10-Q 1 d235903d10q.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 September 30, 2011

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 001-34030

 

 

HATTERAS FINANCIAL CORP.

(Exact name of registrant as specified in its charter)

 

 

 

Maryland   26-1141886

(State or other jurisdiction

of incorporation or organization)

 

(IRS Employer

Identification No.)

110 Oakwood Drive, Suite 340

Winston Salem, North Carolina

  27103
(Address of principal executive offices)   (Zip Code)

(336) 760-9347

(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 October 28, 2011  

Common Stock ($0.001 par value)

     76,546,720   

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page  

PART I

   Financial Information   

Item 1.

   Financial Statements      3   

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      20   

Item 3.

   Quantitative and Qualitative Disclosures about Market Risk      39   

Item 4.

   Controls and Procedures      43   

PART II

   Other Information   

Item 1.

   Legal Proceedings      43   

Item 1A.

   Risk Factors      43   

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds      44   

Item 3.

   Defaults Upon Senior Securities      44   

Item 4.

   [Removed and Reserved.]      45   

Item 5.

   Other Information      45   

Item 6.

   Exhibits      45   
   Signatures      45   


Table of Contents

Hatteras Financial Corp.

Balance Sheets

 

(In thousands, except per share amounts)    (Unaudited)         
     September 30, 2011      December 31, 2010  

Assets

     

Mortgage-backed securities, at fair value (including pledged assets of $16,638,918 and $9,089,095 at September 30, 2011 and December 31, 2010, respectively)

   $ 17,614,374       $ 9,587,216   

Cash and cash equivalents

     88,338         112,626   

Restricted cash

     279,536         75,422   

Unsettled purchased mortgage-backed securities, at fair value

     143,410         49,710   

Accrued interest receivable

     63,873         37,973   

Principal payments receivable

     126,811         84,151   

Debt security, held to maturity, at cost

     15,000         15,000   

Interest rate hedge asset

     —           23,944   

Other assets

     26,860         20,937   
  

 

 

    

 

 

 

Total assets

   $ 18,358,202       $ 10,006,979   
  

 

 

    

 

 

 

Liabilities and shareholders’ equity

     

Repurchase agreements

   $ 15,886,231       $ 8,681,060   

Payable for unsettled securities

     143,393         49,774   

Accrued interest payable

     2,328         3,177   

Interest rate hedge liability

     233,392         71,681   

Dividend payable

     76,547         46,116   

Accounts payable and other liabilities

     1,308         9,687   
  

 

 

    

 

 

 

Total liabilities

     16,343,199         8,861,495   
  

 

 

    

 

 

 

Shareholders’ equity:

     

Preferred stock, $.001 par value, 10,000,000 shares authorized, none outstanding at September 30, 2011 and December 31, 2010

     —           —     

Common stock, $.001 par value, 100,000,000 shares authorized, 76,546,720 and 46,115,990 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively

     77         46   

Additional paid-in capital

     1,897,172         1,043,027   

Retained earnings

     559         (3,480

Accumulated other comprehensive income

     117,195         105,891   
  

 

 

    

 

 

 

Total shareholders’ equity

     2,015,003         1,145,484   
  

 

 

    

 

 

 

Total liabilities and shareholders’ equity

   $ 18,358,202       $ 10,006,979   
  

 

 

    

 

 

 

See accompanying notes.

 

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Hatteras Financial Corp.

Statements of Income

(Unaudited)

 

(In thousands, except per share amounts)    Three months
Ended
September 30,
2011
     Three months
Ended
September 30,
2010
     Nine months
Ended
September 30,
2011
     Nine months
Ended
September 30,
2010
 

Interest income:

           

Interest income on mortgage-backed securities

   $ 110,125       $ 63,701       $ 310,248       $ 196,083   

Interest income on short-term cash investments

     380         323         1,051         898   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interest income

     110,505         64,024         311,299         196,981   

Interest expense

     40,259         24,066         102,363         71,183   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net interest income

     70,246         39,958         208,936         125,798   
  

 

 

    

 

 

    

 

 

    

 

 

 

Other income:

           

Gain on sale of mortgage-backed securities

     13,330         6,723         17,735         7,767   

Operating expenses:

           

Management fee

     3,572         2,321         10,195         6,700   

Share based compensation

     334         463         735         1,153   

General and administrative

     688         665         1,992         1,934   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total operating expenses

     4,594         3,449         12,922         9,787   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income

   $ 78,982       $ 43,232       $ 213,749       $ 123,778   
  

 

 

    

 

 

    

 

 

    

 

 

 

Earnings per share—common stock, basic

   $ 1.04       $ 1.12       $ 3.05       $ 3.33   
  

 

 

    

 

 

    

 

 

    

 

 

 

Earnings per share—common stock, diluted

   $ 1.04       $ 1.11       $ 3.05       $ 3.32   
  

 

 

    

 

 

    

 

 

    

 

 

 

Dividends per share

   $ 1.00       $ 1.10       $ 3.00       $ 3.40   
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average shares outstanding

     75,743,002         38,765,078         70,057,263         37,214,640   
  

 

 

    

 

 

    

 

 

    

 

 

 

See accompanying notes.

 

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Hatteras Financial Corp.

Statement of Changes in Shareholders’ Equity

For the nine months ended September 30, 2011

(Unaudited)

 

(Dollars in thousands)    Common
Stock
Amount
     Paid-in
Capital
     Retained
Earnings
    Accumulated
Other
Comprehensive
Income
    Total  

Balance at December 31, 2010

   $ 46       $ 1,043,027       $ (3,480   $ 105,891      $ 1,145,484   

Issuance of common stock

     31         853,410         —          —          853,441   

Share based compensation

     —           735         —          —          735   

Dividends declared on common stock

     —           —           (209,710     —          (209,710

Comprehensive income:

            

Net income

     —           —           213,749        —          213,749   

Other comprehensive income:

            

Net unrealized gain on securities available for sale

     —           —           —          182,904        182,904   

Net unrealized loss on derivative instruments

     —           —           —          (171,600     (171,600
            

 

 

 

Comprehensive income

               225,053   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Balance at September 30, 2011

   $ 77       $ 1,897,172       $ 559      $ 117,195      $ 2,015,003   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

See accompanying notes.

 

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Hatteras Financial Corp.

Statements of Cash Flows

(Unaudited)

 

(Dollars in thousands)    For the nine
months ended
September 30,
2011
    For the nine
months ended
September 30,
2010
 

Operating activities

    

Net income

   $ 213,749      $ 123,778   

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

    

Net amortization of premium related to mortgage-backed securities

     60,719        30,213   

Amortization related to interest rate swap agreements

     253        168   

Share based compensation expense

     735        1,153   

Hedge ineffectiveness

     516        300   

Gain on sale of mortgage-backed securities

     (17,735     (7,767

Changes in operating assets and liabilities:

    

(Increase) decrease in accrued interest receivable

     (25,900     1,743   

Increase in other assets

     (1,199     (490

Decrease in accrued interest payable

     (849     (475

Increase (decrease) in accounts payable and other liabilities

     165        (483
  

 

 

   

 

 

 

Net cash provided by operating activities

     230,454        148,140   

Investing activities

    

Purchases of mortgage-backed securities

     (11,327,766     (2,812,829

Principal repayments of mortgage-backed securities

     2,360,742        1,889,571   

Sale of mortgage-backed securities

     1,037,064        331,857   
  

 

 

   

 

 

 

Net cash used in investing activities

     (7,929,960     (591,401

Financing activities

    

Issuance of common stock, net of cost of issuance

     853,441        271,377   

Cash dividends paid

     (179,280     (128,333

Increase in restricted cash

     (204,114     (62,053

Proceeds from repurchase agreements

     118,620,023        54,686,260   

Principal repayments on repurchase agreements

     (111,414,852     (54,354,352
  

 

 

   

 

 

 

Net cash provided by financing activities

     7,675,218        412,899   

Net decrease in cash and cash equivalents

     (24,288     (30,362

Cash and cash equivalents, beginning of period

     112,626        225,828   
  

 

 

   

 

 

 

Cash and cash equivalents, end of period

   $ 88,338      $ 195,466   
  

 

 

   

 

 

 

Supplemental disclosure of cash flow information

    

Cash paid during the period for interest

   $ 103,211      $ 71,658   
  

 

 

   

 

 

 

Supplemental schedule of non-cash financing activities

    

Obligation to brokers incurred for purchase of mortgage-backed securities

   $ 1,395,612      $ 1,961,415   
  

 

 

   

 

 

 

See accompanying notes.

 

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Hatteras Financial Corp.

Notes to Financial Statements

September 30, 2011

(Dollars in thousands except per share amounts)

1. Organization and Business Description

Hatteras Financial Corp. (the “Company”) was incorporated in Maryland on September 19, 2007, and commenced its planned business activities on November 5, 2007, the date of the initial closing of a private issuance of common stock. The Company was formed to invest in residential mortgage-backed securities (“MBS”), issued or guaranteed by the U.S. Government or U.S. Government sponsored agencies such as the Government National Mortgage Association (“Ginnie Mae”), the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) (“Agency MBS”). The Company is externally managed by Atlantic Capital Advisors LLC (“ACA”).

The Company has elected to be taxed as a real estate investment trust (“REIT”). As a result, the Company does not pay federal income taxes on taxable income distributed to shareholders if certain REIT qualification tests are met. It is the Company’s policy to distribute 100% of its taxable income, after application of available tax attributes, within the time limits prescribed by the Internal Revenue Code of 1986, as amended (the “Code”), which may extend into the subsequent taxable year.

2. Summary of Significant Accounting Policies

Basis of Presentation and Use of Estimates

The accompanying unaudited financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and 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. Operating results for the three and nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for the calendar year ending December 31, 2011. These unaudited financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2010.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates affecting the accompanying financial statements include the valuation of MBS and derivative instruments.

Financial Instruments

The Company considers its cash and cash equivalents, restricted cash, MBS (settled and unsettled), forward purchase commitments, debt security held to maturity, accrued interest receivable, accounts payable, derivative instruments, repurchase agreements and accrued interest payable to meet the definition of financial instruments. The carrying amount of cash and cash equivalents, restricted cash, accrued interest receivable and accounts payable approximate their fair value due to the short maturities of these instruments. See Note 4 for discussion of the fair value of MBS and forward purchase commitments. See Note 5 for discussion of the fair value of the held to maturity debt security. See Note 7 for discussion of the fair value of derivatives. The carrying amount of the repurchase agreements and accrued interest payable is deemed to approximate fair value since the lines are based upon a variable rate of interest.

 

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Since inception through September 30, 2011, the Company has limited its exposure to credit losses on its portfolio of securities by purchasing MBS guaranteed by Fannie Mae and Freddie Mac. The portfolio is diversified to avoid undue exposure to loan originator, geographic and other types of concentration. The Company manages the risk of prepayments of the underlying mortgages by creating a diversified portfolio with a variety of prepayment characteristics. See Note 4 for additional information on MBS.

The Company is engaged in various trading and brokerage activities including derivative interest rate swap agreements in which counterparties primarily include broker-dealers, banks, and other financial institutions. In the event counterparties do not fulfill their obligations, the Company may be exposed to risk of loss. The risk of default depends on the creditworthiness of the counterparty and/or issuer of the instrument. It is the Company’s policy to review, as necessary, the credit standing for each counterparty. See Note 7 for additional information on interest rate swap agreements.

Mortgage-Backed Securities

The Company invests in Agency MBS representing interests in or obligations backed by pools of single-family adjustable-rate mortgage loans. Guidance under the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic on Investments requires the Company to classify its investments as either trading, available-for-sale or held-to-maturity securities. Management determines the appropriate classifications of the securities at the time they are acquired and evaluates the appropriateness of such classifications at each balance sheet date. The Company currently classifies all of its Agency MBS as available-for-sale. All assets that are classified as available-for-sale are carried at fair value and unrealized gains and losses are included in other comprehensive income or loss as a component of shareholders’ equity. The estimated fair values of MBS are determined by management by obtaining valuations for its MBS from independent sources and averaging these valuations. Security purchase and sale transactions are recorded on the trade date. Gains or losses realized from the sale of securities are included in income and are determined using the specific identification method. Firm purchase commitments to acquire “when issued” or to-be-announced (“TBA”) securities are recorded at fair value in accordance with ASC Topic 815, Derivatives and Hedging. The fair value of these purchase commitments is included in other assets or liabilities in the accompanying balance sheets.

The Company assesses its investment securities for other-than-temporary impairment on at least a quarterly basis. When the fair value of an investment is less than its amortized cost at the balance sheet date of the reporting period for which impairment is assessed, the impairment is designated as either “temporary” or “other-than-temporary.” In deciding on whether or not a security is other than temporarily impaired, the Company uses a two step evaluation process. First, the Company determines whether it has made any decision to sell a security that is in an unrealized loss position, or, if not, the Company determines whether it is more likely than not that the Company will be required to sell the security prior to recovering its amortized cost basis. If the answer to either of these questions is “yes” then the security is considered other-than-temporarily impaired. There were no such impairment losses recognized during the periods presented.

Interest Income

Interest income is earned and recognized based on the outstanding principal amount of the investment securities and their contractual terms. Premiums and discounts associated with the purchase of the investment securities are amortized or accreted into interest income over the actual lives of the securities using the effective interest method.

Income Taxes

The Company has elected to be taxed as a REIT under the Code. The Company will generally not be subject to Federal income tax to the extent that it distributes 100% of its taxable income, after application of available tax attributes, within the time limits prescribed by the Code and as long as it satisfies the ongoing REIT requirements including meeting certain asset, income and stock ownership tests.

 

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Share-Based Compensation

Share-based compensation is accounted for under the guidance included in the ASC Topic on Stock Compensation. For share and share-based awards issued to employees, a compensation charge is recorded in earnings based on the fair value of the award. For transactions with non-employees in which services are performed in exchange for the Company’s common stock or other equity instruments, the transactions are recorded on the basis of the fair value of the service received or the fair value of the equity instruments issued, whichever is more readily measurable at the date of issuance. The Company’s share-based compensation transactions resulted in compensation expense of $334 and $463 for the three months ended September 30, 2011 and 2010, respectively. The Company’s share-based compensation transactions resulted in compensation expense of $735 and $1,153 for the nine months ended September 30, 2011 and 2010, respectively.

Earnings Per Common Share (EPS)

Basic EPS is computed by dividing net income available to holders of common stock by the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed using the two class method, as described in the ASC Topic on Earnings Per Share, which takes into account certain adjustments related to participating securities. Net income available to holders of common stock after deducting dividends on unvested participating securities if antidilutive, is divided by the weighted average shares of common stock and common equivalent shares outstanding during the period. For the diluted EPS calculation, common equivalent shares outstanding includes the weighted average number of shares of common stock outstanding adjusted for the effect of dilutive unexercised stock options.

Recent Accounting Pronouncements

In April 2011, the FASB issued an Accounting Standard Update, (“ASU”) ASU 2011-03, Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements regarding repurchase agreements. 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 is effective for the first interim or annual period beginning on or after December 15, 2011 and is not expected to have a material effect on the Company’s financial statements.

In May 2011, the FASB issued ASU 2011-04, Fair Value Measurements (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. 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 is effective for the first interim or annual period beginning on or after December 15, 2011 and is not expected to have a material effect on the Company’s financial statements.

In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. ASU 2011-05 eliminates the option to report other comprehensive income and its components in the statement of changes in equity. ASU 2011-05 requires that all nonowner changes in stockholders’ equity be presented in either a single continuous statement of comprehensive income or in two separate but consecutive statements. This update is effective for the first interim or annual period beginning on or after December 15, 2011 and is not expected to have a material effect on the Company’s financial statements.

 

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3. Financial Instruments

The Company’s valuation techniques for financial instruments 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. The ASC Topic on Fair Value Measurements 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.

All of our agency securities and derivative and hedging assets and liabilities were valued using Level 2 inputs at September 30, 2011 and December 31, 2010. The carrying values and approximate fair values of all financial instruments as of September 30, 2011 and December 31, 2010 were as follows:

 

     September 30, 2011      December 31, 2010  
     Carrying
Value
     Fair
Value
     Carrying
Value
     Fair
Value
 

Assets

           

Mortgage backed securities

   $ 17,614,374       $ 17,614,374       $ 9,587,216       $ 9,587,216   

Unsettled purchased mortgage backed securities

     143,410         143,410         49,710         49,710   

Cash and cash equivalents

     88,338         88,338         112,626         112,626   

Restricted cash

     279,536         279,536         75,422         75,422   

Accrued interest receivable

     63,873         63,873         37,973         37,973   

Debt Security

     15,000         15,000         15,000         15,000   

Interest rate hedge asset

     —           —           23,944         23,944   

Forward purchase commitments*

     4,993         4,993         —           —     

Short term investment*

     20,261         20,261         19,943         19,943   

Liabilities

           

Repurchase agreements

   $ 15,886,231       $ 15,886,231       $ 8,681,060       $ 8,681,060   

Payable for unsettled securities

     143,393         143,393         49,774         49,774   

Accrued interest payable

     2,328         2,328         3,177         3,177   

Interest rate hedge liability

     233,392         233,392         71,681         71,681   

Forward purchase commitments**

     —           —           8,545         8,545   

 

* This line item is included in other assets on the balance sheet.
** This line item is included in other liabilities on the balance sheet.

 

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4. Mortgage-Backed Securities

All of the Company’s Agency MBS were classified as available-for-sale and, as such, are reported at their estimated fair value. The Agency MBS market is primarily an over-the-counter market. As such, there are no standard, public market quotations or published trading data for individual Agency MBS. The Company estimates the fair value of our Agency securities based on a market approach using Level 2 inputs, primarily from third-party pricing services and dealer quotes. To validate the prices the Company obtains, to ensure the Company’s fair value determinations are consistent with the ASC Topic on Fair Value Measurements and Disclosures, and to ensure that the Company properly classifies its assets and liabilities in the fair value hierarchy, the Company evaluates the pricing information it receives taking into account factors such as coupon, prepayment experience, fixed/adjustable rate, annual and life caps, coupon index, time to next reset and issuing agency, among other factors.

The third-party pricing services gather trade data and use pricing models that incorporate such factors as coupons, primary mortgage rates, prepayment speeds, spread to the Treasury and interest rate swap curves, periodic and life caps and other similar factors. Traders at broker-dealers function as market-makers for these securities, and these brokers have a direct view of the trading activity. Brokers do not receive compensation for providing pricing information to the Company. The prices received are non-binding offers to trade. The brokers receive data from traders that participate in the active markets for these securities and directly observe numerous trades of securities similar to the securities owned by the Company. The Company’s analysis of fair value for these includes comparing the data received to other information, if available, such as repurchase agreement pricing or internal pricing models.

If the fair value of a security is not available using the Level 2 inputs as described above, or such data appears unreliable, the Company may estimate the fair value of the security using a variety of methods including, but not limited to, other independent pricing services, repurchase agreement pricing, discounted cash flow analysis, matrix pricing, option adjusted spread models and other fundamental analysis of observable market factors. At September 30, 2011, all of the Company’s Agency MBS values were based on third-party sources.

The Company’s MBS portfolio consists solely of Agency MBS, which are backed by a U.S. Government agency or a U.S. Government sponsored entity. The following table presents certain information about the Company’s MBS at September 30, 2011.

 

     MBS
Amortized
Cost
     Gross
Unrealized
Loss
    Gross
Unrealized
Gain
     Estimated
Fair Value
 

Agency MBS

          

Fannie Mae Certificates

          

ARMS

   $ 11,427,141       $ (172   $ 255,762       $ 11,682,731   

Fixed Rate

     705,818         (1,044     599         705,373   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total Fannie Mae

     12,132,959         (1,216     256,361         12,388,104   
  

 

 

    

 

 

   

 

 

    

 

 

 

Freddie Mac Certificates

          

ARMS

     4,710,834         (83     90,263         4,801,014   

Fixed Rate

     425,428         (768     596         425,256   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total Freddie Mae

     5,136,262         (851     90,859         5,226,270   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total Agency MBS

   $ 17,269,221       $ (2,067   $ 347,220       $ 17,614,374   
  

 

 

    

 

 

   

 

 

    

 

 

 

The following table presents certain information about the Company’s MBS at December 31, 2010.

 

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Table of Contents
     MBS
Amortized
Cost
     Gross
Unrealized
Loss
    Gross
Unrealized
Gain
     Estimated
Fair Value
 

Agency MBS

          

Fannie Mae Certificates

          

ARMS

   $ 6,537,472       $ (18,342   $ 138,626       $ 6,657,756   

Fixed Rate

     0         0        0         0   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total Fannie Mae

     6,537,472         (18,342     138,626         6,657,756   
  

 

 

    

 

 

   

 

 

    

 

 

 

Freddie Mac Certificates

          

ARMS

     2,887,432         (14,783     56,811         2,929,460   

Fixed Rate

     0         0        0         0   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total Freddie Mae

     2,887,432         (14,783     56,811         2,929,460   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total Agency MBS

   $ 9,424,904       $ (33,125   $ 195,437       $ 9,587,216   
  

 

 

    

 

 

   

 

 

    

 

 

 

The components of the carrying value of available-for-sale MBS at September 30, 2011 and December 31, 2010 are presented below.

 

     September 30, 2011     December 31, 2010  

Principal balance

   $ 16,853,149      $ 9,228,093   

Unamortized premium

     416,081        196,823   

Unamortized discount

     (9     (12

Gross unrealized gains

     347,220        195,437   

Gross unrealized losses

     (2,067     (33,125
  

 

 

   

 

 

 

Carrying value/estimated fair value

   $ 17,614,374      $ 9,587,216   
  

 

 

   

 

 

 

The Company monitors the performance and market value of its Agency MBS portfolio on an ongoing basis. At September 30, 2011 and December 31, 2010, the Company had the following securities in a loss position presented below:

 

     Less than 12 months
as of September 30, 2011
    Less than 12 months
as of December 31, 2010
 
     Fair Market
Value
     Unrealized
Loss
    Fair Market
Value
     Unrealized
Loss
 

Fannie Mae Certificates

          

ARMS

   $ 110,221       $ (172   $ 1,641,355       $ (18,342

Fixed Rate

     321,195         (1,044     0         0   

Freddie Mac Certificates

          

ARMS

     46,398         (83     1,186,443         (14,783

Fixed Rate

     199,571         (768     0         0   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total temporarily impaired securities

   $ 677,385       $ (2,067   $ 2,827,798       $ (33,125
  

 

 

    

 

 

   

 

 

    

 

 

 

 

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The Company did not make the decision to sell the above securities as of September 30, 2011, nor was it deemed more likely than not the Company would be required to sell these securities before recovery of their amortized cost basis.

The following table presents components of interest income on the Company’s Agency MBS portfolio for the three and nine months ended September 30, 2011 and 2010:

 

     Three Months Ended     Nine Months Ended  
     September 30, 2011     September 30, 2010     September 30, 2011     September 30, 2010  

Coupon interest on MBS

   $ 140,234      $ 73,380      $ 370,967      $ 226,296   

Net premium amortization

     (30,109     (9,679     (60,719     (30,213
  

 

 

   

 

 

   

 

 

   

 

 

 

Interest income on MBS, net

   $ 110,125      $ 63,701      $ 310,248      $ 196,083   
  

 

 

   

 

 

   

 

 

   

 

 

 

The contractual maturity of the Company’s Agency MBS ranges from 15 to 30 years. Because of prepayments on the underlying mortgage loans, the actual weighted-average maturity is expected to be significantly less than the stated maturity. The following table presents certain information about the Company’s Agency MBS that will reprice or amortize based on contractual terms, which do not consider prepayment assumptions at September 30, 2011 and December 31, 2010:

 

            September 30, 2011                  December 31, 2010        
     Fair Value      % of Total     Weighted
Average
Coupon
    Fair Value      % of Total     Weighted
Average
Coupon
 

Months to Coupon Reset or Contractual Payment

              

0 - 18 Months

   $ 1,158,144         6.6     4.76   $ 632,979         6.6     3.80

19 - 36 Months

   $ 962,674         5.5     4.47     1,628,967         17.0     5.15

37 - 60 Months

   $ 8,666,670         49.2     3.41     5,195,155         54.2     3.78

61 - 84 Months

   $ 5,389,188         30.6     3.40     1,938,935         20.2     3.46

85 - 120 Months

   $ 307,070         1.7     3.62     191,180         2.0     3.56

121 - 180 Months

   $ 1,130,628         6.4     3.13     —           —          —     
  

 

 

    

 

 

     

 

 

    

 

 

   

Total MBS

   $ 17,614,374         100.0     3.54   $ 9,587,216         100.0     3.94
  

 

 

    

 

 

     

 

 

    

 

 

   

Unsettled Agency MBS Purchases

While most of the Company’s purchases of Agency MBS are accounted for using trade date accounting, some forward purchases, such as certain TBA’s do not qualify for trade date accounting and are considered derivatives for financial statement purposes. Pursuant to ASC Topic 815, the Company accounts for these derivatives as all-in-one cash flow hedges. The net fair value of the forward commitment is reported on the balance sheet as an asset (or liability), with a corresponding unrealized gain (or loss) recognized in other comprehensive income. The following table shows the Agency MBS forward purchase commitments shown as a net liability on the balance sheet as of September 30, 2011.

 

Face

   Cost      Fair Market
Value
     Due to
Brokers (1)
     Net
Liability
 

$1,214,182

   $ 1,252,220       $ 1,253,194       $ 1,252,220       $ 974   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Amounts due to brokers are usually settled within 30-90 days after period end.

 

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Since the Company purchases forward for the purposes of holding the securities for investment, the Company considers all its Agency MBS, settled or unsettled, as part of its portfolio for the purposes of cash flow and interest rate sensitivity, and consequently hedging, duration measurement, and other related investment management activity.

5. Debt Security, Held to Maturity

The Company acquired a $15,000 debt security from a repurchase lending counterparty that matures May 10, 2012. The debt security bears interest at the rate of 4.5% above the three-month LIBOR rate. The Company estimates the fair value of this note to approximate amortized cost based on the prices of other securities with similar maturities, considering the coupon, the lack of marketability and the non-public nature of the issuer.

6. Repurchase Agreements

At September 30, 2011 and December 31, 2010, the Company had repurchase agreements in place in the amount of $15,886,231 and $8,681,060, respectively, to finance Agency MBS purchases. At September 30, 2011 and December 31, 2010, the weighted average interest rate on these borrowings was 0.29% and 0.44%, respectively. The Company’s repurchase agreements are collateralized by the Company’s Agency MBS and typically bear interest at rates that are based on LIBOR. At September 30, 2011 and December 31, 2010, the Company had repurchase agreements outstanding with 23 and 20 counterparties, respectively, with a weighted average contractual maturity of 0.8 months and 0.9 months, respectively. The following table presents the contractual repricing information regarding the Company’s repurchase agreements:

 

     September 30,2011     December 31, 2010  
     Balance      Weighted Average
Contractual Rate
    Balance      Weighted Average
Contractual Rate
 

Within 30 days

   $ 15,886,231         0.29   $ 7,530,317         0.38

30 days to 3 months

     —           —          1,050,743         0.60

3 months to 36 months

     —           —          100,000         2.96
  

 

 

      

 

 

    
   $ 15,886,231         0.29   $ 8,681,060         0.44
  

 

 

      

 

 

    

7. Derivatives—Interest Rate Swap Agreements

Risk Management Objective of Using Derivatives

The Company is exposed to certain risk arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its debt funding. The Company’s primary source of debt funding is repurchase agreements. Since the interest rate on repurchase agreement changes on a monthly basis, the Company is exposed to constantly changing interest rates, and the cash flows associated with these rates. To mitigate the effect of changes in these interest rates, the Company enters into interest rate swap agreements which help to manage the volatility in the interest rate exposures and their related cash flows.

Cash Flow Hedges of Interest Rate Risk

The Company finances its activities primarily through repurchase agreements, which are generally settled on a short-term basis, usually from one to three months. At each settlement date, the Company refinances each

 

14


Table of Contents

repurchase agreement at the market interest rate at that time. Since the interest rates on its repurchase agreements change on a monthly basis, the Company is constantly exposed to changing interest rates. The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company currently uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. The effect of these hedges is to synthetically lock up interest rates on a portion of the Company’s outstanding debt for the terms of the swaps.

For qualifying derivatives under cash flow hedge accounting, effective hedge gains or losses are initially recorded in accumulated other comprehensive income (loss) and subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During the three months ended September 30, 2011 and 2010, these effective hedge losses totaled $150,557 and $46,982, respectively. During the nine months ended September 30, 2011 and 2010, these effective hedge losses totaled $260,244 and $121,931, respectively. Ineffective hedge losses are recorded on a current basis in earnings and for the three months ended September 30, 2011 and 2010, the Company recorded $130 and $39, respectively. For the nine months ending September 30, 2011 and 2010 the Company recorded $515 and $300, respectively, of hedge ineffectiveness losses in earnings. The hedge ineffectiveness is attributable primarily to differences in the reset dates on the Company’s swaps versus the refinancing dates of its repurchase agreements.

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest is accrued and paid on the Company’s repurchase agreements. During the next 12 months, the Company estimates that an additional $99,528 will be reclassified as an increase to interest expense.

The Company is hedging its exposure to the variability in future cash flows for forecasted transactions over an average period of 36 months. The table below shows the remaining term of the Company’s interest rate swaps as of September 30, 2011.

 

Maturity

   Notional
Amount
     Remaining
Term
in Months
     Weighted Average
Fixed Interest
Rate in Contract
 

12 months or less

   $ 400,000         6         2.64

Over 12 months to 24 months

     900,000         19         2.00

Over 24 months to 36 months

     1,600,000         32         1.92

Over 36 months to 48 months

     4,000,000         43         1.70

Over 48 months to 60 months

     600,000         50         1.56
  

 

 

       

Total

   $ 7,500,000         36         1.82
  

 

 

       

 

 

 

The fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts). The variable cash payments (or receipts) are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves. The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheets as of September 30, 2011 and December 31, 2010, respectively.

 

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Table of Contents
     Asset Derivatives      Liability Derivatives  
     As of September 30, 2011      As of December 31, 2010      As of September 30, 2011      As of December 31, 2010  
     Balance Sheet    Fair Value      Balance Sheet      Fair Value      Balance Sheet    Fair Value      Balance Sheet      Fair Value  

Interest rate hedge

   Interest rate
hedge asset
   $ —          
 
Interest rate
hedge asset
  
  
   $ 23,944       Interest rate
hedge liability
   $ 233,392        
 
Interest rate hedge
liability
  
  
   $ 71,681   

Forward purchase commitment

   Other
assets
   $ 4,993         —         $ —         Account payable
and other liabilities
   $ —           —         $ 8,545   

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three months ended September 30, 2011.

 

Derivative type

for cash flow

hedge

   Amount of loss recognized  in
OCI on derivative (effective
portion)
    

Location of loss

reclassified from

accumulated OCI

into income

(effective portion)

   Amount of loss  reclassified
from accumulated OCI into
income (effective portion)
    

Location of loss

recognized in income

on derivative
(ineffective portion)

   Amount of loss recognized  in
income on derivative
(ineffective portion)
 

Interest Rate

   $ 150,557       Interest Expense    $ 30,694       Interest Expense    $ 130   

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three months ended September 30, 2010.

 

Derivative type

for cash flow

hedge

   Amount of loss recognized  in
OCI on derivative (effective
portion)
    

Location of loss
reclassified from
accumulated OCI

into income

(effective portion)

   Amount of loss  reclassified
from accumulated OCI into
income (effective portion)
    

Location of loss

recognized in income

on derivative

(ineffective portion)

   Amount of loss recognized  in
income on derivative
(ineffective portion)
 

Interest Rate

   $ 46,982       Interest Expense    $ 17,314       Interest Expense    $ 39   

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the nine months ended September 30, 2011.

 

Derivative type

for cash flow

hedge

   Amount of loss recognized  in
OCI on derivative (effective
portion)
    

Location of loss

reclassified from
accumulated OCI

into income

(effective portion)

   Amount of loss  reclassified
from accumulated OCI into
income (effective portion)
    

Location of gain

recognized in income

on derivative

(ineffective portion)

   Amount of gain recognized
in  income on derivative
(ineffective portion)
 

Interest Rate

   $ 260,244       Interest Expense    $ 75,106       Interest Expense    $ 515   

 

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Table of Contents

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the nine months ended September 30, 2010.

 

Derivative type

for cash flow

hedge

   Amount of loss recognized  in
OCI on derivative
(effective portion)
    

Location of loss

reclassified from
accumulated OCI

into income

(effective portion)

   Amount of loss reclassified
from accumulated OCI into
income (effective portion)
    

Location of loss
recognized in income

on derivative
(ineffective portion)

   Amount of loss recognized in
income on derivative
(ineffective portion)
 

Interest Rate

   $ 121,931       Interest Expense    $ 47,529       Interest Expense    $ 300   

The following table presents the impact of the Company’s interest rate swap agreements on the Company’s accumulated other comprehensive income for the nine months ended September 30, 2011 and the year ended December 31, 2010, respectively.

 

     September 30, 2011     December 31, 2010  

Beginning balance

   $ (47,676   $ (35,742

Unrealized loss on interest rate swaps

     (260,244     (80,351

Reclassification of net losses included in income statement

     75,106        68,417   
  

 

 

   

 

 

 

Ending balance

   $ (232,814   $ (47,676
  

 

 

   

 

 

 

Credit-risk-related Contingent Features

The Company has agreements with certain of its derivative counterparties that contain a provision where if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender then the Company could also be declared in default on its derivative obligations.

The Company has agreements with certain of its derivative counterparties that contain a provision where if the Company’s GAAP shareholders’ equity declines by a specified percentage over a specified time period, or if the Company fails to maintain a minimum shareholders’ equity threshold, then the Company could be declared in default on its derivative obligations. The Company has an agreement with one of its derivative counterparties that contain a provision where if the Company exceeds a leverage ratio of 12 to 1 then the Company could be declared in default on its derivative obligations with that counterparty.

As of September 30, 2011, the fair value of derivatives in a net liability position related to these agreements was $233,392. The Company has collateral posting requirements with each of its counterparties and all interest rate swap agreements were fully collateralized as of September 30, 2011. At September 30, 2011 the Company was in compliance with these requirements.

8. Capital Stock

Issuance of Common Stock – CEO Program

On October 9, 2009, the Company entered into a Sales Agreement (the “Sales Agreement”) with Cantor Fitzgerald & Co. (“Cantor”) to create a controlled equity offering program (the “CEO Program”). Under the terms of the Sales Agreement, the Company may offer and sell up to 5,000,000 shares of its common stock from time to time through Cantor, acting as agent and/or principal. Sales of the shares of common stock, if any, may be made in private transactions, negotiated transactions or any method permitted by law deemed to an “at the market” offering as

 

17


Table of Contents

defined in Rule 415 under the Securities Act of 1933, as amended, including sales made directly on the New York Stock Exchange (“NYSE”) or to or through a market maker other than on an exchange. For the three months ended September 30, 2011, the Company issued 1,295,000 shares of common stock in at-the-market transactions, raising net proceeds to the Company, after sales commissions and fees, of $35,704. For the nine months ended September 30, 2011, the Company issued 2,090,000 shares of common stock in at-the-market transactions, raising net proceeds to the Company, after sales commissions and fees, of $59,038. The total commissions and fees charged to additional paid in capital in connection with the issuance of these shares were $487 and $857, respectively, for the three and nine months ended September 30, 2011. The shares of common stock issuable pursuant to the CEO Program are registered with the SEC on the Company’s Registration Statement on Form S-3 (No. 333-159145), which became effective upon filing on October 9, 2009.

9. Earnings per Share

 

     For the three months ended      For the nine months ended  
     September 30, 2011      September 30, 2010      September 30, 2011      September 30, 2010  

Basic earnings per share:

           

Net income

   $ 78,982       $ 43,232       $ 213,749       $ 123,778   
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average shares

     75,743,002         38,765,078         70,057,263         37,214,640   
  

 

 

    

 

 

    

 

 

    

 

 

 

Basic earnings per share

   $ 1.04       $ 1.12       $ 3.05       $ 3.33   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted earnings per share:

           

Net income

   $ 78,982       $ 43,232       $ 213,749       $ 123,778   
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average shares

     75,743,002         38,765,078         70,057,263         37,214,640   

Potential dilutive shares from exercise of stock options

     —           25,288         —           21,967   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted weighted average shares

     75,743,002         38,790,366         70,057,263         37,236,607   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted earnings per share

   $ 1.04       $ 1.11       $ 3.05       $ 3.32   
  

 

 

    

 

 

    

 

 

    

 

 

 

10. Transactions with Related Parties

Management Fees

The Company is externally managed by ACA pursuant to a management agreement (the “Management Agreement”). All of the Company’s executive officers are also employees of ACA. ACA manages the Company’s day-to-day operations, subject to the direction and oversight of the Company’s Board of Directors which includes four independent directors. The Management Agreement expires on November 5, 2011 and is thereafter automatically renewed for an additional one-year term unless terminated under certain circumstances. ACA must be provided 180 days prior notice of any such termination and will be paid a termination fee equal to three times the average annual management fee earned by ACA during the two year period immediately preceding termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination. Certain terminations involving the internalization of the Company’s management, however, may result in no or a capped termination fee.

 

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Table of Contents

Under the terms of the Management Agreement, the Company is responsible for all operating expenses of the Company other than those borne by ACA. ACA is generally responsible for costs incident to the performance of its duties, such as compensation of its employees and various overhead expenses. ACA is entitled to receive a management fee payable monthly in arrears in an amount equal to 1/12th of an amount determined as follows:

 

   

for the Company’s equity up to $250 million, 1.50% (per annum) of equity; plus

 

   

for the Company’s equity in excess of $250 million and up to $500 million, 1.10% (per annum) of equity; plus

 

   

for the Company’s equity in excess of $500 million and up to $750 million, 0.80% (per annum) of equity; plus

 

   

for the Company’s equity in excess of $750 million, 0.50% (per annum) of equity.

For purposes of calculating the management fee, equity is defined as the value, computed in accordance with GAAP, of shareholders’ equity, adjusted to exclude the effects of unrealized gains or losses. For the three months ended September 30, 2011 and 2010, the Company incurred $3,572 and $2,321 in management fees, respectively. For the nine months ended September 30, 2011 and 2010, the Company incurred $10,195 and $6,700 in management fees, respectively. At September 30, 2011 and December 31, 2010, the Company owed ACA $1,187 and $828, respectively, for the management fee, which is included in accounts payable and other liabilities.

11. Accumulated Other Comprehensive Income

Accumulated other comprehensive income consists of the following components:

 

     September 30, 2011     December 31, 2010  

Unrealized gain on agency securities, net

     345,153      $ 162,312   

Unrealized gain (loss) on unsettled securities

     17        (64

Unrealized loss on short term investment*

     (154     (136

Unrealized loss on derivative instruments

     (227,821     (56,221
  

 

 

   

 

 

 

Accumulated other comprehensive income

     117,195        105,891   
  

 

 

   

 

 

 

 

* This line item is included in Other Assets on the Balance Sheet.

The Company records unrealized gains and losses on its MBS and swap positions as is described in Notes 4 and 7, respectively. Reclassification adjustment for realized gains and losses on the sale of securities included in unrealized gains and losses on available-for-sale securities at September 30, 2011 and December 31, 2010 was approximately $17,735 and $13,551, respectively.

Comprehensive income for the three and nine months ended September 30, 2011 and 2010 consists of the following components:

 

     Three months ended     Six months ended  
     September 30, 2011     September 30, 2010     September 30, 2011     September 30, 2010  

Net Income

   $ 78,982      $ 43,232      $ 213,749      $ 123,778   

Unrealized gain on securities

     85,953        18,744        182,904        59,538   

Unrealized loss on derivative instruments

     (116,032     (25,455     (171,600     (61,659
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income

   $ 48,903      $ 36,521      $ 225,053      $ 121,657   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents
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 Hatteras Financial Corp. 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: “MBS” refers to mortgage-backed securities; “Agency MBS” and “agency securities” refer to our residential MBS that are issued or guaranteed by a U.S. Government sponsored entity, 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” refer to adjustable-rate mortgage loans which typically either 1) at all times have interest rates that adjust periodically to an increment over a specified interest rate index; or 2) 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 Part 1, Item 1 of this quarterly report on Form 10-Q as well as our Annual Report on Form 10-K for the year ended December 31, 2010, filed with the Securities and Exchange Commission (“SEC”) on February 18, 2011.

Forward-Looking Statements

When used in this quarterly report on Form 10-Q, in future filings with the 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 (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and, as such, may involve known and unknown risks, uncertainties and assumptions.

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: 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, the credit markets, the general economy or the real estate market; changes in interest rates and the market value of our agency securities; changes in the prepayment rates on the mortgage loans securing our agency securities; our ability to borrow to finance our assets; changes in government regulations affecting our business; our ability to maintain our qualification as a real estate investment trust (“REIT”) for federal income tax purposes; our ability to maintain our exemption from registration under the Investment Company Act of 1940, as amended (the “Investment Company Act”); 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 in our annual report on Form 10-K for the year ended December 31, 2010, including those set forth under the section captioned “Risk Factors” in our quarterly and current reports that we file with the SEC, 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.

 

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Overview

We are an externally-managed mortgage REIT that invests primarily in single-family residential mortgage pass-through securities guaranteed or issued by a U.S. Government agency (such as the Ginnie Mae), or by a U.S. Government-sponsored entity (such as the Fannie Mae and Freddie Mac). We refer to these securities as “agency securities.” We were incorporated in Maryland in September 2007 and commenced operations in November 2007. Our common stock is listed on the New York Stock Exchange (“NYSE”) under the symbol “HTS.”

We are externally-managed and advised by our manager, Atlantic Capital Advisors LLC.

We are organized and conduct our operations to qualify as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”), and generally are not subject to federal taxes on our income to the extent we distribute our income to our shareholders and maintain our qualification as a REIT.

Our principal goal is to generate net income for distribution to our shareholders, through regular quarterly dividends, from the difference between the interest income on our investment portfolio and the interest costs of our borrowings and hedging activities, which we refer to as our net interest income, and other expenses. In general, our strategy is to manage interest rate risk while trying to eliminate any exposure to credit risk. We believe that the best approach to generating a positive net interest income is to manage our liabilities in relation to the interest rate risks of our investments. To help achieve this result, we employ repurchase financing, generally short-term, and combine our financings with hedging techniques, relying primarily on interest rate swaps. We may, subject to maintaining our REIT qualification, also employ other hedging techniques from time to time, including interest rate caps, floors and swap options to protect against adverse interest rate movements.

We focus on agency securities consisting of mortgage loans with short effective durations, which we believe limits the impact of changes in interest rates on the market value of our portfolio and on our net interest income. However, because our investments vary in interest rate, prepayment speed and maturity, the leverage or borrowings that we employ to fund our asset purchases will never exactly match the terms or performance of our assets, even after we have employed our hedging techniques. Based on our manager’s experience, the interest rates of our assets will change more slowly than the corresponding short-term borrowings used to finance our assets. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net income and shareholders’ equity.

Our manager’s approach to managing our portfolio is to take a longer term view of assets and liabilities; accordingly, our periodic earnings and mark-to-market valuations at the end of a period will not significantly influence our strategy of providing stable cash distributions to shareholders over the long term. Our manager has invested and seeks to invest in agency securities that it believes are likely to generate attractive risk-adjusted returns on capital invested, after considering (1) the amount and nature of anticipated cash flows from the asset, (2) our ability to borrow against the asset, (3) the capital requirements resulting from the purchase and financing of the asset, and (4) the costs of financing, hedging, and managing the asset.

Our focus on asset selection is to own assets with short durations and predictable prepayment characteristics. Since our formation, all of our invested assets have been in agency securities, and we currently intend that our investment assets will continue to be agency securities. These agency securities currently consist of mortgages that have principal and interest payments guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac. We invest in both fixed-rate and adjustable-rate agency securities. ARMs are mortgages that have floating interest rates that reset on a specific time schedule, such as monthly, quarterly or annually, based on a specified index, such as the 12-month moving average of the one-year constant maturity U.S. Treasury rate (“CMT) or the London Interbank Offered Rate (“LIBOR”). The ARMs we generally invest in, sometimes referred to as hybrid ARMS, have interest rates that are fixed for an initial period (typically three, five, seven or 10 years) and then reset annually thereafter to an increment over a pre-determined interest rate index. As of September 30, 2011, our portfolio consisted of approximately $19.0 billion in market value of Agency MBS, consisting of $17.8 billion of adjustable-rate securities and $1.2 billion of fixed rate securities.

We are organized and conduct our operations to qualify as a REIT under the Code, and generally are not subject to federal taxes on our income to the extent we currently distribute our income to our shareholders and maintain our qualification as a REIT.

 

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The following table represents key data regarding our company since January 1, 2009:

(in thousands except per share amounts)

 

As of    Agency MBS (1)      Repurchase
Agreements
     Equity      Shares
Outstanding
     Book Value
Per Share
     Quarterly Weighted
Average Earnings
Per Share
 

September 30, 2011

   $ 19,014,997       $ 15,886,231       $ 2,015,003         76,547       $ 26.32       $ 1.04   

June 30, 2011

   $ 16,678,511       $ 14,800,594       $ 2,006,606         75,092       $ 26.72       $ 1.04   

March 31, 2011

   $ 14,811,137       $ 11,495,749       $ 1,894,540         72,572       $ 26.11       $ 0.96   

December 31, 2010

   $ 10,418,764       $ 8,681,060       $ 1,145,484         46,116       $ 24.84       $ 0.99   

September 30, 2010

   $ 9,581,916       $ 6,678,426       $ 1,190,313         46,085       $ 25.83       $ 1.12   

June 30, 2010

   $ 7,651,266       $ 5,982,998       $ 965,619         37,388       $ 25.83       $ 1.01   

March 31, 2010

   $ 7,125,065       $ 6,102,661       $ 929,433         36,472       $ 25.48       $ 1.21   

December 31, 2009

   $ 7,038,987       $ 6,346,518       $ 931,713         36,200       $ 25.74       $ 1.28   

September 30, 2009

   $ 7,303,441       $ 6,007,909       $ 943,597         36,200       $ 26.07       $ 1.26   

June 30, 2009

   $ 6,699,512       $ 5,496,854       $ 865,204         36,200       $ 23.90       $ 1.20   

March 31, 2009

   $ 6,329,731       $ 5,250,382       $ 803,575         36,192       $ 22.20       $ 1.07   

 

(1) Includes gross unsettled purchases and forward commitments to purchase agency MBS.

Factors that Affect our Results of Operations and Financial Condition

Our results of operations and financial condition are affected by various factors, many of which are beyond our control, including, among other things, our net interest income, the market value of our assets and the supply of and demand for such assets. We invest in financial assets and markets, and recent events, those discussed below, can affect our business in ways that are difficult to predict, and produce results outside of typical operating variances. Our net interest income varies primarily as a result of changes in interest rates, borrowing costs and prepayment speeds, the behavior of which involves various risks and uncertainties. Prepayment rates, as reflected by the rate of principal paydown, and interest rates vary according to the type of investment, conditions in financial markets, government actions, competition and other factors, none of which can be predicted with any certainty. In general, as prepayment rates on our agency securities purchased at a premium increase, related purchase premium amortization increases, thereby reducing the net yield on such assets. Because changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our ability to manage interest rate risks and prepayment risks effectively while maintaining our status as a REIT.

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 our borrowings, such assets will reprice more slowly than the corresponding liabilities. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net interest income. With the maturities of our assets generally of longer term than those of our liabilities, interest rate increases will tend to decrease our net interest income. Rate increases may also have a depressing impact on the market value of our assets (and therefore our book value), albeit temporary, as, unless sold beforehand, these assets will ultimately be redeemed at par. Such rate increases could possibly result in operating losses or adversely affect our ability to make distributions to our shareholders.

Prepayments on agency securities and the underlying mortgage loans may be influenced by changes in market interest rates and a variety of economic, geographic and other factors beyond our control; and consequently, such prepayment rates cannot be predicted with certainty. To the extent we have acquired agency securities at a premium or discount to par, or face value, changes in prepayment rates may impact our anticipated yield. In periods of declining interest rates, prepayments on our agency securities will likely increase. Such prepayments accelerate the losses of any initial premiums paid on asset related assets. Moreover, if we are unable to reinvest the proceeds

 

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of these prepayments at comparable yields, our net interest income may suffer further. The current climate of government intervention in the mortgage markets significantly increases the risk associated with prepayments.

While we intend to use hedging to mitigate some of our interest rate risk, we do not intend to hedge all of our exposure to changes in interest rates and prepayment rates, as 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 seek attractive net spreads on our portfolio.

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

 

   

our degree of leverage;

 

   

our access to funding and borrowing capacity;

 

   

our hedging activities;

 

   

changes in the credit ratings of the securities in our portfolio; and

 

   

the REIT requirements, the requirements to qualify for an exemption under the Investment Company Act and other regulatory and accounting policies related to our business.

Our manager is entitled to receive a management fee that is based on our equity (as defined in our management agreement), regardless of the performance of our portfolio. Accordingly, the payment of our management fee may not decline in the event of a decline in our profitability and may cause us to incur losses.

For a discussion of additional risks relating to our business see the section captioned “Risk Factors” in Part II, Item 1A of this Form 10-Q, and in our Annual Report on Form 10-K for the year ended December 31, 2010.

Market and Interest Rate Trends and the Effect on our Portfolio

Credit Market Disruptions

Since 2007, the residential housing and mortgage markets in the United States have experienced a variety of difficulties and changed economic conditions including loan defaults, credit losses and decreased liquidity. These conditions have resulted in volatility in the value of residential MBS, including agency securities. Recently, the financial weakness of the European Union sovereign nations, particularly the default of Greece, has renewed concerns of the stability of financial systems worldwide. Further increased volatility and deterioration in the broader residential mortgage and residential MBS markets may adversely affect the performance and market value of the agency securities in which we invest. In addition, we rely on the availability of financing to acquire agency securities on a leveraged basis. If market conditions deteriorate further, our lenders may exit the repurchase market, further tighten lending standards, or increase the amount of equity capital (or “haircut”) required to obtain financing, any of which could make it more difficult or costly for us to obtain financing.

Developments at Fannie Mae and Freddie Mac

Payments on the agency securities in which we invest are guaranteed by Fannie Mae and Freddie Mac. Because of the guarantee and the underwriting standards associated with mortgages underlying agency securities, agency securities historically have had high stability in value and have been considered to present low credit risk. In 2008, Fannie Mae and Freddie Mac were placed under the conservatorship of the U.S. government due to the significant weakness of their financial condition. The turmoil in the residential mortgage sector and concern over the future role of Fannie Mae and Freddie Mac at the time generally increased credit spreads and decreased price stability of agency securities. In response to the credit market disruption and the deteriorating financial condition of Fannie Mae and Freddie Mac, Congress and the U.S. Department of the Treasury (the “U.S. Treasury”) undertook a

 

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series of actions in 2008 aimed at stabilizing the financial markets in general, and the mortgage market in particular. These actions include the large-scale buying of mortgage-backed securities, significant equity infusions into banks and aggressive monetary policy.

In February 2011, the U.S. Treasury along with the U.S. Department of Housing and Urban Development released a report entitled “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 securities as the method of reform is undecided and has not yet been defined by the regulators. Without government support for residential mortgages, we may not be able to execute our current business model in an efficient manner.

U.S. Treasury Market Intervention

One of the main factors impacting market prices has been the U.S. Federal Reserve System’s (the “U.S. Federal Reserve”) programs to purchase Treasury and agency securities in the open market. The most significant of these programs commenced in January 2009 and was terminated on March 31, 2010. In total, $1.25 trillion of agency securities was purchased. In November 2010, the U.S. Federal Reserve announced another program to purchase an additional $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. On September 21, 2011, the U.S. Federal Reserve, in a program dubbed “Operation Twist,” announced that they intend to sell $400 billion shorter term U.S. Treasury securities by the end of June 2012, and reinvest the proceeds to purchase longer term U.S. Treasury securities with a goal of further monetary stimulus. They also announced that they will continue to reinvest principal repayments from agency securities back into agency securities.

These programs have had many effects on our assets. One effect of these purchases has been an increase in the prices of agency securities, which has decreased our net interest margin. The unpredictability of these programs has also injected additional volatility into the pricing and availability of our assets. It is difficult to quantify the impact, as there are many factors at work at the same time which affects the price of our securities and, therefore, our yield and book value. Due to the unpredictability in the markets for our securities in particular and yield generating assets in general, there is no pattern that can be implied with any certainty. We believe the largest risk is that if the government decides to sell significant portions of its portfolio, then we may see meaningful price declines.

U.S Government Credit Rating

The current U.S. debt ceiling and budget deficit concerns led to the downgrade by Standard & Poor’s of the U.S. government’s credit rating for the first time in history. As assets backed by Fannie Mae and Freddie Mac are considered to have the credit of the U.S. government, and thus were also downgraded at that time. While the other rating agencies have not downgraded the U.S. government’s rating, if they were to do so it would likely impact the perceived credit risk associated with Agency MBS and, therefore, decrease the value of the Agency MBS in our portfolio. In addition, further downgrades of the U.S. government’s credit rating would likely create broader financial turmoil and uncertainty, which could have a serious negative impact on the global banking system. This could have an adverse impact on our business, financial condition and results of operations.

Regulatory Concerns

We believe that we conduct our business in a manner that allows us to avoid being regulated as an investment company under the Investment Company Act pursuant to the exemption provided by Section 3(c)(5)(C) for entities that are primarily engaged in the business of purchasing or otherwise acquiring “mortgages and other liens on and interests in real estate.” On September 1, 2011, the SEC issued a concept release (No. IC-29778; File No. SW7-34-11, Companies Engaged in the Business of Acquiring Mortgages and Mortgage-Related Instruments) pursuant to which it is reviewing whether certain companies that invest in MBS and rely on the exemption from registration

 

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under Section 3(c)(5)(C) of the Investment Company Act (such as us) should continue to be allowed to rely on such exemption from registration. If we fail to continue to qualify for this exemption from registration as an investment company, or the SEC determines that companies that invest in MBS are no longer able to rely on this exemption, our ability to use leverage would be substantially reduced and we would be unable to conduct our business as planned, or we may be required to register as an investment company under the Investment Company Act, either of which could negatively affect the value of shares of our common stock and our ability to make distributions to our shareholders.

Certain programs initiated by the U.S. Government, through the Federal Housing Administration and the Federal Deposit Insurance Corporation (“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 securities could be that such holders would experience changes in the anticipated yields of their agency securities due to (i) increased prepayment rates and (ii) lower interest and principal payments.

On July 21, 2010, President Obama signed the Dodd-Frank Act into law. The Dodd-Frank Act is extensive, complicated and comprehensive legislation that impacts practically all aspects of banking, and 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 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 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 securities and interest rate swaps as much of the bill’s implementation has not yet been defined by the regulators.

 

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In addition, in 2010, the Group of Governors and Heads of Supervisors of the Basel Committee on Banking Supervision, the oversight body of the Basel Committee, published its “calibrated” capital standards for major banking institutions (“Basel III”). Under these standards, when fully phased in on January 1, 2019, banking institutions will be required to maintain heightened Tier 1 common equity, Tier 1 capital and total capital ratios, as well as maintaining a “capital conservation buffer.” Beginning with the Tier 1 common equity and Tier 1 capital ratio requirements, Basel III will be phased in incrementally between January 1, 2013 and January 1, 2019. The final package of Basel III reforms were approved by the G20 leaders in November 2010 and are subject to individual adoption by member nations, including the United States by January 1, 2013. It is unclear how the adoption of Basel III will affect our business at this time.

On October 24, 2011, the Federal Housing Finance Agency (“FHFA”) announced that it is revamping and expanding the rules regarding the Home Affordable Refinance Program (“HARP”) with the intent of increasing significantly the number of homeowners eligible to refinance their mortgage under this program. While final guidance is not due until November 15, 2011, the FHFA announced the relaxation of underwriting guidelines, such as loan-to-value, appraisals, and certain fees, among other things, subject to a variety of qualifications. The expansion does not change the time period which these loans were originated, maintaining the requirement that the loans must have been guaranteed by Fannie Mae or Freddie Mac prior to June 2009. We do not expect this announcement to have a significant impact on our results of operations. The following table shows our loan portfolio which could be impacted by this program.

 

Gross Weighted-Average Coupon

   Outstanding
Current Face
     Percentage of
Total Portfolio(1)
    Weighted
Average
Cost Basis
     Weighted
Average
Months to Reset

4.51 - 5.00

   $ 117,990,687         0.69   $ 101.41       28

5.01 - 5.50

     852,990,780         5.02     101.44       24

5.51 - 6.00

     744,995,096         4.38     101.34       25

6.01 - 6.50

     501,562,760         2.95     101.11       19

6.51 - 7.00

     61,282,239         0.36     101.07       15
  

 

 

    

 

 

      

Total

   $ 2,278,821,562         13.40     

 

(1) Paper issued on or before June ‘09 as % of Total MBS Portfolio.

Interest Rates

Mortgage markets in general, and our strategy in particular, are interest rate sensitive. The relationship between several interest rates is generally determinant of the performance of our company. Our borrowings in the repurchase market have historically closely tracked LIBOR and Federal Funds. Significant volatility in these rates or a divergence from the historical relationship among these rates could negatively impact our ability to manage our portfolio. The MBS we buy are affected by the shape of the yield curve, particularly along the area between two year Treasury rate and 10 year Treasury rates. The following table shows the 30-day LIBOR as compared to these rates at each period end:

 

     30- day
LIBOR
    Fed Funds     Two Year
Treasury
    10 Year
Treasury
 

September 30, 2011

     0.24     0.25     0.25     1.92

June 30, 2011

     0.19     0.25     0.46     3.16

March 31, 2011

     0.24     0.25     0.83     3.47

December 31, 2010

     0.26     0.25     0.60     3.30

September 30, 2010

     0.26     0.25     0.43     2.51

June 30, 2010

     0.35     0.25     0.61     2.93

 

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March 31, 2010

     0.25     0.25     1.02     3.83

December 31, 2009

     0.23     0.25     1.14     3.84

September 30, 2009

     0.25     0.25     0.95     3.31

June 30, 2009

     0.31     0.25     1.11     3.53

March 31, 2009

     0.50     0.25     0.80     2.66

At its regularly scheduled meeting on August 8, 2011, the U.S. Federal Reserve stated that economic conditions were “likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” Generally the Federal Reserve has not made public its intentions for anything more than a short period of time. This statement, while appearing to remove near-term rising rates as a risk to the results of our operations, does not rule out changes in their strategy at any period.

Principal Repayment Rate

Our net income is primarily a function of the difference between the yield on our assets and the financing cost of owning those assets. Since we tend to purchase assets at a premium to par, the main item that can affect the yield on our assets after they are purchased is the rate at which the mortgage borrowers repay the loan. While the scheduled repayments, which are the principal portion of the homeowners’ regular monthly payments, are fairly predictable, the unscheduled repayments, which are generally refinancing of the mortgage, are less so. Being able to accurately estimate and manage these repayment rates is a critical portion of the management of our portfolio, not only for estimating current yield but also to consider the rate of reinvestment of those proceeds into new securities and the yields which those new securities may add to our portfolio. The following table shows the average principal repayment rate for each quarter since our commencement of operations:

 

Quarter ended    Average
Quarterly Principal
Repayment Rate
    Average Rate
Annualized
 

September 30, 2011

     7.14     28.55

June 30, 2011

     4.64     18.54

March 31, 2011

     5.61     22.44

December 31, 2010

     7.81     31.26

September 30, 2010

     8.48     33.91

June 30, 2010

     11.27     45.08

March 31, 2010

     9.01     36.04

December 31, 2009

     5.67     22.70

September 30, 2009

     5.56     22.26

June 30, 2009

     5.23     20.93

March 31, 2009

     3.09     12.36

Investing the Proceeds of our Offerings

Due to the regulation requiring the distribution of REIT income, our ability to grow our company is based on raising additional equity capital. We began operations following the consummation of our initial private offering on November 5, 2007. We raised additional private equity again in February 2008 and completed our initial public offering in April 2008. We have completed four follow-on offering transactions since that time. The following is a summary of these transactions:

 

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(Dollars in thousands except per share amounts)

 

Date of Offering

   Number of Shares of
Common Stock Sold
     Offering Price
Per Share
     Net Proceeds (1)  

March 18, 2011

     16,675,000       $ 28.50       $ 468,765   

January 5, 2011

     11,500,000       $ 28.75       $ 325,707   

September 21, 2010

     7,475,000       $ 28.75       $ 205,642   

December 15, 2008

     9,409,090       $ 22.00       $ 196,463   

April 30, 2008 (IPO)

     11,500,000       $ 24.00       $ 255,440   

February 5, 2008

     6,900,000       $ 24.00       $ 158,743   

November 5, 2007

     8,203,937       $ 20.00       $ 157,054   

 

(1) After deducting underwriting costs and other fees and costs associates with issuance.

While our operations are affected in many ways by the issuance of additional shares, a significant earnings impact may be that we are not able to invest all of the proceeds immediately. Depending on market conditions, and considering the fact that normal trade settlement on agency securities is not based on the trade date, on average, we have invested the proceeds from these offerings in approximately two months from the date of these offerings. Since each capital raise was individually significant to the size of our portfolio, our results from operations, and some statistics regarding such results, may not be meaningful or portray the underlying fundamentals of our investment portfolio.

Book Value per Share

As of September 30, 2011, our book value per share of common stock (total shareholders’ equity divided by shares of common stock outstanding) was $26.32, an increase of $1.48, from $24.84 at December 31, 2010. This increase can be attributed in part to our common equity offerings during the first nine months of 2011, all of which were done at prices which were above our then current book value per share. The unrealized gain per share on our MBS increased slightly, while the unrealized loss per share on our interest rate swaps also increased. Although we attempt to structure our interest rate swap portfolio to offset the changes in asset prices, the price movements of the swaps and mortgage-backed securities are not perfectly correlated, and depend on various market forces. The following table shows the components of our book value on a per share basis at each period end:

 

As of    Common
Equity
     Undistributed
Earnings
  Unrealized
Gain/(Loss)
on MBS
     Unrealized
Gain/(Loss) on
Interest Rate Swaps
  Book Value
Per Share
 

September 30, 2011

   $ 24.79       0.01     4.56       (3.04)   $ 26.32   

June 30, 2011

   $ 24.79       (0.03)     3.47       (1.51)   $ 26.72   

March 31, 2011

   $ 24.67       (0.06)     1.67       (0.17)   $ 26.11   

December 31, 2010

   $ 22.62       (0.08)     3.33       (1.03)   $ 24.84   

September 30, 2010

   $ 22.63       (0.07)     5.66       (2.39)   $ 25.83   

June 30, 2010

   $ 21.50       0.12     6.36       (2.15)   $ 25.83   

March 31, 2010

   $ 21.32       0.24     5.25       (1.33)   $ 25.48   

December 31, 2009

   $ 21.28       0.24     5.21       (0.99)   $ 25.74   

September 30, 2009

   $ 21.27       0.16     5.96       (1.32)   $ 26.07   

June 30, 2009

   $ 21.26       0.05     3.69       (1.10)   $ 23.90   

March 31, 2009

   $ 21.26       (0.05)     2.75       (1.76)   $ 22.20   

 

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Investments

Agency Securities

As of September 30, 2011 and December 31, 2010, our agency securities portfolio was purchased at a net premium to par, or face value, with a weighted-average amortized cost of 102.47 and 102.13, respectively, of face value. As of September 30, 2011 and December 31, 2010, we had approximately $416.1 million and $196.8 million, respectively, of unamortized premium included in the cost basis of our investments.

As of September 30, 2011, our investment portfolio consisted of agency securities as follows:

 

(dollars in thousands)

Months to Reset or Maturity

   % of
Portfolio
    Current Face
value (1)
     Weighted
Avg. Coupon (2)
    Weighted
Avg.
Amortized
Purchase
Price (3)
     Amortized
Cost (4)
     Weighted
Avg.
Market
Price (5)
     Market
Value (6)
 

0-18

     6.6   $ 1,091,863         4.76   $ 101.35       $ 1,106,555       $ 106.07       $ 1,158,144   

19-36

     5.5     907,792         4.47   $ 101.41         920,568       $ 106.05       $ 962,674   

37-60

     49.2     8,299,571         3.41   $ 102.45         8,502,916       $ 104.42       $ 8,666,670   

61-84

     30.6     5,167,829         3.40   $ 102.65         5,304,845       $ 104.28       $ 5,389,188   

85-120

     1.7     293,712         3.62   $ 103.19         303,091       $ 104.55       $ 307,070   

121-180

     6.4     1,092,382         3.13   $ 103.56         1,131,246       $ 103.50       $ 1,130,628   
  

 

 

   

 

 

         

 

 

       

 

 

 

Total MBS

     100.0   $ 16,853,149         3.54   $ 102.47       $ 17,269,221       $ 104.52       $ 17,614,374   
  

 

 

   

 

 

         

 

 

       

 

 

 

As of December 31, 2010, our investment portfolio consisted of agency securities as follows:

 

(dollars in thousands)

Months to Reset or Maturity

   % of
Portfolio
    Current
Face value (1)
     Weighted Avg.
Coupon (2)
    Weighted Avg.
Amortized
Purchase Price (3)
     Amortized Cost (4)      Weighted Avg.
Market Price (5)
     Market Value (6)  

0-18

     6.6   $ 605,242         3.80   $ 101.54       $ 614,569       $ 104.58       $ 632,978   

19-36

     17.0     1,535,856         5.15   $ 101.29         1,555,726       $ 106.06         1,628,967   

37-60

     54.2     5,001,576         3.78   $ 102.13         5,107,959       $ 103.87         5,195,156   

61-84

     20.2     1,897,287         3.46   $ 102.88         1,951,899       $ 102.20         1,938,935   

85-120

     2.0     188,132         3.56   $ 103.52         194,751       $ 101.62         191,180   
  

 

 

   

 

 

         

 

 

       

 

 

 

Total MBS

     100.0   $ 9,228,093         3.94   $ 102.13       $ 9,424,904       $ 103.89       $ 9,587,216   
  

 

 

   

 

 

         

 

 

       

 

 

 

 

(1) The current face value is the current monthly remaining dollar amount of principal of a mortgage security. We compute current face value by multiplying the original face value of the security by the current principal balance factor. The current principal balance factor is essentially a fraction, where the numerator is the current outstanding balance and the denominator is the original principal balance.
(2) For a pass-through certificate, the coupon reflects the weighted average nominal rate of interest paid on the underlying mortgage loans, net of fees paid to the servicer and the agency. The coupon for a pass-through certificate may change as the underlying mortgage loans are prepaid. The percentages indicated in this column are the nominal interest rates that will be effective through the interest rate reset date and have not been adjusted to reflect the purchase price we paid for the face amount of security.
(3) Amortized purchase price is the dollar amount, per $100 of current face, of our purchase price for the security, adjusted for amortization as a result of scheduled and unscheduled principal paydowns.
(4) Amortized cost is our total purchase price for the mortgage security, adjusted for amortization as a result of scheduled and unscheduled principal paydowns.
(5) Market price is the dollar amount of market value, per $100 of nominal, or face, value, of the mortgage security. Under normal conditions, we compute market value by obtaining valuations for the mortgage security from separate and independent sources and averaging valuations.

 

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(6) Market value is the total market value for the mortgage security. Under normal conditions, we compute market value by obtaining valuations for the mortgage security from separate and independent sources and averaging valuations.

Our investment portfolio consisted of the following breakdown between Fannie Mae and Freddie Mac at September 30, 2011 and December 31, 2010:

 

     September 30, 2011     December 31, 2010  
(dollars in thousands)    Estimated
Fair Value
     % of Total     Estimated
Fair Value
     % of Total  

Agency MBS

          

Fannie Mae Certificates

   $ 12,388,104         70.3   $ 6,657,756         69.4

Freddie Mac Certificates

     5,226,270         29.7     2,929,460         30.6
  

 

 

      

 

 

    

Total MBS

   $ 17,614,374         $ 9,587,216      
  

 

 

      

 

 

    

We typically want to own a higher percentage of Fannie Mae adjustable-rate MBS than Freddie Mac adjustable-rate MBS as Fannie Mae has better cash flow to the security holder because it pays the principal and interest quicker after accrual (45 days) as compared to Freddie Mac (75 days).

As of September 30, 2011 and December 31, 2010, the ARMs underlying our adjustable rate agency securities had fixed interest rates for an average period of approximately 53 months, after which time the interest rates reset and become adjustable annually. At September 30, 2011, 92.5% of our Agency ARMs were still in their initial fixed-rate period, and approximately 0.6% of our Agency MBS will reach the end of their initial fixed-rate period in the next 12 months. The balance of our Agency ARMs, have already reached their initial reset period and will reset annually for the life of the security.

After the reset date, interest rates on our agency ARMs float based on spreads over various indices, usually LIBOR or the one-year CMT. These interest rate adjustments are subject to caps that limit the amount the applicable interest rate can increase during any year, known as an annual cap, and through the maturity of the security, known as a lifetime cap. Our agency ARMs typically have a maximum initial one-time adjustment of 5%, and the average annual interest rate increase (or decrease) to the interest rates on our agency securities is 2% per year. The average lifetime cap on increases (or decreases) to the interest rates on our agency securities is 5% from the initial stated rate.

In addition to adjustable-rate securities, we also invest in fixed-rate securities. All of our fixed-rate MBS purchased to date have been 15-year amortizing fixed rate securities. At September 30, 2011 we owned $1.1 billion of 15-year fixed-rate MBS with a weighted average life, assuming a constant prepayment rate of 10, of 4.1 years.

While most of our purchases of Agency MBS are accounted for using trade date accounting, some forward purchases, such as certain to-be-announced securities (“TBAs”) do not qualify for trade date accounting and are considered derivatives for financial statement purposes. Pursuant to ASC Topic 815, we account for these derivatives as all-in-one cash flow hedges. The net fair value of the forward commitment is reported on the balance sheet as an asset (or liability), with a corresponding unrealized gain (or loss) recognized in other comprehensive income. Since we purchase MBS forward for the purposes of holding the securities for investment, we consider all our Agency MBS, settled or unsettled, as part of our portfolio for the purposes of cash flow and interest rate sensitivity, and consequently hedging, duration measurement, and other related investment management activity.

Liabilities

 

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We have entered into repurchase agreements to finance most of our agency securities. Our repurchase agreements are secured by our agency securities and bear interest at rates that have historically moved in close relationship to LIBOR. As of September 30, 2011 and December 31, 2010, we had established 30 and 26 borrowing relationships, respectively, with various banking firms and other lenders. We had outstanding balances under our repurchase agreements at September 30, 2011 and December 31, 2010 of $15.9 billion and $8.7 billion, respectively.

Hedging Instruments

We generally intend to hedge as much of our interest rate risk as our manager deems prudent in light of market conditions. No assurance can be given that our hedging activities will have the desired beneficial impact on our results of operations or financial condition. Our policies do not contain specific requirements as to the percentages or amount of interest rate risk that our manager is required to hedge.

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

As of September 30, 2011, we had in place 69 interest rate swap agreements with 14 counterparties designed to lock in funding costs for specific funding activities associated with specific assets, in an effort to assure realizing attractive net interest margins. Such hedge selection incorporates an assumed prepayment schedule, which, if not realized, will cause our operating results to differ from expectations. These swap agreements provide for fixed interest rates indexed off of one-month LIBOR and effectively fix the floating interest rates on $7.5 billion of borrowings under our repurchase agreements.

Summary Financial Data

 

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(in thousands, except per share amounts)    Three months ended (unaudited)     Nine months ended (unaudited)  
     September 30, 2011     September 30, 2010     September 30, 2011     September 30, 2010  

Statement of Income Data

        

MBS interest income

   $ 110,125      $ 63,701      $ 310,248      $ 196,084   

Other interest income

     380        323        1,051        897   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Interest Income

     110,505        64,024        311,299        196,981   

Interest expense

     (40,259     (24,065     (102,363     (71,182
  

 

 

   

 

 

   

 

 

   

 

 

 

Net Interest Income

     70,246        39,959        208,936        125,799   

Gain on sale of mortgage-backed securities

     13,330        6,723        17,735        7,767   

Operating Expenses

     (4,594     (3,449     (12,922     (9,787
  

 

 

   

 

 

   

 

 

   

 

 

 

Net Income

   $ 78,982      $ 43,233      $ 213,749      $ 123,779   
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings per share-common stock, basic

   $ 1.04      $ 1.12      $ 3.05      $ 3.33   

Earnings per share-common stock, diluted

   $ 1.04      $ 1.11      $ 3.05      $ 3.32   

Weighted average shares outstanding

     75,743        38,765        70,057        37,215   

Cash dividends declared per common share

   $ 1.00      $ 1.10      $ 3.00      $ 3.40   

Key Portfolio Statistics*

        

Average MBS (1)

   $ 16,192,903      $ 6,881,681      $ 14,030,450      $ 6,735,802   

Average Repurchase Agreements (2)

   $ 14,884,196      $ 6,302,601      $ 12,820,514      $ 6,206,242   

Average Equity (3)

   $ 2,035,296      $ 1,001,956      $ 1,851,482      $ 962,184   

Average Portfolio Yield (4)

     2.72     3.70     2.95     3.88

Average Cost of Funds (5)

     1.08     1.53     1.06     1.53

Interest Rate Spread (6)

     1.64     2.17     1.89     2.35

Return on Average Equity (7)

     15.52     17.26     15.39     17.15

Average Annual Portfolio Repayment Rate (8)

     28.55     33.91     23.37     38.26

Debt to Equity (at period end) (9)

     7.9:1        5.6:1        7.9:1        5.6:1   

Debt to Additional Paid in Capital at period end) (10)

     8.4:1        6.4:1        8.4:1        6.4:1   

Selected Balance Sheet Data

        

Mortgage-backed securities

   $ 17,614,374      $ 7,608,062      $ 17,614,374      $ 7,608,062   

Total Assets

     18,358,202        8,177,855        18,358,202        8,177,855   

Repurchase Agreements

     15,886,231        6,678,426        15,886,231        6,678,426   

Stockholder’s Equity

     2,015,003        1,190,313        2,015,003        1,190,313   

 

* 

Average numbers for each period are weighted based on days on our books and records. All percentages are annualized.

 

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(1) Our daily average investment in Agency MBS was calculated by dividing the sum of our daily Agency MBS investments during the period by the number of days in the period.
(2) Our daily average balance outstanding under our repurchase agreements was calculated by dividing the sum of our daily outstanding balances under our repurchase agreements during the period by the number of days in the period.
(3) Our daily average shareholders’ equity was calculated by dividing the sum of our daily shareholders’ equity during the period by the number of days in the period.
(4) Our average portfolio yield was calculated by dividing our MBS interest income, net of amortization, by our average Agency MBS.
(5) Our average cost of funds was calculated by dividing our total interest expense (including hedges) by our average balance outstanding under our repurchase agreements.
(6) Our interest rate spread was calculated by subtracting our average cost of funds from our average portfolio yield.
(7) Our return on average equity was calculated by dividing net income by average equity.
(8) Our average annual principal repayment rate was calculated by dividing our total principal payments received during the year (scheduled and unscheduled) by our average MBS.
(9) Our debt to equity ratio was calculated by dividing the amount outstanding under our repurchase agreements at period end by total shareholders’ equity at period end.
(10) Our debt to additional paid in capital ratio was calculated by dividing the amount outstanding under our repurchase agreements at period end by additional paid in capital at period end.

Results of Operations

Overview

The results discussed in this section should be read with keeping in mind that there were a number of significant events that have occurred in the three months ended September 30, 2011 that generally did not materially affect results, but did increase the perceived risks to our operations as macro events covering the broad mortgage and finance market. At times volatility was exacerbated due to fears of events, some of which either did not come to pass or did not occur. These events included the downgrade of U.S. government credit rating, the near failure of the U.S. government to extend the debt ceiling, the European debt crisis, government sponsored mortgage refinancing, new U.S. Treasury programs designed to stimulate mortgage financing, and increased regulatory concerns.

Three months ended September 30, 2011 and 2010

Our primary source of income is the interest income we earn on our investment portfolio. Our interest income for the quarter ended September 30, 2011 was $110.5 million, as compared to $64.0 million for the quarter ended September 30, 2010. The most significant factor in this increase was the larger securities portfolio. Our average MBS for the quarter ended September 30, 2011 was $16.2 billion as compared to $6.9 billion for the quarter ended September 30, 2010. The increase in our interest income generally is not exactly proportionate to the increase in average MBS because the coupon rate on our recent purchases will be at different rates than in the portfolio in any comparable period. Our weighted average coupon at September 30, 2011 was 3.54%, as compared to 4.29% at September 30, 2010. As mortgage rates rise and fall, they will increase or decrease our overall average coupon rate as we replace and/or add securities in our portfolio.

Our annualized yield on average assets for the quarter ended September 30, 2011 was 2.72% as compared to 3.70% for the quarter ended September 30, 2010. After coupon rate, the yield on our assets is most directly affected by the rate of repayments on our agency securities. Our annualized rate of portfolio repayment for the three months ended September 30, 2011 was 28.55%, which was lower than the rate of 33.91% for the three months ended September 30, 2010. The rate for the quarter ended September 30, 2010 was elevated as compared to the current quarter primarily due to the impact of Fannie Mae and Freddie Mac repurchasing delinquent mortgages from existing MBS, which was a one-time event. Historically, the prepayment rate of mortgages has been most affected by the increase or decrease of interest rates. However, the current condition of the U.S. economy and housing market has inhibited, and may continue to inhibit, some homeowners’ ability to purchase a new home or refinance an existing mortgage, keeping prepayment rates slower than expected. The U.S. Government continues to be active in the mortgage market, and their ability to influence the market poses a risk to the sustainability of our current earnings.

Our interest expense for the quarter ended September 30, 2011 was $40.3 million as compared to $24.1 million for the quarter ended September 30, 2010. Our average borrowings increased from $6.3 billion for the quarter ended September 30, 2010 to $14.9 billion for the quarter ended September 30, 2011, due to the increase in

 

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portfolio size. Although our borrowings increased, our total interest expense increased by a lesser amount due to a lower overall cost of funds. Our annualized average cost of funds, including hedges, was 1.08% for the quarter ended September 30, 2011, as compared to 1.53% for the quarter ended September 30, 2010. The components of our cost of funds are 1) rates on our repurchase agreement, and 2) rates on our interest rate swaps. While short term borrowing rates were relatively unchanged between the periods, we had some longer term repurchase agreements and interest rate swaps with higher rates expire during the past year. Although we added to our total interest rate swap position, the lower rate environment allowed us to decrease the average rate of our swap positions.

Our net interest income for the quarter ended September 30, 2011 was $70.2 million, and our net interest margin, or “spread”, was 1.64%. For the quarter ended September 30, 2010 our net interest income was $40.0 million and our spread was 2.17%. This decrease in our spread was due to our decreased yield, as described above, mitigated by a lower cost of funds, as compared to a year ago. The dollar figure is influenced by the size of our portfolio and overall interest rate levels, while we believe our spread is the more important indicator of our performance.

We occasionally sell securities as part of normal portfolio adjusting. We typically will selectively sell certain of our MBS when we think they are likely to underperform in the future as compared with other investment opportunities. We sold $678 million of MBS in the third quarter of 2011, realizing gains of $13.3 million and $302 million of MBS in the third quarter of 2010, realizing gains of $6.7 million.

Our total operating expenses for the quarters ended September 30, 2011 and 2010 were $4.6 million and $3.4 million, respectively. The majority of this increase was due to the increase in the fee we pay our manager, which is based on our equity, which grew significantly from the prior year. This equates to an annualized expense ratio of 90 and 138 basis points, respectively, of average equity. While our expenses increased, the increase in our average equity, which was due to the additional equity capital raised in our offerings, decreased the ratio as compared to a year ago. The scalability of our business model means that growth in assets is not closely correlated to growth in expenses.

Our net income for the quarter ended September 30, 2011 was $79.0 million or $1.04 per weighted average share. This represents an annualized return on average equity of 15.52% for the period. For the quarter ended September 30, 2010, our net income was $43.2 million or $1.12 per weighted average share, and the annualized return on average equity was 17.26%. While many factors may affect these numbers, the decrease in the per share earnings was due primarily to a lower yielding portfolio as we experienced spread compression from investing in increasingly lower coupon securities while our costs of funding decreased at a lesser pace.

Nine months ended September 30, 2011 and 2010

In general, most of the items influencing our operating results for the nine month periods ended September 30, 2011 and 2010 were similar as the items affecting the quarterly results described above. For the nine month period ended September 30, 2011 we had interest income of $311.3 million compared to $197.0 million for the same period in 2010. Due to investing the proceeds of our common stock offerings, our portfolio was significantly larger during this period, as we had average earning assets of $14.0 billion for the nine months ended September 30, 2011 compared to $6.7 billion for the nine months ended September 30, 2010. Offsetting this increase in earning assets was a lower yield on the portfolio. Our yield dropped from 3.88% for the nine months ended September 30, 2010 to 2.95% for the nine months ended September 30, 2011. This was the result of buying lower coupon MBS with our offering proceeds and replacing repayments of principal on our MBS. The portfolio prepayment rate decreased on an annualized basis, from 38.26% for the first nine months of 2010 to 23.37% for the same period in 2011. The Fannie Mae and Freddie Mac delinquent loan repurchase program, as mentioned above, were the primary cause of our faster rate of repayment in 2010.

Our interest expense for the nine months ended September 30, 2011 was $102.4 million as compared to $71.2 million for the nine months ended September 30, 2010. While our average borrowings increased proportionately along with our assets, the interest rates we pay on these borrowing were lower on average during the first half of 2011. Our average cost of funds, including hedges, fell from 1.53% for the nine months ended September 30, 2010 to 1.06% for the same period in 2011. We realized gains on sale of our MBS of $17.7 million for the nine months ended September 30, 2011 as compared to $7.8 million for the nine months ended September 30, 2010.

 

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Our net interest income for the nine months ended September 30, 2011 was $208.9 million, and our spread was 1.89%. For the nine months ended September 30, 2010, our net interest income was $125.8 million and our spread was 2.35%. We incurred expenses for the nine months ended September 30, 2011 and 2010 of $12.9 million and $9.8 million, respectively. We earned net income of $213.7 million or $3.05 per weighted average share for the nine months ended September 30, 2011. For the nine months ended September 30, 2010, we earned net income of $123.8 million or $3.33 per weighted average share. Our per share income for the nine months ended September 30, 2011 was lower than the nine months ended September 30, 2010 due to two main factors. First, we had lower spread in the first nine months of 2011 due to lower overall mortgage rates. Second, we were investing the proceeds from our common stock offerings in January and March 2011. Our investment process generally takes from one to three months to complete, and therefore, we were not at our typical run-rate of earnings until the third quarter of 2011.

Contractual Obligations and Commitments

We had the following contractual obligations under repurchase agreements as of September 30, 2011 and December 31, 2010 (dollar amounts in thousands):

 

     September 30, 2011  
(dollars in thousands)    Balance      Weighted Average
Contractual Rate
    Contractual
Interest Payments
     Total Contractual
Obligation
 

Within 30 days

   $ 15,886,231         0.29   $ 3,024       $ 15,889,255   

30 days to 3 months

     —           —          —           —     

3 months to 36 months

     —           —          —           —     
  

 

 

      

 

 

    

 

 

 
   $ 15,886,231         0.29   $ 3,024       $ 15,889,255   
  

 

 

      

 

 

    

 

 

 

 

     December 31, 2010  
(dollars in thousands)    Balance      Weighted Average
Contractual Rate
    Contractual
Interest Payments
     Total Contractual
Obligation
 

Within 30 days

   $ 7,530,317         0.38   $ 1,758       $ 7,532,075   

30 days to 3 months

     1,050,743         0.60     572         1,051,315   

3 months to 36 months

     100,000         2.96     1,660         101,660   
  

 

 

      

 

 

    

 

 

 
   $ 8,681,060         0.44   $ 3,990       $ 8,685,050   
  

 

 

      

 

 

    

 

 

 

In addition, we had contractual commitments under interest rate swap agreements as of September 30, 2011. These agreements were for a total notional amount of $7.5 billion, had a weighted average rate of 1.82% and a weighted average term of 36 months.

Off-Balance Sheet Arrangements

As of September 30, 2011 and December 31, 2010, we did not maintain any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, or 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 September 30, 2011 and December 31, 2010, we had not guaranteed any obligations of unconsolidated entities or entered into any commitment or intent to provide funding to any such entities.

Liquidity and Capital Resources

 

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Our primary sources of funds are borrowings under repurchase arrangements and monthly principal and interest payments on our investments. Other sources of funds may include proceeds from debt and equity offerings and asset sales. We generally maintain liquidity to pay down borrowings under repurchase arrangements to reduce borrowing costs and otherwise efficiently manage our long-term investment capital. Because the level of these borrowings can be adjusted on a daily basis, the level of cash and cash equivalents carried on the balance sheet is significantly less important than our potential liquidity available under our borrowing arrangements. We currently believe that we have sufficient liquidity and capital resources available for the acquisition of additional investments, repayments on borrowings and the payment of cash dividends as required for continued qualification as a REIT.

In response to the growth of our agency securities portfolio and to recent turbulent market conditions, we have aggressively pursued additional lending counterparties in order to help increase our financial flexibility and ability to withstand periods of contracting liquidity in the credit markets. At September 30, 2011, we had uncommitted repurchase facilities with 30 lending counterparties to finance this portfolio, subject to certain conditions, and have borrowings outstanding with 23 of these counterparties.

Liquidity Sources—Repurchase Facilities

With repurchase facilities being an integral part of our financing strategy, and thus our financial condition, full understanding of the repurchase market is necessary to understand the risks and drivers of our business. For example, we anticipate that, upon repayment of each borrowing under a repurchase agreement, we will use the collateral immediately for borrowing under a new repurchase agreement. And while we have borrowing capacity under our repurchase facilities well in excess of what is required for our operations, these borrowing lines are uncommitted and generally do not provide long term excess liquidity. Currently, we have not entered into any commitment agreements under which the lender would be required to enter into new repurchase agreements during a specified period of time, nor do we presently plan to have liquidity facilities with commercial banks.

The table below sets forth the average amount of repurchase agreements outstanding during each quarter and the amount of these repurchase agreements outstanding as of the end of each quarter since January 1, 2009. The amounts at a period end can be both above and below the average amounts for the quarter. We do not manage our portfolio to have a pre-designated amount of borrowings at quarter end. These numbers will differ as we implement our portfolio management strategies and risk management strategies over changing market conditions.

 

(In thousands)    Average Daily
Repurchase
Agreements
     Repurchase
Agreements at
Period End
     Highest Daily
Repurchase
Balance
During Quarter
     Lowest Daily
Repurchase
Balance
During Quarter
 

September 30, 2011

   $ 14,884,196       $ 15,886,231       $ 15,907,289       $ 14,334,014   

June 30, 2011

   $ 13,540,291       $ 14,800,594       $ 14,800,594       $ 11,401,240   

March 31, 2011

     9,983,197         11,495,749         11,495,749         8,566,200   

December 31, 2010

     7,326,776         8,681,060         8,681,060         6,633,989   

September 30, 2010

     6,302,601         6,678,426         6,736,759         5,934,419   

June 30, 2010

     6,092,328         5,982,998         6,218,628         5,956,811   

March 31, 2010

     6,222,923         6,102,661         6,346,518         6,047,628   

December 31, 2009

     6,079,893         6,346,518         6,346,518         6,005,602   

September 30, 2009

     5,781,639         6,007,909         6,012,302         5,496,854   

June 30, 2009

     5,359,086         5,496,854         5,567,486         5,242,988   

March 31, 2009

     4,985,718         5,250,382         5,273,594         4,519,435   

As of September 30, 2011, the weighted average margin requirement, or the percentage amount by which the collateral value must exceed the loan amount, which we also refer to as the haircut, under all our repurchase agreements, was approximately 4.4% (weighted by borrowing amount). As of December 31, 2010, our weighted

 

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average haircut was approximately 4.4%. We commonly receive margin calls from our lenders. We may receive margin calls daily, although we typically receive them once or twice per month. We receive margin calls under our repurchase agreements for two reasons. One of these is what is known as a “factor call” which occurs each month when the new factors (amount of principal remaining on the security) are published by the issuing agency, such as Fannie Mae. The second type of margin call we may receive is a valuation margin call. Both factor and valuation margin calls occur whenever the total value of our MBS assets pledged as collateral drops beyond a threshold amount, which is usually between $100,000 and $250,000. Both of these margin calls require a dollar for dollar restoration of the margin shortfall above a certain minimum threshold. This threshold is usually between $50,000 and $150,000. The total amount of our unrestricted cash and cash equivalents, plus any unpledged securities, is available to satisfy margin calls, if necessary. As of September 30, 2011 and December 31, 2010, we had approximately $1.2 billion and $630 million, respectively, in agency securities, 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 require any amount due by us to the counterparty to be payable immediately. Our agreements for our repurchase facilities generally conform to the terms in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association (SIFMA) as to repayment, margin requirements and the segregation of all purchased securities covered by the repurchase agreement. In addition, each lender may require that we include supplemental terms and conditions to the standard master repurchase agreement that are generally required by the lender. Some of the typical terms which are included in such supplements and which supplement and amend terms contained in the standard agreement include changes to the margin maintenance requirements, purchase price maintenance requirements, the addition of a requirement that all controversies related to the repurchase agreement be litigated in a particular jurisdiction and cross default provisions. These provisions differ for each of our lenders.

As discussed above under “—Market and Interest Rate Trends and the Effect on our Portfolio,” over the last two years the residential mortgage market in the United States has experienced difficult conditions including:

 

   

increased volatility of many financial assets, including agency securities and other high-quality MBS assets, due to news of potential security liquidations;

 

   

increased volatility and deterioration in the broader residential mortgage and MBS markets; and

 

   

significant disruption in financing of MBS.

If these conditions persist, our lenders may be forced to exit the repurchase market, become insolvent or further tighten lending standards or increase the amount of haircut, any of which could make it more difficult or costly for us to obtain financing.

Effects of Margin Requirements, Leverage and Credit Spreads

Our agency securities have values that fluctuate according to market conditions and, as discussed above, the market value of our agency securities will decrease as prevailing interest rates or credit spreads increase. When the value of the securities pledged to secure a repurchase loan decreases to the point where the positive difference between the collateral value and the loan amount is less than the haircut, our lenders may issue a margin call, which means that the lender will require us to pay the margin call in cash or pledge additional collateral to meet that margin call. Under our repurchase facilities, our lenders have full discretion to determine the value of the agency securities we pledge to them. Most of our lenders will value securities based on recent trades in the market. Lenders also issue margin calls as the published current principal balance factors change on the pool of mortgages underlying the securities pledged as collateral when scheduled and unscheduled paydowns are announced monthly.

Similar to the valuation margin calls that we receive on our repurchase agreements, we also receive margin calls on our interest rate swaps when the value of a hedge position declines. This typically occurs when prevailing

 

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market rates decrease, with the severity of the decrease also dependent on the term of the hedges involved. The amount of any margin call will be dollar for dollar, with a minimum transfer amount of between $100,000 and $250,000. Our posting of collateral with our hedge counterparties can be done in cash or securities, and is generally bilateral, which means that if the value of our interest rate hedges increases, our counterparty will post collateral with us.

We experience margin calls in the ordinary course of our business, and under certain conditions, such as during a period of declining market value for agency securities, we experience margin calls at least monthly. In seeking to manage effectively the margin requirements established by our lenders, we maintain a position of cash and unpledged securities. We refer to this position as our liquidity. The level of liquidity we have available to meet margin calls is directly affected by our leverage levels, our haircuts and the price changes on our securities. If interest rates increase as a result of a yield curve shift or for another reason or if credit spreads widen, the prices of our collateral (and our unpledged assets that constitute our liquidity) will decline, we will experience margin calls, and we will use our liquidity to meet the margin calls. There can be no assurance that we will maintain sufficient levels of liquidity to meet any margin calls. If our haircuts increase, our liquidity will proportionately decrease. In addition, if we increase our borrowings, our liquidity will decrease by the amount of additional haircut on the increased level of indebtedness.

We intend to maintain a level of liquidity in relation to our assets that enables us to meet reasonably anticipated margin calls but that also allows us to be substantially invested in agency securities. We may misjudge the appropriate amount of our liquidity by maintaining excessive liquidity, which would lower our investment returns, or by maintaining insufficient liquidity, which would force us to liquidate assets into unfavorable market conditions and harm our results of operations and financial condition.

As of September 30, 2011, the weighted average haircut under our repurchase facilities was approximately 4.4%, and our leverage (defined as our debt-to-shareholders equity ratio) was approximately 7.9:1.

Liquidity Sources—Capital Offerings

In addition to our repurchase borrowings, we also rely on primary securities offerings as a source of both short-term and long-term liquidity. During the third quarter of 2011, we received funds from sales of our common stock under an “at-the-market” offering program.

Under the terms of our Sales Agreement for our CEO Program, we may offer and sell up to 5,000,000 shares of our common stock from time to time through Cantor Fitzgerald & Co. (“Cantor”) acting as agent and/or principal. Sales of the shares of common stock, if any, may be made in private transactions, negotiated transactions or any method permitted by law deemed to be an “at the market” offering as defined in Rule 415 under the Securities Act, including sales made directly on the NYSE or to or through a market maker other than on an exchange. Under the Sales Agreement, Cantor will use its commercially reasonable efforts consistent with its normal sales and trading practices to sell the shares of common stock as directed by us. The compensation payable to for sales of shares of common stock pursuant to the Sales Agreement will be up to 2% of the gross sales price per share for any shares sold under the Sales Agreement.

During the three months ended September 30, 2011, we issued 1,295,000 shares of common stock in at-the-market transactions at an average price of $27.95 per share raising net proceeds, after sales commissions and expenses, of approximately $35.7 million. We paid $0.5 million in sales commissions to Cantor during the three months ended September 30, 2011. The shares of common stock issuable pursuant to the CEO Program are registered with the SEC on our Registration Statement on Form S-3 (No. 333-159145), which became effective upon filing on October 9, 2009.

We used the proceeds of our stock offerings to purchase additional agency securities, provide working capital, and to provide liquidity for our hedging strategy.

Forward-Looking Statements Regarding Liquidity

 

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Based on our current portfolio, leverage rate and available borrowing arrangements, we believe that the net proceeds of our common equity offerings, combined with cash flow from operations and available borrowing capacity, will be sufficient to enable us to meet anticipated short-term (one year or less) liquidity requirements such as to fund our investment activities, to pay fees under our management agreement, to fund our distributions to shareholders and for general corporate expenses.

Our ability to meet our long-term (greater than one year) liquidity and capital resource requirements will be subject to obtaining additional debt financing and equity capital. We may increase our capital resources by obtaining long-term credit facilities or making public or private offerings of equity or debt securities, possibly including classes of preferred stock, common stock, and senior or subordinated notes. 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.

We generally seek to borrow (on a recourse basis) between eight and 12 times the amount of our shareholders’ equity. At September 30, 2011 and December 31, 2010, our total borrowings were approximately $15.9 billion and $8.7 billion (excluding accrued interest), respectively, which represented a leverage ratio of approximately 7.9:1 and 7.6:1, respectively. We have maintained a lower leverage than we might at times due to having a defensive posture against future rate increases and to preserve liquidity as there are still significant unknowns in the financial markets, including government intervention in our industry, especially as it relates to prepayment speeds. Also, our leverage ratio will increase when asset prices drop, making some of the apparent safety of low leverage temporary.

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 any distributions we may make will be determined by our board of directors based in part on our REIT taxable income as calculated according to the requirements of the 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

We seek to manage our risks related to the credit quality of our assets, interest rates, liquidity, prepayment speeds and market value while, at the same time, seeking to provide an opportunity to shareholders to realize attractive risk-adjusted returns through ownership of our capital stock. While we do not seek to avoid risk completely, we believe the risk can be quantified from historical experience and seek to actively manage that risk, to earn sufficient compensation to justify taking those risks and to maintain capital levels consistent with the risks we undertake.

Interest Rate Risk

Interest rate risk is the primary component of our market risk. Interest rates are highly sensitive to many factors, including fiscal and monetary policies and domestic and international economic and political considerations, as well as other factors beyond our control. We will be subject to interest rate risk in connection with our investments and our related financing obligations.

Interest Rate Effect on Net Interest Income

Our operating results depend in large part on differences between the yields earned on our investments and our cost of borrowing and hedging activities. The cost of our borrowings will generally be based on prevailing market interest rates. During periods of rising interest rates, the borrowing costs associated with agency securities

 

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tend to increase while the income earned on agency securities may remain substantially unchanged until the interest rates reset. This results in a narrowing of the net interest spread between the assets and related borrowings and may even result in losses. The severity of any such decline would depend on our asset/liability composition at the time as well as the magnitude and duration of the interest rate increase. Further, an increase in short-term interest rates could also have a negative impact on the market value of our investments. If any of these events happen, we could experience a decrease in net income or incur a net loss during these periods, which could adversely affect our liquidity and results of operations.

We seek to mitigate interest rate risk through utilization of extended term repurchase agreements and hedging instruments, primarily interest rate swap agreements. Interest rate swap agreements are intended to serve as a hedge against future interest rate increases on our variable rate borrowings. As of September 30, 2011, we had entered into interest rate swap agreements designed to mitigate the effects of increases in interest rates under $7.5 billion of our repurchase agreements.

The selection of hedging instruments is partly based on assumed levels of prepayments of our agency securities. If prepayments are slower or faster than assumed, the life of the agency securities will be longer or shorter, which would reduce the effectiveness of any hedging strategies we may use and may cause losses on such transactions. Hedging strategies involving the use of derivative securities are highly complex and may produce volatile returns. Hedging techniques are also limited by the rules relating to REIT qualification. In order to preserve our REIT status, we may be forced to terminate a hedging transaction at a time when the transaction is most needed.

Interest Rate Cap Risk

The ARMs that underlie our agency securities are typically subject to periodic and lifetime interest rate caps and floors, which limit the amount by which the security’s interest rate may change during any given period. However, our borrowing costs pursuant to our financing agreements will not be subject to similar restrictions. Therefore, in a period of increasing interest rates, interest rate costs on our borrowings could increase without limitation, while the interest-rate increases on our adjustable-rate agency securities could effectively be limited by caps. Agency securities backed by ARMs 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 from such investments than we would need to pay the interest cost on our related borrowings. These factors could lower our net interest 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 fund a substantial portion of our acquisition of agency securities with borrowings that are based on LIBOR, while the interest rates on these agency securities may be indexed to LIBOR or another index rate, such as the one-year CMT rate. Accordingly, any increase in LIBOR relative to one-year CMT rates will generally result in an increase in our borrowing costs that is not matched by a corresponding increase in the interest earnings on these investments. Any such interest rate index mismatch could adversely affect our profitability, which may negatively impact distributions to our shareholders. To seek to mitigate interest rate mismatches, we may utilize the hedging strategies discussed above.

Our analysis of risks is based on our manager’s experience, estimates and assumptions, including estimates of fair value and interest rate sensitivity. Actual economic conditions or implementation of investment decisions by our manager may produce results that differ significantly from our manager’s estimates and assumptions.

Prepayment Risk

As we receive repayments of principal on our agency securities from prepayments and scheduled payments, premiums paid on such securities are amortized against interest income and discounts are accreted to interest income. Premiums arise when we acquire agency securities at prices in excess of the principal balance of the

 

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mortgage loans underlying such agency securities. Conversely, discounts arise when we acquire agency securities at prices below the principal balance of the mortgage loans underlying such agency securities.

For financial accounting purposes, interest income is accrued based on the outstanding principal balance of the investment securities and their contractual terms. In general, purchase premiums on investment securities are amortized against interest income over the lives of the securities using the effective yield method, adjusted for actual prepayment and cash flow activity. An increase in the principal repayment rate will typically accelerate the amortization of purchase premiums and a decrease in the repayment rate will typically slow the accretion of purchase discounts, thereby reducing the yield/interest income earned on such assets.

Extension Risk

We invest in agency securities backed by ARMs which have interest rates that are fixed for the early years of the loan (typically three, five, or seven years) and thereafter reset periodically, usually annually. We compute the projected weighted-average life of our agency securities backed by ARMs based on assumptions regarding the rate at which the borrowers will prepay the underlying mortgage loans. In general, when agency securities backed by ARMs are 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 securities. 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 mortgage loans underlying the related agency securities.

We may structure our interest rate swap agreements to expire in conjunction with the estimated weighted average life of the fixed period of the mortgage loans underlying our agency securities. However, in a rising interest rate environment, the weighted average life of the fixed-rate mortgage loans underlying our agency securities 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 securities would remain fixed for a period of time. This situation may also cause the market value of our agency securities 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 Risk and Effect on Market Value Risk

Another component of interest rate risk is the effect changes in interest rates will have on the market value of our agency securities. We face the risk that the market value of our agency securities 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 effective duration of our assets and the effective duration of our liabilities and by estimating the time difference between the interest rate adjustment of our assets and the interest rate adjustment of our liabilities. Effective duration essentially measures the market price volatility of financial instruments as interest rates change. We generally estimate effective duration using various financial models and empirical data. Different models and methodologies can produce different effective duration estimates for the same securities.

The sensitivity analysis tables presented below show the estimated impact of an instantaneous parallel shift in the yield curve, up and down 50 and 100 basis points, on the market value of our interest rate-sensitive investments and net interest income, at September 30, 2011 and December 31, 2010, assuming a static portfolio. When evaluating the impact of changes in interest rates, prepayment assumptions and principal reinvestment rates are adjusted based on our manager’s expectations. The analysis presented utilized assumptions, models and estimates of the manager based on the manager’s judgment and experience.

September 30, 2011

 

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Change in Interest rates

   Percentage Change in
Projected Net Interest
Income
  Percentage Change in
Projected Portfolio
Value

+ 1.00%

   (9.38%)   (1.45%)

+ 0.50%

   (4.35%)   (0.35%)

- 0.50%

   (0.46%)   0.10%

- 1.00%

   (6.62%)   0.05%

December 31, 2010

 

Change in Interest rates

   Percentage Change in
Projected  Net Interest
Income
  Percentage Change in
Projected Portfolio
Value

+ 1.00%

   (7.25%)   (1.50%)

+ 0.50%

   (3.0%)   (0.54%)

- 0.50%

   1.48%   0.26%

- 1.00%

   (3.68%)   0.38%

While the tables 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 seek to take advantage of or reduce the impact of changes in interest rates. It is important to note that the impact of changing interest rates on market value and net interest income can change significantly when interest rates change beyond 100 basis points from current levels. Therefore, the volatility in the market value of our assets could increase significantly when interest rates change beyond amounts shown in the table above. In addition, other factors impact the market value of and net interest 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, interest income would likely differ from that shown above, and such difference might be material and adverse to our shareholders.

The above table quantifies the potential changes in net interest income and portfolio value, which includes the value of swaps, should interest rates immediately change. Given the low level of interest rates at September 30, 2011 and December 31, 2010, we applied a floor of 0%, for all anticipated interest rates included in our assumptions. Due to presence of this floor, it is anticipated that any hypothetical interest rate decrease would have a limited positive impact on our funding costs beyond a certain level; however, because prepayments speeds are unaffected by this floor, it is expected that any increase in our prepayment speeds (occurring as a result of any interest rate decrease or otherwise) could result in an acceleration of our premium amortization and the reinvestment of such prepaid principal in lower yielding assets. As a result, the presence of this floor limits the positive impact of any interest rate decrease on our funding costs. Therefore, at some point, a hypothetical interest rate decrease could cause the fair value of our financial instruments and our net interest income to decline.

Risk Management

To the extent consistent with maintaining our REIT status, we seek to manage our interest rate risk exposure to protect our portfolio of agency securities and related debt against the effects of major interest rate changes. We generally seek to manage our interest rate risk by:

 

   

monitoring and adjusting, if necessary, the reset index and interest rate related to our agency securities and our borrowings;

 

   

attempting to structure our borrowing agreements to have a range of different maturities, terms, amortizations and interest rate adjustment periods;

 

   

using derivatives, financial futures, swaps, options, caps, floors and forward sales to adjust the interest rate sensitivity of our agency securities and our borrowings;

 

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actively managing, on an aggregate basis, the interest rate indices, interest rate adjustment periods, interest rate caps and gross reset margins of our agency securities and the interest rate indices and adjustment periods of our borrowings; and

 

   

monitoring and managing, on an aggregate basis, our liquidity and leverage to maintain tolerance for market value changes.

 

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We have established disclosure controls and procedures to ensure that material information relating to our company is made known to the officers who certify our financial reports and to the members of senior management and the board of directors.

Based on management’s evaluation as of September 30, 2011, our Chief Executive Officer and Chief Financial Officer believe our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as amended) are effective to ensure that the information required to be disclosed by our company in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

Changes in Internal Control over Financial Reporting

There was no change to our internal control over financial reporting during the quarter ended September 30, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II.    Other Information

 

Item 1. Legal Proceedings

Our company and our manager are not currently subject to any material legal proceedings.

 

Item 1A. Risk Factors

Other than the following, 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, 2010 filed with the SEC on February 18, 2011.

Certain actions by the U.S. Federal Reserve could cause a flattening of the yield curve, which could materially adversely affect our business, financial condition and results of operations and our ability to pay distributions to our shareholders.

On September 21, 2011, the U.S. Federal Reserve announced “Operation Twist,” which is a program by which it intends to purchase, by the end of June 2012, $400 billion of U.S. Treasury securities with remaining maturities between six and 30 years and sell an equal amount of U.S. Treasury securities with remaining maturities of three years or less. The effect of Operation Twist could be a flattening in the yield curve, which could result in increased prepayment rates due to lower long-term interest rates and a narrowing of our net interest margin. Consequently, Operation Twist and any other future securities purchase programs by the U.S. Federal Reserve could materially adversely affect our business, financial condition and results of operations and our ability to pay distributions to our shareholders.

 

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The recent downgrade of the U.S. government’s credit rating and any future downgrades of the U.S. government’s credit rating may materially adversely affect our business, financial condition and results of operations.

On August 5, 2011, Standard & Poor’s downgraded the U.S. government’s credit rating for the first time in history. Because Fannie Mae and Freddie Mac are in conservatorship of the U.S. government, downgrades to the U.S. government’s credit rating could impact the credit risk associated with Agency MBS and, therefore, decrease the value of the Agency MBS in our portfolio. In addition, the downgrade of the U.S. government’s credit rating has created broader financial turmoil and uncertainty, which has weighed heavily on the global banking system. Therefore, the recent downgrade of the U.S. government’s credit rating and any future downgrades of the U.S. government’s credit rating may materially adversely affect our business, financial condition and results of operations.

Failure to maintain an exemption from the Investment Company Act would adversely affect our results of operations.

We believe that we conduct our business in a manner that allows us to avoid being regulated as an investment company under the Investment Company Act. Under Section 3(c)(5)(C), the Investment Company Act exempts entities that are primarily engaged in the business of purchasing or otherwise acquiring “mortgages and other liens on and interests in real estate.” The staff of the SEC has provided guidance on the availability of this exemption. Specifically, the staff’s position generally requires us to maintain at least 55% of our assets directly in qualifying real estate interests and 80% in real estate-related investments (including our qualifying real estate interests). We refer to this exemption as the “Mortgage Exemption.” In order to constitute a qualifying real estate interest under the 55% requirement, a real estate interest must meet various criteria. Mortgage securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and, thus, may not qualify for purposes of the 55% requirement. Our ownership of these mortgage securities, therefore, is limited by the provisions of the Investment Company Act. Accordingly, we intend to maintain at least 55% of our assets in whole pools of mortgages issued by Ginnie Mae, Fannie Mae or Freddie Mac. We may, consistent with our investment allocation guidelines and the Investment Company Act, invest up to 45% but not less than 25% of our remaining assets in partial pools of mortgages and other real estate-related investments (including our qualifying real estate interests). However, competition for investments may prevent us from acquiring mortgage securities that meet the 55% requirement at favorable yields or from acquiring sufficient qualifying securities to comply with the Mortgage Exemption under the Investment Company Act.

In addition, on September 1, 2011, the SEC issued a concept release (No. IC-29778; File No. SW7-34-11, Companies Engaged in the Business of Acquiring Mortgages and Mortgage-Related Instruments) pursuant to which it is reviewing whether certain companies that invest in MBS and rely on the exemption from registration under Section 3(c)(5)(C) of the Investment Company Act (such as us) should continue to be allowed to rely on such exemption from registration. If we fail to continue to qualify for this exemption from registration as an investment company, or the SEC determines that companies that invest in MBS are no longer able to rely on this exemption, our ability to use leverage would be substantially reduced and we would be unable to conduct our business as planned, or we may be required to register as an investment company under the Investment Company Act, either of which could negatively affect the value of shares of our common stock and our ability to make distributions to our shareholders.

 

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. [Removed and Reserved.]

 

Item 5. Other Information

None.

 

Item 6. 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)

 

(1) Submitted electronically herewith. Attached as Exhibit 101 to this report are the following documents formatted in XBRL (Extensible Business Reporting Language): (i) Balance Sheets at September 30, 2011 (Unaudited) and December 31, 2010 (Derived from the audited balance sheet at December 31, 2010); (ii) Statements of Income (Unaudited) for the three and nine months ended September 30, 2011 and 2010; (iii) Statement of Changes in Shareholders’ Equity (Unaudited) for the nine months ended September 30, 2011; (iv) Statements of Cash Flows (Unaudited) for the three and nine months ended September 30, 2011 and 2010; and (v) Notes to Financial Statements (Unaudited) for the nine months ended September 30, 2011. 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.

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.

HATTERAS FINANCIAL CORP.

 

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Dated:    October 31, 2011

 

BY:

 

/s/ KENNETH A. STEELE

    Kenneth A. Steele
    Chief Financial Officer, Treasurer and Secretary
    (Principal Financial Officer and Principal Accounting Officer)

 

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EXHIBIT INDEX

 

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)

 

(1) Submitted electronically herewith. Attached as Exhibit 101 to this report are the following documents formatted in XBRL (Extensible Business Reporting Language): (i) Balance Sheets at September 30, 2011 (Unaudited) and December 31, 2010 (Derived from the audited balance sheet at December 31, 2010); (ii) Statements of Income (Unaudited) for the three and nine months ended September 30, 2011 and 2010; (iii) Statement of Changes in Shareholders’ Equity (Unaudited) for the nine months ended September 30, 2011; (iv) Statements of Cash Flows (Unaudited) for the three and nine months ended September 30, 2011 and 2010; and (v) Notes to Financial Statements (Unaudited) for the nine months ended September 30, 2011. 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.