS than we need in order to pay the interest cost on our related borrowings. These factors could lower our net investment income or cause a net loss during periods of rising interest rates, which would harm our financial condition, cash flows and results of operations.

Interest Rate Mismatch Risk. We intend to fund a substantial portion of our acquisitions of Agency RMBS with borrowings that, after the effect of hedging, have interest rates based on indices and repricing terms similar to, but of somewhat shorter maturities than, the interest rate indices and repricing terms of the Agency RMBS. Thus, we anticipate that in most cases the interest rate indices and repricing terms of our Agency RMBS and our funding sources will not be identical, thereby creating an interest rate mismatch between assets and liabilities. Therefore, our cost of funds would likely rise or fall more quickly than would our earnings rate on assets. During periods of changing interest rates, such interest rate mismatches could negatively impact our financial condition, cash flows and results of operations. To mitigate interest rate mismatches, we may utilize the hedging strategies discussed above.

Our analysis of risks is based on management’s experience, estimates, models and assumptions. These analyses rely on models which utilize estimates of fair value and interest rate sensitivity. Actual economic conditions or implementation of investment decisions by our management may produce results that differ significantly from the estimates and assumptions used in our models and the projected results reflected herein.

Prepayment Risk

Prepayments are the full or partial repayment of principal prior to the original contractual maturity of a mortgage loan and typically occur due to refinancing of mortgage loans. Prepayment rates for existing Agency RMBS generally increase when prevailing mortgage interest rates fall. In addition, prepayment rates on Agency RMBS collateralized by ARMs and hybrid ARMs generally increase when the difference between long term and short term interest rates declines or becomes negative. Additionally, we currently own Agency RMBS that were purchased at a premium. The prepayment of such Agency RMBS at a rate faster than anticipated would result in a write-off of any remaining capitalized premium amount.

We seek to mitigate our prepayment risk by investing in Agency RMBS with (i) a variety of prepayment characteristics, (ii) prepayment prohibitions and penalties and (iii) prepayment protections, as well as by balancing Agency RMBS purchased at a premium with Agency RMBS purchased at a discount.

 

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Effect on Fair Value and Net Income

Another component of interest rate risk is the effect changes in interest rates will have on the fair value of our assets and our net income exclusive of the effect on fair value. We face the risk that the fair value of our assets and net investment income will increase or decrease at different rates than that of our liabilities, including our hedging instruments.

We primarily assess our interest rate risk by estimating the duration of our assets and the duration of our liabilities. Duration essentially measures the market price volatility of financial instruments as interest rates change. We generally calculate duration using various financial models and empirical data. Different models and methodologies can produce different duration numbers for the same securities.

The following sensitivity analysis table shows the estimated impact of our interest rate-sensitive investments and repurchase agreement liabilities on the fair value of our assets and our net income, exclusive of the effect of changes in fair value on our net income, at March 31, 2012 and December 31, 2011, assuming a static portfolio and that rates instantaneously fall 25, 50 and 75 basis points and rise 25, 50 and 75 basis points.

March 31, 2012

 

Change in Interest Rates

   Projected Change in the
Fair Value of Our Assets*
    Projected Change in
Our Net
Income
 

- 75 basis points

     0.88     7.70

- 50 basis points

     0.87     6.14

- 25 basis points

     0.48     3.03

No Change

     0.00     0.00

+ 25 basis points

     -0.82     -7.73

+ 50 basis points

     -1.63     -15.63

+ 75 basis points

     -2.53     -23.41

December 31, 2011

 

Change in Interest Rates

   Projected Change in the
Fair Value of Our Assets*
    Projected Change in
Our Net
Income
 

- 75 basis points

     0.42     5.52

- 50 basis points

     0.34     4.41

- 25 basis points

     0.20     2.18

No Change

     0.00     0.00

+ 25 basis points

     -0.39     -5.61

+ 50 basis points

     -0.93     -11.17

+ 75 basis points

     -1.59     -16.74

 

*

Analytics provided by The Yield Book® Software

While the charts above reflect the estimated immediate impact of interest rate increases and decreases on a static portfolio, we rebalance our portfolio from time to time either to take advantage or minimize the impact of changes in interest rates. Additionally, the effects of interest rate changes on our portfolio illustrated in the above chart do not take into account the effect that our hedging instruments, mainly interest rate swaps and caps, would have on the fair value of our portfolio, but do take into account the effect that our hedging instruments, would have on our net income exclusive of the effect on fair value. Generally, our interest rate swaps reset in the quarter following changes in interest rates. It is important to note that the impact of changing interest rates on fair value and net income can change significantly when interest rates change beyond 75 basis points from current levels. Therefore, the volatility in the fair value of our assets could increase significantly when interest rates change beyond 75 basis points. In addition, other factors impact the fair value of and net income from our interest rate-sensitive investments and hedging instruments, such as the shape of the yield curve, market expectations as to future interest rate changes and other market conditions. Accordingly, in the event of changes in actual interest rates, the change in the fair value of our assets and our net income would likely differ from that shown above, and such difference might be material and adverse to our stockholders.

 

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Risk Management

Our board of directors exercises its oversight of risk management in many ways, including overseeing our senior management’s risk-related responsibilities, including reviewing management policies and performance against these policies and related benchmarks.

As part of our risk management process, we actively manage the interest rate, liquidity, prepayment and counterparty risks associated with our Agency RMBS portfolio. We seek to mitigate our interest rate risk exposure by entering into various hedging instruments in order to minimize our exposure to potential interest rate mismatches between the interest we earn on our investments and our borrowing costs.

We seek to mitigate our liquidity risks by monitoring our liquidity position on a daily basis and maintaining a prudent level of leverage, which we currently consider to be between six and 10 times the amount of net assets in our overall portfolio, based on current market conditions and various other factors, including the health of the financial institutions that lend to us under our repurchase agreements and the presence of special liquidity programs provided by domestic and foreign central banks.

We seek to mitigate our prepayment risk by investing in Agency RMBS with (i) a variety of prepayment characteristics, (ii) prepayment prohibitions and penalties and (iii) prepayment protections, as well as by balancing Agency RMBS purchased at a premium with Agency RMBS purchased at a discount.

We seek to mitigate our counterparty risk by (i) diversifying our exposure across a broad number of counterparties, (ii) limiting our exposure to any one counterparty and (iii)  monitoring the financial stability of our counterparties.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2012. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of March 31, 2012, our Chief Executive Officer and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective.

There have been no changes in our internal controls over financial reporting that occurred during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

PART II. Other Information

Item 1. Legal Proceedings

The Company is not currently subject to any material legal proceedings.

Item 1A. Risk Factors

There have been no material changes from the risk factors disclosed in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2011, filed with the SEC on February 13, 2012.

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

None.

Item 3. Defaults Upon Senior Securities

None.

 

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Item 4. Mine Safety Disclosures

None.

Item 5. Other Information

None.

Item 6. Exhibits

 

  (a) Exhibits.

 

Exhibit

Number

 

Description of Exhibit

31.1*   Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002
31.2*   Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002
32.1**   Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes – Oxley Act of 2002
32.2**   Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes – Oxley Act of 2002
Exhibit 101.INS XBRL   Instance Document (1)
Exhibit 101.SCH XBRL   Taxonomy Extension Schema Document (1)
Exhibit 101.CAL XBRL   Taxonomy Extension Calculation Linkbase Document (1)
Exhibit 101.DEF XBRL   Additional Taxonomy Extension Definition Linkbase Document Created (1)
Exhibit 101.LAB XBRL   Taxonomy Extension Label Linkbase Document (1)
Exhibit 101.PRE XBRL   Taxonomy Extension Presentation Linkbase Document (1)

 

* Filed herewith.
** Furnished herewith.
(1) Submitted electronically herewith. Attached as Exhibit 101 to this report are the following documents formatted in XBRL (Extensible Business Reporting Language): (i) Statements of Assets and Liabilities at March 31, 2012(Unaudited) and December 31, 2011 (Derived from the audited balance sheet at December 31, 2011); (ii) Condensed Statements of Operations (Unaudited) for the three months ended March 31, 2012 and 2011; (iii) Condensed Statement of Changes in Net Assets (Unaudited) for the three months ended March 31, 2012; (iv) Condensed Statements of Cash Flows (Unaudited) for the three months ended March 31, 2012 and 2011; and (v) Condensed Notes to Financial Statements (Unaudited) for the three months ended March 31, 2012. Users of this data are advised pursuant to Rule 406T of Regulation S-T that this interactive data file is deemed not filed or part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of section 18 of the Securities and Exchange Act of 1934, and otherwise is not subject to liability under these sections.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    CYS INVESTMENTS, INC.
Dated: April 23, 2012     BY:  

/s/ FRANCES R. SPARK

      Frances R. Spark
      Chief Financial Officer and Treasurer
      (Principal Financial Officer and Principal Accounting Officer)

 

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EXHIBIT INDEX

 

Exhibit

Number

 

Description

31.1*   Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002
31.2*   Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002
32.1**   Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes – Oxley Act of 2002
32.2**   Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes – Oxley Act of 2002
Exhibit 101.INS XBRL   Instance Document (1)
Exhibit 101.SCH XBRL   Taxonomy Extension Schema Document (1)
Exhibit 101.CAL XBRL   Taxonomy Extension Calculation Linkbase Document (1)
Exhibit 101.DEF XBRL   Additional Taxonomy Extension Definition Linkbase Document Created (1)
Exhibit 101.LAB XBRL   Taxonomy Extension Label Linkbase Document (1)
Exhibit 101.PRE XBRL   Taxonomy Extension Presentation Linkbase Document (1)

 

* Filed herewith.
** Furnished herewith.
(1) Submitted electronically herewith. Attached as Exhibit 101 to this report are the following documents formatted in XBRL (Extensible Business Reporting Language): (i) Statements of Assets and Liabilities at March 31, 2012(Unaudited) and December 31, 2011 (Derived from the audited balance sheet at December 31, 2011); (ii) Condensed Statements of Operations (Unaudited) for the three months ended March 31, 2012 and 2011; (iii) Condensed Statement of Changes in Net Assets (Unaudited) for the three months ended March 31, 2012; (iv) Condensed Statements of Cash Flows (Unaudited) for the three months ended March 31, 2012 and 2011; and (v) Condensed Notes to Financial Statements (Unaudited) for the three months ended March 31, 2012. Users of this data are advised pursuant to Rule 406T of Regulation S-T that this interactive data file is deemed not filed or part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of section 18 of the Securities and Exchange Act of 1934, and otherwise is not subject to liability under these sections.

 

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