10-Q 1 form10q.htm ARLINGTON ASSET INVESTMENT CORP. 10-Q 6-30-2012 form10q.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


FORM 10-Q

 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2012
OR

o
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: 001-34374


ARLINGTON ASSET INVESTMENT CORP.
(Exact name of Registrant as specified in its charter)

 
Virginia
 
54-1873198
(State or Other Jurisdiction of Incorporation or Organization)
 
(I.R.S. Employer Identification No.)
 
 
 
1001 Nineteenth Street North
Arlington, VA
 
22209
(Address of Principal Executive Offices)
 
(Zip Code)

(703) 373-0200
(Registrant’s Telephone Number, Including Area Code)
 

 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

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

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

Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
Smaller reporting company o

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

Number of shares outstanding of each of the registrant’s classes of common stock, as of July 31, 2012:

Title
 
Outstanding
Class A Common Stock
 
9,115,203 shares
Class B Common Stock
 
566,112 shares
 


 
 

 
 
ARLINGTON ASSET INVESTMENT CORP.
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2012

 
 
 
Page
PART I—FINANCIAL INFORMATION
 
 
 
 
 
Item 1.
 
1
 
 
 
 
 
 
1
 
 
 
 
 
 
2
 
 
 
 
 
 
3
 
 
 
 
 
 
4
 
 
 
 
 
 
5
 
 
 
 
Item 2.
 
17
 
 
 
 
Item 3.
 
29
 
 
 
 
Item 4.
 
32
 
 
 
 
PART II—OTHER INFORMATION
 
 
 
 
 
Item 1.
 
34
 
 
 
 
Item 1A.
 
34
 
 
 
 
Item 2.
 
34
 
 
 
 
Item 4.
 
34
 
 
 
 
Item 6.
 
35
 
 
 
 
 
 
36

 
 


PART I
FINANCIAL INFORMATION


ARLINGTON ASSET INVESTMENT CORP.
(Dollars in thousands)
(Unaudited)

 
 
June 30, 2012
 
 
December 31, 2011
 
ASSETS
 
 
 
 
 
 
Cash and cash equivalents
 
$
21,137
 
 
$
20,018
 
Receivables
 
 
 
 
 
 
 
 
Interest
 
 
3,360
 
 
 
2,366
 
Sold securities receivable
 
 
70,727
 
 
 
41,321
 
Other
 
 
106
 
 
 
11
 
Mortgage-backed securities, at fair value
 
 
 
 
 
 
 
 
Available-for-sale
 
 
173,042
 
 
 
179,566
 
Trading
 
 
1,017,822
 
 
 
636,872
 
Other investments
 
 
2,931
 
 
 
2,946
 
Derivative assets, at fair value
 
 
1,899
 
 
 
504
 
Deposits
 
 
88,074
 
 
 
71,079
 
Prepaid expenses and other assets
 
 
367
 
 
 
377
 
Total assets
 
$
1,379,465
 
 
$
955,060
 
 
 
 
 
 
 
 
 
 
LIABILITIES AND EQUITY
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
Repurchase agreements
 
$
963,051
 
 
$
647,977
 
Interest payable
 
 
410
 
 
 
504
 
Accrued compensation and benefits
 
 
2,564
 
 
 
6,177
 
Dividend payable
 
 
8,566
 
 
 
6,785
 
Derivative liabilities, at fair value
 
 
81,028
 
 
 
63,024
 
Purchased securities payable
 
 
 
 
 
15,820
 
Securities sold but not yet purchased, at fair value
 
 
70,965
 
 
 
 
Accounts payable, accrued expenses and other liabilities
 
 
16,789
 
 
 
16,401
 
Long-term debt
 
 
15,000
 
 
 
15,000
 
Total liabilities
 
 
1,158,373
 
 
 
771,688
 
 
 
 
 
 
 
 
 
 
Commitments and contingencies
 
 
 
 
 
 
Equity:
 
 
 
 
 
 
 
 
Preferred stock, $0.01 par value, 25,000,000 shares authorized, none issued and outstanding
 
 
 
 
 
 
Class A common stock, $0.01 par value, 450,000,000 shares authorized, 9,115,203 and 7,099,336 shares issued and outstanding, respectively
 
 
91
 
 
 
71
 
Class B common stock, $0.01 par value, 100,000,000 shares authorized, 566,112 shares issued and outstanding
 
 
6
 
 
 
6
 
Additional paid-in capital
 
 
1,554,952
 
 
 
1,508,713
 
Accumulated other comprehensive income, net of taxes
 
 
33,807
 
 
 
38,367
 
Accumulated deficit
 
 
(1,367,764
)
 
 
(1,363,785
)
Total equity
 
 
221,092
 
 
 
183,372
 
Total liabilities and equity
 
$
1,379,465
 
 
$
955,060
 

See notes to consolidated financial statements.

 
1

 
ARLINGTON ASSET INVESTMENT CORP.
(Dollars in thousands, except per share data)
 
(Unaudited)
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Interest income
  $ 16,031     $ 13,262     $ 29,394     $ 25,757  
                                 
Interest expense
                               
Interest on short-term debt
    994       477       1,686       794  
Interest on long-term debt
    123       115       248       230  
Total interest expense
    1,117       592       1,934       1,024  
Net interest income
    14,914       12,670       27,460       24,733  
Other (loss) income, net
                               
Investment (loss) gain, net
    (8,677 )     (8,484 )     (5,869 )     2,740  
Other loss
    (4 )     (4 )     (8 )     (7 )
Total other (loss) income, net
    (8,681 )     (8,488 )     (5,877 )     2,733  
Operating income before other expenses
    6,233       4,182       21,583       27,466  
Other expenses
                               
Compensation and benefits
    2,101       2,570       4,061       5,006  
Professional services
    891       561       2,475       684  
Business development
    55       47       72       79  
Occupancy and equipment
    150       92       245       188  
Communications
    53       50       105       96  
Other operating expenses
    460       425       898       720  
Total other expenses
    3,710       3,745       7,856       6,773  
Income before income taxes
    2,523       437       13,727       20,693  
Income tax provision
    379       346       821       817  
Net income
  $ 2,144     $ 91     $ 12,906     $ 19,876  
                                 
Basic earnings per share
  $ 0.22     $ 0.01     $ 1.47     $ 2.58  
Diluted earnings per share
  $ 0.22     $ 0.01     $ 1.47     $ 2.57  
Dividends declared per share
  $ 0.875     $ 0.875     $ 1.75     $ 1.625  
Weighted-average shares outstanding
                               
(in thousands)
                               
Basic
    9,726       7,723       8,795       7,692  
Diluted
    9,733       7,736       8,803       7,728  
                                 
Other comprehensive income (loss), net of taxes
                               
Unrealized gains (losses) for the period on available-for-sale securities (net of taxes of $-0-)
  $ 343     $ (1,597 )   $ (4,560 )   $ (136 )
Reclassification adjustment for gains included in net income on available-for-sale securities (net of taxes of $-0-)
          (2,089 )           (13,794 )
Comprehensive income (loss)
  $ 2,487     $ (3,595 )   $ 8,346     $ 5,946  
 
See notes to consolidated financial statements.

 
2

 
ARLINGTON ASSET INVESTMENT CORP.
(Dollars in thousands)
(Unaudited)

 
 
Class A
Common
Stock (#)
 
 
Class A
Amount
($)
 
 
Class B
Common
Stock (#)
 
 
Class B
Amount
($)
 
 
Additional
Paid-In
Capital
 
 
Accumulated
Other
Comprehensive
Income
 
 
Accumulated
Deficit
 
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balances, December 31, 2010
 
 
7,106,330
 
 
$
71
 
 
 
566,112
 
 
$
6
 
 
$
1,505,971
 
 
$
63,495
 
 
$
(1,352,799
)
 
$
216,744
 
Net income
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
15,173
 
 
 
15,173
 
Issuance of Class A common stock
 
 
29,147
 
 
 
 
 
 
 
 
 
 
 
 
545
 
 
 
 
 
 
 
 
 
545
 
Repurchase of Class A common stock
 
 
(8,910
)
 
 
 
 
 
 
 
 
 
 
 
(229
)
 
 
 
 
 
 
 
 
(229
)
Forfeitures of Class A common stock
 
 
(27,231
)
 
 
 
 
 
 
 
 
 
 
 
(770
)
 
 
 
 
 
 
 
 
(770
)
Amortization of Class A common shares issued as stock-based awards
 
 
 
 
 
 
 
 
 
 
 
 
 
 
601
 
 
 
 
 
 
 
 
 
601
 
Reclassification of restricted stock units issued as stock based awards
 
 
 
 
 
 
 
 
 
 
 
 
 
 
2,595
 
 
 
 
 
 
 
 
 
2,595
 
Other comprehensive income
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net change in unrealized gain on available-for-sale investment securities, (net of taxes of $-0-)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(25,128
)
 
 
 
 
 
(25,128
)
Dividends declared
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(26,159
)
 
 
(26,159
)
Balances, December 31, 2011
 
 
7,099,336
 
 
 
71
 
 
 
566,112
 
 
 
6
 
 
 
1,508,713
 
 
 
38,367
 
 
 
(1,363,785
)
 
 
183,372
 
Net income
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
12,906
 
 
 
12,906
 
Issuance of Class A common stock
 
 
2,018,250
 
 
 
20
 
 
 
 
 
 
 
 
 
45,995
 
 
 
 
 
 
 
 
 
46,015
 
Forfeitures of Class A common stock
 
 
(2,383
)
 
 
 
 
 
 
 
 
 
 
 
(55
)
 
 
 
 
 
 
 
 
(55
)
Amortization of Class A common shares issued as stock-based awards
 
 
 
 
 
 
 
 
 
 
 
 
 
 
299
 
 
 
 
 
 
 
 
 
299
 
Other comprehensive income
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net change in unrealized gain on available-for-sale investment securities, (net of taxes of $-0-)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(4,560
)
 
 
 
 
 
(4,560
)
Dividends declared
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(16,885
)
 
 
(16,885
)
Balances, June 30, 2012
 
 
9,115,203
 
 
$
91
 
 
 
566,112
 
 
$
6
 
 
$
1,554,952
 
 
$
33,807
 
 
$
(1,367,764
)
 
$
221,092
 

See notes to consolidated financial statements.

 
3


ARLINGTON ASSET INVESTMENT CORP.

(Dollars in thousands)
(Unaudited)

 
 
Six Months Ended June 30,
 
 
 
2012
 
 
2011
 
Cash flows from operating activities:
 
 
 
 
 
 
Net income
 
$
12,906
 
 
$
19,876
 
Adjustments to reconcile net income to net cash provided by operating activities
 
 
 
 
 
 
 
 
Net investment loss (gain)
 
 
5,869
 
 
 
(2,740
)
Net (discount)/premium (accretion)/amortization on mortgage-backed securities
 
 
(5,458
)
 
 
(5,991
)
Depreciation and amortization
 
 
24
 
 
 
24
 
Other
 
 
538
 
 
 
465
 
Changes in operating assets
 
 
 
 
 
 
 
 
Interest receivable
 
 
(994
)
 
 
(1,409
)
Other receivables
 
 
(95
)
 
 
19
 
Prepaid expenses and other assets
 
 
692
 
 
 
664
 
Changes in operating liabilities
 
 
 
 
 
 
 
 
Accounts payable and accrued expenses
 
 
1
 
 
 
592
 
Accrued compensation and benefits
 
 
(3,613
)
 
 
(1,467
)
Net cash provided by operating activities
 
 
9,870
 
 
 
10,033
 
 
 
 
 
 
 
 
 
 
Cash flows from investing activities:
 
 
 
 
 
 
 
 
Purchases of available-for-sale mortgage-backed securities
 
 
(470
)
 
 
(17,190
)
Purchases of trading mortgage-backed securities
 
 
(508,374
)
 
 
(663,542
)
Proceeds from sales of available-for-sale mortgage-backed securities
 
 
 
 
 
73,294
 
Proceeds from sales of trading mortgage-backed securities
 
 
112,067
 
 
 
176,278
 
Receipt of principal payments on available-for-sale mortgage-backed securities
 
 
7,807
 
 
 
8,097
 
Receipt of principal payments on trading mortgage-backed securities
 
 
31,143
 
 
 
13,255
 
Payments for purchased securities payable
 
 
(15,820
)
 
 
(2,555
)
Proceeds from sold securities receivable
 
 
41,321
 
 
 
 
Payments for derivatives and deposits, net
 
 
(18,085
)
 
 
(31,623
)
Other
 
 
(4,325
)
 
 
5,253
 
Net cash used in investing activities
 
 
(354,736
)
 
 
(438,733
)
 
 
 
 
 
 
 
 
 
Cash flows from financing activities:
 
 
 
 
 
 
 
 
Proceeds from repurchase agreements, net
 
 
315,074
 
 
 
449,023
 
Proceeds from stock issuance
 
 
46,015
 
 
 
 
Dividends paid
 
 
(15,104
)
 
 
(10,459
)
Repayments of short-term debt
 
 
 
 
 
(970
)
Repurchase of common stock
 
 
 
 
 
(229
)
Net cash provided by financing activities
 
 
345,985
 
 
 
437,365
 
 
 
 
 
 
 
 
 
 
Net increase in cash and cash equivalents
 
 
1,119
 
 
 
8,665
 
Cash and cash equivalents, beginning of period
 
 
20,018
 
 
 
12,412
 
Cash and cash equivalents, end of period
 
$
21,137
 
 
$
21,077
 
 
 
 
 
 
 
 
 
 
Supplemental cash flow information
 
 
 
 
 
 
 
 
Cash payments for interest
 
$
2,028
 
 
$
966
 
Cash payments for taxes
 
$
274
 
 
$
195
 

See notes to consolidated financial statements.

 
4


ARLINGTON ASSET INVESTMENT CORP.

(Dollars in thousands, except per share data)
(Unaudited)

1.
Basis of Presentation:

The consolidated financial statements of Arlington Asset Investment Corp. (Arlington Asset) and its subsidiaries (unless the context otherwise provides, collectively, the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to Form 10-Q. Therefore, they do not include all information required by GAAP for complete financial statements. The interim financial statements reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair statement of the results for the periods presented. All significant intercompany accounts and transactions have been eliminated in consolidation. The results of operations for the three and six months ended June 30, 2012 are not necessarily indicative of the operating results for the entire year or any other subsequent interim period. The Company’s unaudited condensed consolidated financial statements and notes thereto should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

The preparation of the Company’s financial statements in conformity with GAAP requires the Company to make estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Although the Company based the estimates and assumptions on historical experience, when available, market information, and on various other factors that the Company believes to be reasonable under the circumstances, management exercises significant judgment in the final determination of the estimates. Actual results may differ from these estimates.

Certain amounts in the consolidated financial statements and notes for prior periods have been reclassified to conform to the current period presentation. These reclassifications had no effect on the results of operations of the Company.

2.
Financial Instruments:
 
  Fair Value of Financial Instruments

The accounting principles related to fair value measurements define fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, not adjusted for transaction costs. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures (ASC 820), establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels giving the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3) as described below:

Level 1 Inputs—
Unadjusted quoted prices in active markets for identical assets or liabilities that are accessible by the Company;

Level 2 Inputs—
Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly; and

Level 3 Inputs—
Unobservable inputs for the asset or liability, including significant assumptions of the Company and other market participants.

The Company determines fair values for the following assets and liabilities:

Mortgage-backed securities (MBS), at fair value

Agency-backed MBS - The Company’s agency-backed MBS, the principal and interest payments on which are guaranteed by the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac), are generally classified within Level 2 of the fair value hierarchy as they are valued after considering quoted market prices provided by a broker or dealer, or alternative pricing sources with reasonable levels of price transparency. The Company reviews broker or pricing service quotes to determine whether the quotes are relevant, for example, whether an active market exists to provide price transparency or whether the quote is an indicative price or a binding offer. The independent brokers and dealers providing market prices are those who make markets in these financial instruments.
 
 
5

 
Private-label MBS - The Company classifies private-label MBS within Level 3 of the fair value hierarchy because they trade infrequently and, therefore, have little or no price transparency. The Company utilizes present value techniques based on estimated cash flows of the instrument taking into consideration various assumptions derived by management and other assumptions used by other market participants. These assumptions are corroborated by evidence such as historical data, risk characteristics, transactions in similar instruments, and completed or pending transactions, when available. The significant inputs in the Company’s valuation process include default rate, loss severity, prepayment rate and discount rate. In general, significant increases (decreases) in default rate, loss severity or discount rate, in isolation, would result in a significantly lower (higher) fair value measurement.  However, significant increases (decreases) in prepayment rate may result in a significantly higher (lower) fair value measurement. It is difficult to generalize the interrelationships between these significant inputs as the actual results could differ considerably on an individual security basis.  For example, an increase in the default rate may not increase the loss severity rate if actual losses are lower than the average.  Also, changes in discount rates may be greatly influenced by market expectation at any given point based upon many variables not directly related to the MBS market.  Therefore, each significant input is closely analyzed to ascertain the reasonableness for the Company’s valuation purposes.

Establishing fair value is inherently subjective given the volatile and sometimes illiquid markets for these private-label MBS and requires management to make a number of assumptions, including assumptions about the future of interest rates, prepayment rates, discount rates, credit loss rates, and the timing of cash flows and credit losses. The assumptions the Company applies are specific to each security. Although the Company relies on the internal calculations to compute the fair value of these private-label MBS, the Company requests and considers indications of value (mark) from third-party dealers to assist in the valuation process.

Securities sold but not yet purchased, at fair value—The Company’s securities sold but not yet purchased, at fair value, represent obligations of the Company to deliver a specified MBS at a contracted price, which create a liability to purchase that MBS at prevailing prices in order to deliver the MBS in satisfaction of this obligation. The Company’s liability for the purchase of the MBS to be delivered is measured at the fair value of the MBS as of the date of the financial statements. However, these transactions expose the Company to price risk until settled, as the Company’s ultimate cost to satisfy the delivery of securities sold but not yet purchased, at fair value, may exceed the amount reflected in the consolidated balance sheet. The Company classifies MBS sold but not yet purchased, at fair value, within Level 2 of the fair value hierarchy, as they are valued after considering quoted market prices provided by a broker or dealer, or alternative pricing sources, with reasonable levels of price transparency. The Company reviews broker or pricing service quotes to determine whether the quotes are relevant, for example, whether an active market exists to provide price transparency or whether the quote is an indicative price or a binding offer. The independent brokers and dealers providing market prices are those who make markets in these financial instruments.

Other investments—The Company’s other investments consist of investments in equity securities, investment funds, interest-only MBS, and other MBS-related securities. Interest-only MBS and residual interest in a securitization of which the Company is not considered the primary beneficiary are classified within Level 3 of the fair value hierarchy.

Derivative instruments—In the normal course of the Company’s operations, the Company is a party to various financial instruments that are accounted for as derivatives in accordance with ASC 815, Derivatives and Hedging (ASC 815). The derivative instruments that trade in active markets or exchanges are classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices. Other derivative instruments are generally classified within Level 2 of the fair value hierarchy because they are valued using broker or dealer quotations, which are model-based calculations based on market-based inputs, including, but not limited to, contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs.
 
Other—Cash and cash equivalents, interest receivable, sold securities receivable, deposits, other receivable, repurchase agreements, purchase securities payable, interest payable, accounts payable, accrued expenses and other liabilities are reflected in the consolidated balance sheets at their amortized cost, which approximates fair value because of the short term nature of these instruments.
 
 
6

 
The estimated fair values of the Company’s financial instruments are as follows:

 
 
June 30, 2012
 
 
December 31, 2011
 
 
 
Carrying
Amount
 
 
Estimated
Fair Value
 
 
Carrying
Amount
 
 
Estimated
Fair Value
 
Financial assets
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
21,137
 
 
$
21,137
 
 
$
20,018
 
 
$
20,018
 
Interest receivable
 
 
3,360
 
 
 
3,360
 
 
 
2,366
 
 
 
2,366
 
Sold securities receivable
 
 
70,727
 
 
 
70,727
 
 
 
41,321
 
 
 
41,321
 
Other receivables
 
 
106
 
 
 
106
 
 
 
11
 
 
 
11
 
MBS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency-backed MBS
 
 
1,017,916
 
 
 
1,017,916
 
 
 
637,011
 
 
 
637,011
 
Private-label MBS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior securities
 
 
8,498
 
 
 
8,498
 
 
 
9,311
 
 
 
9,311
 
Re-REMIC securities
 
 
164,450
 
 
 
164,450
 
 
 
170,116
 
 
 
170,116
 
Derivative assets
 
 
1,899
 
 
 
1,899
 
 
 
504
 
 
 
504
 
Other investments
 
 
2,931
 
 
 
2,931
 
 
 
2,946
 
 
 
2,946
 
Deposits
 
 
88,074
 
 
 
88,074
 
 
 
71,079
 
 
 
71,079
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Financial liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
 
 
963,051
 
 
 
963,051
 
 
 
647,977
 
 
 
647,977
 
Purchased securities payable
 
 
 
 
 
 
 
 
15,820
 
 
 
15,820
 
Securities sold but not yet purchased
 
 
70,965
 
 
 
70,965
 
 
 
 
 
 
 
Interest payable
 
 
410
 
 
 
410
 
 
 
504
 
 
 
504
 
Long-term debt
 
 
15,000
 
 
 
15,000
 
 
 
15,000
 
 
 
15,000
 
Derivative liabilities
 
 
81,028
 
 
 
81,028
 
 
 
63,024
 
 
 
63,024
 
Accounts payable, accrued expenses and other liabilities
 
 
16,789
 
 
 
16,789
 
 
 
16,401
 
 
 
16,401
 

  Fair Value Hierarchy

The following tables set forth financial instruments accounted for under ASC 820 by level within the fair value hierarchy as of June 30, 2012 and December 31, 2011. As required by ASC 820, assets and liabilities that are measured at fair value are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Financial Instruments Measured at Fair Value on a Recurring Basis

 
 
June 30, 2012
 
 
 
Total
 
 
Level 1
 
 
Level 2
 
 
Level 3
 
MBS, at fair value
 
 
 
 
 
 
 
 
 
 
 
 
Trading
 
 
 
 
 
 
 
 
 
 
 
 
Agency-backed MBS
 
$
1,017,822
 
 
$
 
 
$
1,017,822
 
 
$
 
Available-for-sale
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency-backed MBS
 
 
94
 
 
 
 
 
 
94
 
 
 
 
Private-label MBS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior securities
 
 
8,498
 
 
 
 
 
 
 
 
 
8,498
 
Re-REMIC securities
 
 
164,450
 
 
 
 
 
 
 
 
 
164,450
 
Total available-for-sale
 
 
173,042
 
 
 
 
 
 
94
 
 
 
172,948
 
Total MBS
 
 
1,190,864
 
 
 
 
 
 
1,017,916
 
 
 
172,948
 
Derivative assets, at fair value
 
 
1,899
 
 
 
 
 
 
1,899
 
 
 
 
Derivative liabilities, at fair value
 
 
(81,028
)
 
 
(80,512
)
 
 
(516
)
 
 
 
Securities sold but not yet purchased, at fair value
 
 
(70,965
)
 
 
 
 
 
(70,965
)
 
 
 
Interest-only MBS, at fair value
 
 
935
 
 
 
 
 
 
 
 
 
935
 
Total
 
$
1,041,705
 
 
$
(80,512
)
 
$
948,334
 
 
$
173,883
 

 
7

 
 
 
December 31, 2011
 
 
 
Total
 
 
Level 1
 
 
Level 2
 
 
Level 3
 
MBS, at fair value
 
 
 
 
 
 
 
 
 
 
 
 
Trading
 
 
 
 
 
 
 
 
 
 
 
 
Agency-backed MBS
 
$
636,872
 
 
$
 
 
$
636,872
 
 
$
 
Available-for-sale
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency-backed MBS
 
 
139
 
 
 
 
 
 
139
 
 
 
 
Private-label MBS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior securities
 
 
9,311
 
 
 
 
 
 
 
 
 
9,311
 
Re-REMIC securities
 
 
170,116
 
 
 
 
 
 
 
 
 
170,116
 
Total available-for-sale
 
 
179,566
 
 
 
 
 
 
139
 
 
 
179,427
 
Total MBS
 
 
816,438
 
 
 
 
 
 
637,011
 
 
 
179,427
 
Derivative assets, at fair value
 
 
504
 
 
 
 
 
 
504
 
 
 
 
Derivative liabilities, at fair value
 
 
(63,024
)
 
 
(63,024
)
 
 
 
 
 
 
Interest-only MBS, at fair value
 
 
1,060
 
 
 
 
 
 
 
 
 
1,060
 
Total
 
$
754,978
 
 
$
(63,024
)
 
$
637,515
 
 
$
180,487
 

The total financial assets measured and reported at fair value on a recurring basis and classified within Level 3 were $173,883, or 12.61%, and $180,487, or 18.90%, of the Company’s total assets as of June 30, 2012 and December 31, 2011, respectively.

There were no significant transfers of securities in or out of Levels 1, 2 or 3 during the three or six months ended June 30, 2012 or the year ended December 31, 2011.

Level 3 Financial Assets and Liabilities

Financial Instruments Measured at Fair Value on a Recurring Basis

As of June 30, 2012, the fair value of the Company’s Level 3, available-for-sale, private-label MBS was $173,883. These securities are primarily senior and re-REMIC tranches in securitization trusts issued between 2005 and 2010. The senior securities represent interests in securitizations that have the first right to cash flows and absorb losses last. The re-REMIC securities represent interests in re-securitizations of senior MBS and pro-rata mezzanine securities. For re-REMIC securities, the cash flows from, and any credit losses absorbed by, the underlying MBS are allocated among the re-REMIC securities issued in the re-securitization transactions based on the re-REMIC structure. For example, prime and non-prime residential senior securities have been resecuritized to create a two-tranche structure with a re-REMIC senior security and a re-REMIC subordinated security. In these re-REMIC securities, all principal payments from the underlying securities are directed to the re-REMIC senior security until the face value is fully paid off. Thereafter, all principal payments are directed to the re-REMIC subordinated security. For pro-rata mezzanine securities, principal payments from the underlying MBS are typically allocated concurrently and proportionally to the mezzanine securities along with senior securities. The re-REMIC subordinated and mezzanine securities absorb credit losses, if any, first; however, these credit losses occur only when credit losses exceed the credit protection provided to the underlying securities. Senior, re-REMIC and mezzanine securities receive interest while any face value is outstanding.
 
As of June 30, 2012, the Company’s senior securities and re-REMIC securities were collateralized by residential Prime and Alt-A mortgage loans and had a weighted-average original loan-to-value of 71%, weighted-average original FICO score of 729, weighted-average three-month prepayment rate of 15% and weighted-average three-month loss severities of 49%. These underlying collateral loans had a weighted-average coupon rate of 5.20%. These securities are currently rated below investment grade. The significant unobservable inputs for the valuation model include the following weighted-averages:

 
 
June 30, 2012
 
 
December 31, 2011
 
 
 
Senior
Securities
 
 
Re-REMIC
Securities
 
 
Senior
Securities
 
 
Re-REMIC
Securities
 
Discount rate
 
 
6.80
%
 
 
8.50
%
 
 
7.00
%
 
 
8.75
%
Default rate
 
 
9.30
%
 
 
5.19
%
 
 
10.30
%
 
 
5.55
%
Loss severity rate
 
 
57.50
%
 
 
43.51
%
 
 
60.00
%
 
 
43.06
%
Prepayment rate
 
 
16.30
%
 
 
14.89
%
 
 
17.30
%
 
 
15.20
%

 
8

 
The ranges of the significant unobservable inputs for the valuation model were as follows as of the dates indicated:

 
 
June 30, 2012
 
 
December 31, 2011
 
 
 
Senior
Securities
 
 
Re-REMIC
Securities
 
 
Senior
Securities
 
 
Re-REMIC
Securities
 
Discount rate
 
 
6.80
%
 
 
7.15 – 13.73
%
 
 
7.00
%
 
 
7.45 – 13.73
%
Default rate
 
 
9.30
%
 
 
1.75 – 11.50
%
 
 
10.30
%
 
 
2.10 – 13.00
%
Loss severity rate
 
 
57.50
%
 
 
28.21 – 57.50
%
 
 
60.00
%
 
 
28.18 – 57.50
%
Prepayment rate
 
 
16.30
%
 
 
7.75 – 21.05
%
 
 
17.30
%
 
 
9.60 – 21.00
%
 
The tables below set forth a summary of changes in the fair value and gains and losses of the Company’s Level 3 financial assets and liabilities that are measured at fair value on a recurring basis for the three and six months ended June 30, 2012 and 2011.

 
 
Three Months Ended June 30, 2012
 
 
 
Senior
Securities
 
 
Re-REMIC
Securities
 
 
Total
 
Beginning balance, April 1, 2012
 
$
8,647
 
 
$
166,892
 
 
$
175,539
 
Total net gains (losses)
 
 
 
 
 
 
 
 
 
 
 
 
Included in earnings
 
 
 
 
 
(4,531
)
 
 
(4,531
)
Included in other comprehensive income
 
 
(74
)
 
 
503
 
 
 
429
 
Purchases
 
 
 
 
 
470
 
 
 
470
 
Sales
 
 
 
 
 
 
 
 
 
Payments, net
 
 
(428
)
 
 
(4,930
)
 
 
(5,358
)
Accretion of discount
 
 
353
 
 
 
6,046
 
 
 
6,399
 
Ending balance, June 30, 2012
 
$
8,498
 
 
$
164,450
 
 
$
172,948
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date
 
$
 
 
$
(4,531
)
 
$
(4,531
)

 
 
Three Months Ended June 30, 2011
 
 
 
Senior
Securities
 
 
Re-REMIC
Securities
 
 
Total
 
Beginning balance, April 1, 2011
 
$
15,865
 
 
$
185,457
 
 
$
201,322
 
Total net gains (losses)
 
 
 
 
 
 
 
 
 
 
 
 
Included in earnings
 
 
53
 
 
 
1,419
 
 
 
1,472
 
Included in other comprehensive income
 
 
(856
)
 
 
(2,837
)
 
 
(3,693
)
Purchases
 
 
 
 
 
6,212
 
 
 
6,212
 
Sales
 
 
(4,294
)
 
 
(6,971
)
 
 
(11,265
)
Payments, net
 
 
(586
)
 
 
(5,746
)
 
 
(6,332
)
Accretion of discount
 
 
391
 
 
 
6,246
 
 
 
6,637
 
Ending balance, June 30, 2011
 
$
10,573
 
 
$
183,780
 
 
$
194,353
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date
 
$
 
 
$
 
 
$
 
 
 
 
Six Months Ended June 30, 2012
 
 
 
Senior
Securities
 
 
Re-REMIC
Securities
 
 
Total
 
Beginning balance, January 1, 2012
 
$
9,311
 
 
$
170,116
 
 
$
179,427
 
Total net gains (losses)
 
 
 
 
 
 
 
 
 
 
 
 
Included in earnings
 
 
 
 
 
(4,531
)
 
 
(4,531
)
Included in other comprehensive income
 
 
(681
)
 
 
(3,773
)
 
 
(4,454
)
Purchases
 
 
 
 
 
470
 
 
 
470
 
Sales
 
 
 
 
 
 
 
 
 
Payments, net
 
 
(839
)
 
 
(9,816
)
 
 
(10,655
)
Accretion of discount
 
 
707
 
 
 
11,984
 
 
 
12,691
 
Ending balance, June 30, 2012
 
$
8,498
 
 
$
164,450
 
 
$
172,948
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date
 
$
 
 
$
(4,531
)
 
$
(4,531
)
 
 
9

 
 
 
Six Months Ended June 30, 2011
 
 
 
Senior
Securities
 
 
Re-REMIC
Securities
 
 
Total
 
Beginning balance, January 1, 2011
 
$
51,038
 
 
$
201,697
 
 
$
252,735
 
Total net gains (losses)
 
 
 
 
 
 
 
 
 
 
 
 
Included in earnings
 
 
3,525
 
 
 
8,628
 
 
 
12,153
 
Included in other comprehensive income
 
 
(6,082
)
 
 
(7,058
)
 
 
(13,140
)
Purchases
 
 
330
 
 
 
16,860
 
 
 
17,190
 
Sales
 
 
(37,229
)
 
 
(36,066
)
 
 
(73,295
)
Payments, net
 
 
(2,620
)
 
 
(13,334
)
 
 
(15,954
)
Accretion of discount
 
 
1,611
 
 
 
13,053
 
 
 
14,664
 
Ending balance, June 30, 2011
 
$
10,573
 
 
$
183,780
 
 
$
194,353
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date
 
$
 
 
$
 
 
$
 
 
Gains and losses included in earnings for the three and six months ended June 30, 2012 and 2011 are reported in the following statement of comprehensive income line descriptions:
 
   
Other (Loss) Income, Investment (Loss) Gain, net
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Total gains included in earnings for the period
  $ (4,531 )   $ 1,472     $ (4,531 )   $ 12,153  
                                 
Change in unrealized gains relating to assets still held at reporting date
  $ (4,531 )   $     $ (4,531 )   $  
 
Level 3 Financial Instruments Measured at Fair Value on a Non-Recurring Basis

The Company also measures certain financial assets at fair value on a non-recurring basis. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets due to impairments. Due to the nature of these financial assets, enterprise values are primarily used to value these financial assets. In determining the enterprise value, the Company analyzes various financial, performance and market factors to estimate fair value, including where applicable, market trading activity. As a result, these financial assets are classified within Level 3 of the fair value hierarchy. As of June 30, 2012, these financial assets are classified within the other investments category and represent the Company’s interest in non-public equity securities and investment funds. For the six months ended June 30, 2011, the Company recorded a loss of $85 in the carrying value of these financial assets. For the three months ended June 30, 2011 and for the three and six months ended June 30, 2012, there were no changes to the carrying value of these financial assets.

 
10

 
MBS, at Fair Value

MBS, at fair value(1) (2), consisted of the following as of the dates indicated:
 
 
 
June 30, 2012
 
 
December 31, 2011
 
 
 
Fair
Value
 
 
Net
Unamortized
Premium
(Discount)
 
 
Percent
of
Total
Fair
Value
 
 
Weighted
Average
Life
 
 
Weighted
Average
Rating(3)
 
 
Fair
Value
 
 
Net
Unamortized
Premium
(Discount)
 
 
Percent
of
Total
Fair
Value
 
 
Weighted
Average
Life
 
Weighted
Average
Rating(3)
 
Trading
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fannie Mae
 
$
639,581
 
 
$
 
 
 
53.71
%
 
 
6.1
 
 
AAA
 
 
$
432,039
 
 
$
 
 
 
52.92
%
 
 
5.7
 
AAA
 
Freddie Mac
 
 
378,241
 
 
 
 
 
 
31.76
%
 
 
6.5
 
 
AAA
 
 
 
204,833
 
 
 
 
 
 
25.09
%
 
 
6.0
 
AAA
 
Available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency-backed
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fannie Mae
 
 
94
 
 
 
 
 
 
0.01
%
 
 
3.0
 
 
AAA
 
 
 
139
 
 
 
 
 
 
0.01
%
 
 
5.2
 
AAA
 
Private-label
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior securities
 
 
8,498
 
 
 
(4,778
)
 
 
0.71
%
 
 
6.3
 
 
 
CC+
 
 
 
9,311
 
 
 
(5,196
)
 
 
1.14
%
 
 
5.0
 
CC+
 
Re-REMIC securities
 
 
164,450
 
 
 
(127,244
)
 
 
13.81
%
 
 
9.5
 
 
NR
 
 
 
170,116
 
 
 
(131,541
)
 
 
20.84
%
 
 
9.1
 
NR
 
 
 
$
1,190,864
 
 
$
(132,022
)
 
 
100.00
%
 
 
 
 
 
 
 
 
 
$
816,438
 
 
$
(136,737
)
 
 
100.00
%
 
 
 
 
 
 
 

(1)
The Company’s MBS portfolio was primarily comprised of fixed-rate MBS at June 30, 2012 and December 31, 2011. The weighted-average coupon of the MBS portfolio at June 30, 2012 and December 31, 2011 was 4.52% and 4.85%, respectively.
(2)
As of June 30, 2012 and December 31, 2011, the Company’s MBS investments with a fair value of $1,065,807 and $731,432, respectively, were pledged as collateral for repurchase agreements.
(3)
The securities issued by Fannie Mae and Freddie Mac are not rated by any rating agency; however, they are commonly thought of as having an implied rating of “AAA.” There is no assurance, particularly given the downgrade of the U.S.’s credit rating to “AA” by Standard & Poors during the quarter ended September 30, 2011, that these securities would receive such a rating if they were ever rated by a rating agency. The weighted-average rating of the Company’s private-label senior securities is calculated based on face value of the securities.

The Company has generally purchased private-label MBS at a discount. The Company, at least on a quarterly basis, estimates the future expected cash flows based on the Company’s observation of current information and events and applying a number of assumptions related to prepayment rates, interest rates, default rates, and the timing and amount of cash flows and credit losses. These assumptions are difficult to predict as they are subject to uncertainties and contingencies related to future events that may impact the Company’s estimates and its interest income.

Interest income on the private-label MBS that were purchased at a discount to face value is recognized based on the security’s expected effective interest rate. At acquisition, the accretable yield is calculated as the difference between the undiscounted expected cash flows and the purchase price which is expected to be accreted into interest income over the remaining life of the security on a level-yield basis. The difference between the contractually required payments and the undiscounted expected cash flows represents the non-accretable difference. Based on actual payment activities and changes in estimates of undiscounted expected future cash flows, the accretable yield and the non-accretable difference can change over time. Significant increases in the amount or timing of undiscounted expected future cash flows are recognized prospectively as an adjustment to the accretable yield.
 
The following table presents the changes in the accretable yield on available-for-sale, private-label MBS for the three and six months ended June 30, 2012 and 2011.

 
 
Three Months Ended June 30,
 
 
Six Months Ended June 30,
 
 
 
2012
 
 
2011
 
 
2012
 
 
2011
 
Beginning balance
 
$
182,867
 
 
$
258,017
 
 
$
194,619
 
 
$
316,029
 
Accretion of discount
 
 
(6,399
)
 
 
(6,637
)
 
 
(12,691
)
 
 
(14,664
)
Reclassifications, net
 
 
1,984
   
 
(11,250
)
 
 
(3,476
)
 
 
(23,347
)
Acquisitions
 
 
1,749
 
 
 
9,057
 
 
 
1,749
 
 
 
24,163
 
Sales
 
 
 
 
 
(13,720
)
 
 
 
 
 
(66,714
)
Ending balance
 
$
180,201
 
 
$
235,467
 
 
$
180,201
 
 
$
235,467
 

 
11

 
For the available-for-sale, private-label MBS acquired during the three and six months ended June 30, 2012 and 2011, the contractually required payments receivable, the cash flow expected to be collected, and the fair value at the acquisition date were as follows for the dates indicated:

 
 
Three Months Ended June 30,
 
 
Six Months Ended June 30,
 
 
 
2012
 
 
2011
 
 
2012
 
 
2011
 
Contractually required payments receivable
 
$
2,219
 
 
$
15,270
 
 
$
2,219
 
 
$
47,228
 
Cash flows expected to be collected
 
 
2,219
 
 
 
15,270
 
 
 
2,219
 
 
 
43,909
 
Basis in acquired securities
 
 
470
 
 
 
6,213
 
 
 
470
 
 
 
19,746
 

The Company’s available-for-sale MBS are carried at fair value in accordance with ASC 320, Debt and Equity Securities (ASC 320), the securities with resulting unrealized gains and losses reflected as other comprehensive income or loss. Gross unrealized gains and losses on these securities were the following as of the dates indicated:

 
 
June 30, 2012
 
 
 
Amortized
 
 
 
 
 
 
 
 
 
 
 
 
Cost/
 
 
Unrealized
 
 
 
 
 
 
Cost Basis(1)
 
 
Gains
 
 
Losses
 
 
Fair Value
 
Agency-backed MBS
 
$
86
 
 
$
8
 
 
$
 
 
$
94
 
Private-label MBS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior securities
 
 
8,265
 
 
 
233
 
 
 
 
 
 
8,498
 
Re-REMIC securities
 
 
130,767
 
 
 
33,683
 
 
 
 
 
 
164,450
 
Total
 
$
139,118
 
 
$
33,924
 
 
$
 
 
$
173,042
 
 

 
(1)
The amortized cost of MBS includes unamortized net discounts of $132,022 at June 30, 2012.
 
 
 
December 31, 2011
 
 
 
Amortized
 
 
 
 
 
 
 
 
 
 
 
 
Cost/
 
 
Unrealized
 
 
 
 
 
 
Cost Basis(1)
 
 
Gains
 
 
Losses
 
 
Fair Value
 
Agency-backed MBS
 
$
128
 
 
$
11
 
 
$
 
 
$
139
 
Private-label MBS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior securities
 
 
8,397
 
 
 
914
 
 
 
 
 
 
9,311
 
Re-REMIC securities
 
 
132,661
 
 
 
37,455
 
 
 
 
 
 
170,116
 
Total
 
$
141,186
 
 
$
38,380
 
 
$
 
 
$
179,566
 
 

(1)
The amortized cost of MBS includes unamortized net discounts of $136,737 at December 31, 2011.
 
 
The Company recorded other-than-temporary impairment charges of $4,531, as a component of investment (loss) gain, net on the consolidated statements of comprehensive income, for the three and six months ended June 30, 2012 related to deterioration in credit quality on available-for-sale, private-label MBS with a cost basis of $12,422 prior to recognizing the other-than-temporary impairment charges. The Company recorded no other-than-temporary impairment charges on MBS during the three and six months ended June 30, 2011.

The following table presents the results of sales of MBS for the periods indicated:

 
 
Three Months Ended June 30,
 
 
Six Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
 
 
Agency-
Backed
MBS
 
 
Private-
Label
MBS
 
 
Agency-
Backed
MBS
 
 
Private-
Label
MBS
 
 
Agency-
Backed
MBS
   
Private-
Label
MBS
   
Agency-
Backed
MBS
 
 
Private-
Label
MBS
 
Proceeds from sales
 
$
90,519
 
 
$
 
 
$
70,675
 
 
$
11,264
 
 
$
112,128
   
$
 
 
$
176,278
 
 
$
73,294
 
Gross gains
 
 
376
 
 
 
 
 
 
985
 
 
 
1,472
 
 
 
341
 
 
 
 
 
 
828
 
 
 
12,153
 
Gross losses
 
 
228
 
 
 
 
 
 
116
 
 
 
 
 
 
251
 
 
 
   
 
389
 
 
 
 

 
12


  Other Investments
 
The Company’s other investments consisted of the following as of the dates indicated:
 
 
 
June 30, 2012
 
 
December 31, 2011
 
Interest-only MBS
 
$
935
 
 
$
1,060
 
Non-public equity securities
 
 
975
 
 
 
975
 
Investment funds
 
 
1,021
 
 
 
911
 
Total other investments
 
$
2,931
 
 
$
2,946
 

3.
Borrowings:

  Repurchase Agreements

The Company has entered into repurchase agreements to fund its investments in MBS. As of June 30, 2012, the amount at risk related to $295,924 of repurchase agreements with Credit Suisse Securities USA LLC was $53,332, or 24.12% of the Company’s equity, with a weighted-average maturity of 14 days. As of December 31, 2011, the amount at risk related to $177,402 and $219,737 of repurchase agreements with Credit Suisse Securities USA LLC and Barclays Capital Inc., respectively, was $46,848 and $19,995, respectively, or 25.55% and 10.90% of the Company’s equity, respectively, with a weighted-average maturity of 16 and 12 days, respectively. The amount at risk is defined as the excess of the higher of carrying amount or market value of the collateral provided under repurchase agreements, including any cash or other assets on deposit to secure the repurchase obligation, over the amount of the repurchase liability. The following tables provide information regarding the Company’s outstanding repurchase agreement borrowings as of the dates and for the periods indicated:

   
June 30, 2012
   
December 31, 2011
 
Outstanding balance
 
$
963,051
 
 
$
647,977
 
Value of assets pledged as collateral
 
 
 
 
 
 
 
 
Agency-backed MBS
 
 
988,674
 
 
 
653,322
 
Private-label MBS
 
 
77,133
 
 
 
78,110
 
Weighted-average rate
 
 
0.47
%
 
 
0.49
%
Weighted-average term to maturity
 
12.6 days
 
 
13.1 days
 
 
   
June 30, 2012
   
June 30, 2011
 
Weighted-average outstanding balance during the three months ended
 
$
892,659
 
 
$
617,825
 
Weighted-average rate during the three months ended
 
 
0.44
%
 
 
0.31
%
Weighted-average outstanding balance during the six months ended
 
$
769,064
 
 
$
469,838
 
Weighted-average rate during the six months ended
 
 
0.43
%
 
 
0.34
%

  Long-Term Debt

As of June 30, 2012 and December 31, 2011, the Company had $15,000 of outstanding long-term debentures. The long-term debentures accrue and require payments of interest quarterly at an annual rate of three-month LIBOR plus 2.25% to 3.00%. The weighted-average interest rate on these long-term debentures was 3.22% and 3.15% as of June 30, 2012 and December 31, 2011, respectively. All of these borrowings mature between 2033 and 2035.

4.
Derivative Financial Instruments and Hedging Activities:

In the normal course of its operations, the Company is a party to financial instruments that are accounted for as derivative financial instruments in accordance with ASC 815. These instruments may include interest rate swaps, Eurodollar and U.S. Treasury futures contracts, put options and certain commitments to purchase and sell MBS.
 
During the three and six months ended June 30, 2012, the Company entered into various financial contracts to hedge certain MBS and related borrowings and other long-term debt. These financial contracts are not designated as hedges under ASC 815. The changes in fair value on these derivatives are recorded to net investment gain or loss in the statement of comprehensive income. For the three and six months ended June 30, 2012, the Company recorded net losses of $16,609 and $16,994, respectively, on these derivatives. For the three and six months ended June 30, 2011, the Company recorded net losses of $21,569 and $24,116, respectively, on these derivatives. The Company held the following derivative instruments as of the dates indicated:
 
 
13

 
 
 
June 30, 2012
 
 
December 31, 2011
 
 
 
Notional Amount
 
 
Fair Value
 
 
Notional Amount
 
 
Fair Value
 
No hedge designation
 
 
 
 
 
 
 
 
 
 
 
 
Eurodollar futures(1)
 
$
15,744,000
 
 
$
(80,512
)
 
$
12,157,000
 
 
$
(62,556
)
10-year U.S. Treasury note futures
 
 
 
 
 
 
 
 
39,700
 
 
 
(468
)
Commitment to purchase MBS(2)
 
 
305,000
 
 
 
1,899
 
 
 
75,000
 
 
 
504
 
Commitment to sell MBS(3)
 
 
200,000
 
 
 
(516
)
 
 
 
 
 
 
 

(1)
The $15,744,000 total notional amount of Eurodollar futures contracts as of June 30, 2012 represents the accumulation of Eurodollar futures contracts that mature on a quarterly basis between 2012 and 2017 and have a lifetime weighted-average rate of 3.12% as compared to a lifetime weighted-average market rate of 1.07%. As of June 30, 2012, the Company maintained $88,074 as a deposit and margin against the open Eurodollar futures contracts.
(2)
The $305,000 total notional amount of commitment to purchase MBS as of June 30, 2012 represents forward commitments to purchase fixed-rate MBS securities with settlement dates in the three months ending September 30, 2012.
(3)
The $200,000 total notional amount of commitment to sell MBS as of June 30, 2012 represents forward commitments to sell fixed-rate MBS securities with settlement dates in the three months ending September 30, 2012.

5.
Income Taxes:

The total income tax provision for the three and six months ended June 30, 2012 was $379 and $821, respectively. The total income tax provision for the three and six months ended June 30, 2011 was $346 and $817, respectively. The Company generated a pre-tax book income of $2,523 and $13,727 for the three and six months ended June 30, 2012, respectively. The Company generated pre-tax book income of $437 and $20,693 for the three and six months ended June 30, 2011, respectively.

The Company’s effective tax rate for the six months ended June 30, 2012 and 2011 was 6.0% and 3.9%, respectively. The effective tax rate during these periods was lower than the highest marginal tax rates due to the realization of deferred tax assets that were offset by a full valuation allowance. The net deferred tax assets, which are offset by a full valuation allowance, include net operating losses (NOLs), which are available to offset the current and future taxable income. The Company recorded an expected tax liability for these periods due to the expected alternative minimum taxes. Limitations prevent the Company from using its NOLs to fully offset its taxable income for alternative minimum tax purposes. The Company expects to realize additional tax benefits of NOLs in 2012, which are reflected in the Company’s projected effective tax rate for the year, along with a corresponding release of the valuation allowance previously recorded against these losses. The Company will continue to provide a valuation allowance against the other deferred tax assets to the extent the Company believes that it is more likely than not that the benefits will not be realized in the future. The Company will continue to assess the need for a valuation allowance at each reporting date.

The Company is subject to examination by the U.S. Internal Revenue Service (IRS), and other taxing authorities in jurisdictions where the Company has significant business operations, such as Virginia. An IRS examination of the Company’s tax years 2009 and 2010 is currently on-going.

6.
Earnings Per Share:

Basic earnings per share includes no dilution and is computed by dividing net income or loss available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share includes the impact of dilutive securities such as stock options and unvested shares of restricted stock. The following tables present the computations of basic and diluted earnings per share for the periods indicated:

 
14

 
 
 
Three Months Ended June 30,
 
(Shares in thousands)
 
2012
 
 
2011
 
 
 
Basic
 
 
Diluted
 
 
Basic
 
 
Diluted
 
Weighted-average shares outstanding
 
 
 
 
 
 
 
 
 
 
 
 
Common stock
 
 
9,726
 
 
 
9,726
 
 
 
7,723
 
 
 
7,723
 
Stock options and unvested restricted stock
 
 
 
 
 
7
 
 
 
 
 
 
13
 
Weighted-average common and common equivalent shares outstanding
 
 
9,726
 
 
 
9,733
 
 
 
7,723
 
 
 
7,736
 
Net income applicable to common stock
 
$
2,144
 
 
$
2,144
 
 
$
91
 
 
$
91
 
Earnings per common share
 
$
0.22
 
 
$
0.22
 
 
$
0.01
 
 
$
0.01
 
 
 
 
Six Months Ended June 30,
 
(Shares in thousands)
 
2012
 
 
2011
 
 
 
Basic
 
 
Diluted
 
 
Basic
 
 
Diluted
 
Weighted-average shares outstanding
 
 
 
 
 
 
 
 
 
 
 
 
Common stock
 
 
8,795
 
 
 
8,795
 
 
 
7,692
 
 
 
7,692
 
Stock options and unvested restricted stock
 
 
 
 
 
8
 
 
 
 
 
 
36
 
Weighted-average common and common equivalent shares outstanding
 
 
8,795
 
 
 
8,803
 
 
 
7,692
 
 
 
7,728
 
Net income applicable to common stock
 
$
12,906
 
 
$
12,906
 
 
$
19,876
 
 
$
19,876
 
Earnings per common share
 
$
1.47
 
 
$
1.47
 
 
$
2.58
 
 
$
2.57
 

The diluted earnings per share for the three and six months ended June 30, 2012 did not include the antidilutive effect of 55,217 and 39,547 shares, respectively, of awarded restricted stock units, stock options and restricted stock. The diluted earnings per share for the three and six months ended June 30, 2011 did not include the antidilutive effect of 17,758 and 33,808 shares, respectively, of awarded restricted stock units, stock options and restricted stock.

7.
Equity:

Equity Offering

On March 26, 2012, the Company completed a public offering of 1,755,000 shares of Class A common stock, at a public offering price of $23.90 per share, for net proceeds of $40,164, after deducting underwriting discounts and commissions and expenses. The Company also granted the underwriters a 30-day option to purchase up to 263,250 additional shares of Class A common stock to cover over-allotments, if any. On April 18, 2012, the Company completed the issuance and sale of 263,250 additional shares of Class A common stock pursuant to the full exercise of the underwriters’ 30-day over-allotment option, at a public offering price of $23.90 per share less the $0.875 per share dividend declared on March 16, 2012 per the Underwriting Agreement dated March 22, 2012, for net proceeds of $5,851, net of underwriting discounts and commissions and expenses.

Dividends

Pursuant to the Company’s variable dividend policy, the Board of Directors evaluates dividends on a quarterly basis and, in its sole discretion, approves the payment of dividends. The Company’s dividend payments, if any, may vary significantly from quarter to quarter. The Board of Directors has approved and the Company has declared the following dividends to date in 2012:

Quarter Ended
 
Dividend Amount
 
Declaration Date
 
Record Date
 
Pay Date
June 30
 
$
0.875
 
June 15
 
June 29
 
July 31
March 31
 
 
0.875
 
March 16
 
March 26
 
April 30

 
15


The Board of Directors approved and the Company declared and paid the following dividends for 2011:

Quarter Ended
 
Dividend Amount
 
Declaration Date
 
Record Date
 
Pay Date
December 31
 
$
0.875
 
December 21
 
December 31
 
January 31, 2012
September 30
 
 
0.875
 
September 19
 
September 30
 
October 31
June 30
 
 
0.875
 
June 23
 
July 5
 
July 29
March 31
 
 
0.750
 
March 24
 
April 4
 
April 29

  Long-Term Incentive Plan

On April 13, 2011, the Board of Directors adopted the Arlington Asset Investment Corp. 2011 Long-Term Incentive Plan (2011 Plan). The 2011 Plan was approved by the Company’s shareholders and became effective on June 2, 2011. Under the 2011 Plan, shares of Class A common stock of the Company may be issued to employees, directors, consultants and advisors of the Company and its affiliates. As of June 30, 2012 and December 31, 2011, 512,698 and 530,519 shares, respectively, remained available for issuance under the 2011 Plan.

Restricted Stock

The following tables present the activities and balances related to restricted stock for the dates and periods indicated:
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Shares granted
                      14,000  
Weight-average share price
  $     $     $     $ 27.66  
Compensation expense recognized during the period
  $ 32     $ 74     $ 86     $ 442  

   
June 30, 2012
   
December 31, 2011
 
Restricted Class A shares outstanding, unvested
    9,335       15,206  
Unrecognized compensation cost related to unvested shares
  $ 113     $ 200  
Weighted-average vesting period remaining
 
1.65 years
   
2.02 years
 
 
  Share Repurchases

From time to time, the Company repurchases shares of its Class A common stock under a share repurchase program authorized by the Board of Directors in July 2010 (Repurchase Program), pursuant to which the Company is authorized to repurchase up to 500,000 shares of its Class A common stock.

Repurchases under the Repurchase Program may be made from time to time on the open market and in private transactions at management’s discretion in accordance with applicable federal securities laws. The timing of repurchases and the exact number of shares of Class A common stock to be repurchased will depend upon market conditions and other factors. The Repurchase Program is funded using the Company’s cash on hand and cash generated from operations. The Repurchase Program has no expiration date and may be suspended or terminated at any time without prior notice.

The following table summarizes the Company’s share repurchase activities for the periods indicated:

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Shares repurchased
                      8,910  
Total cost
  $     $     $     $ 229  
Average price
  $     $     $     $ 25.70  

As of June 30, 2012 and December 31, 2011, 247,275 shares of Class A common stock remained available for repurchases under the Repurchase Program.

 
16



Unless the context otherwise requires or provides, references in this Quarterly Report on Form 10-Q to “we,” “us,” “our” and “our company” refer to Arlington Asset Investment Corp. (Arlington Asset) and its subsidiaries. This discussion and analysis should be read in conjunction with our financial statements and accompanying notes included in Item 1 of this Quarterly Report on Form 10-Q, as well as our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011.

The discussion of our consolidated financial condition and results of operations below may contain forward-looking statements. These statements, which reflect management’s beliefs and expectations, are subject to risks and uncertainties that may cause actual results to differ materially. For a discussion of the risks and uncertainties that may affect our future results, please see “Cautionary Statement About Forward-Looking Statements” immediately following Item 4 of Part I of this Quarterly Report on Form 10-Q.

Our Company

We are a principal investment firm that acquires and holds mortgage-related and other assets. We acquire residential mortgage-backed securities (MBS), either issued by U.S. government agencies or guaranteed as to principal and interest by U.S. government agencies or U.S. government-sponsored entities (agency-backed MBS). We also acquire MBS issued by private organizations (private-label MBS) subject to maintaining our exemption from regulation as an investment company under the Investment Company Act of 1940, as amended (1940 Act). We are a Virginia corporation and taxed as a C corporation for federal income tax purposes.  We operate primarily in the United States.

Factors that Affect our Results of Operations and Financial Condition

Our business is materially affected by a variety of industry and economic factors, including:

 
conditions in the global financial markets and economic conditions;
 
changes in interest rates and prepayment rates;
 
actions taken by the U.S. Federal Reserve and the U.S. Treasury;
 
changes in laws and regulations and industry practices;
 
actions taken by ratings agencies with respect to the U.S.’s credit rating; and
 
other market developments.

In recent years and months, the conditions in the U.S. and global financial markets have changed suddenly and negatively and may continue to change adversely in future periods. In response to the financial issues affecting the banking system and the financial markets, governments, regulators and central banks in the United States and worldwide have taken, and may continue to take, numerous steps to increase liquidity and to restore investor confidence.
 
Adverse market conditions and actions by governmental authorities could adversely affect our business in many ways, including but not limited to making it more difficult for us to analyze our investment portfolio, adversely affecting our ability to maintain targeted amounts of leverage on our MBS portfolio and successfully implement our hedging strategy, and limiting our ability to follow our current investment and financing strategies. While uncertain, these potentially adverse market conditions and actions by governmental authorities may adversely affect our liquidity, financial position and results of operations. We have been and will continue to evaluate the potential impact of recent government actions, including developments relating to foreclosure suspensions and affidavit errors and various state and federal government actions affecting the market price of MBS and related derivative securities.  While it is predictably difficult to foresee the short- and long-term impact of foreclosure issues given all the uncertainties, at this time, we do not anticipate that the current foreclosure issues will have a material negative effect on our overall position and results of operations.  For further discussions on how market conditions and government actions may adversely affect our business, see “Item 1A—Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011.
 
Our MBS portfolio is affected by general U.S. residential real estate market conditions and the overall U.S. economic environment. In particular, our MBS strategy and the performance of our MBS portfolio is influenced by the specific characteristics of these markets, including prepayment rates, credit losses, interest rates and the interest rate yield curve. Our results of operations with respect to our MBS portfolio primarily depend on, among other things, the level of our interest income and the amount and cost of borrowings we may obtain by pledging our investment portfolio as collateral for the borrowings. Our interest income, which includes the amortization of purchase premiums and accretion of discounts, varies primarily as a result of changes in prepayment speeds of the securities in our MBS portfolio. Our borrowing cost varies based on changes in interest rates and changes in the amount we can borrow which is generally based on the fair value of the MBS portfolio and the advance rate the lenders are willing to lend against the collateral provided.
 
 
17

 
The payment of principal and interest on the agency-backed MBS that we acquire and hold is guaranteed by the Federal Home Loan Mortgage Corporation (Freddie Mac) or the Federal National Mortgage Association (Fannie Mae). The payment of principal and interest on agency-backed MBS issued by Freddie Mac or Fannie Mae is not guaranteed by the U.S. government. Any failure to honor its guarantee of agency-backed MBS by Freddie Mac or Fannie Mae or any downgrade of securities issued by Freddie Mac or Fannie Mae by the rating agencies could cause a significant decline in the value of and cash flow from any agency-backed MBS we own that are guaranteed by such entity.

Current Market Conditions and Trends

Our MBS portfolio continued to perform well and as expected during the quarter ended June 30, 2012.  The overall value of our agency-backed MBS portfolio increased, primarily as a result of the low interest rate environment, and the value of our private-label MBS portfolio held steady, primarily from an expected improvement in credit performance in general.  However, uncertainty continues to dominate the market, due to the continued historically low interest rate environment and the European financial crisis. We believe the general business environment will continue to be challenging in the remainder of 2012 and future periods. Our growth outlook is dependent, in part, on the strength of the financial markets, the impact of fiscal and monetary policy actions by the United States and other countries, the overall market value of U.S. equities and liquidity in the financial system. Depending on the market development and movement, we may seek to re-align our strategy and our portfolio.  We will continue to closely monitor the developments in the market and evaluate the opportunities across the spectrum in the mortgage industry and seek the highest risk-adjusted returns for our capital.

Executive Summary

For the three months ended June 30, 2012, we had net income of $2.1 million, or $0.22 per share (diluted). As of June 30, 2012, our book value per share was $22.58.

In addition to the financial results reported in accordance with generally accepted accounting principles as consistently applied in the United States (GAAP), we calculated non-GAAP core operating income for the three and six months ended June 30, 2012. Our core operating income for the three and six months ended June 30, 2012 was $11.3 million and $20.2 million, respectively. In determining core operating income, we excluded certain costs and the following non-cash expenses: (1) compensation costs associated with stock-based awards, (2) accretion of MBS purchase discounts adjusted for principal repayments in excess of proportionate invested capital, (3) unrealized mark-to-market adjustments on the trading MBS and hedge instruments and (4) other-than-temporary impairment charges recognized. This non-GAAP measurement is used by management to analyze and assess the operating results and dividends. We believe that this non-GAAP measurement assists investors in understanding the impact of these non-core items and non-cash expenses on our performance and provides additional clarity around our forward earnings capacity and trend. A limitation of utilizing this non-GAAP measure is that the GAAP accounting effects of these events do in fact reflect the underlying financial results of our business and these effects should not be ignored in evaluating and analyzing our financial results. Therefore, we believe net income on a GAAP basis and core operating income on a non-GAAP basis should be considered together.

The following is a reconciliation of GAAP net income to non-GAAP core operating income for the three and six months ended June 30, 2012 (dollars in thousands):
 
      June 30, 2012  
   
Three Months Ended
   
Six Months Ended
 
GAAP net income
  $ 2,144     $ 12,906  
Adjustments
               
Adjusted expenses(1)
    826       2,323  
Stock compensation
    140       301  
Net unrealized mark-to-market loss on trading MBS and hedge instruments
    5,578       3,759  
Other-than-temporary impairment charges
    4,531       4,531  
Adjusted interest related to purchase discount accretion(2)
    (1,895 )     (3,582 )
Non-GAAP core operating income
  $ 11,324     $ 20,238  
 

(1)
Adjusted expenses reflect certain professional fees and income taxes that are not considered representative of routine or core operating-related activities of our company.
(2)
Adjusted interest related to purchase discount accretion represents purchase discount accretion in excess of principal repayment in excess of proportional share of invested capital.
 
 
18

 
As of June 30, 2012, our agency-backed MBS consisted of $934.3 million in face value with a cost basis of $976.9 million and was fair valued at $1.0 billion. Our agency-backed MBS had a weighted-average coupon of 4.32% and a weighted-average cost of funding of 0.41% at June 30, 2012. During the three months ended June 30, 2012, we received proceeds of $90.5 million from the sale of $82.8 million in face value of our agency-backed MBS, realizing $0.1 million in net gains, or realized net gains of $2.2 million from the acquisition price. During the six months ended June 30, 2012, we received proceeds of $112.1 million from the sale of $102.8 million in face value of our agency-backed MBS, realizing $0.1 million in gains, or realized gains of $2.7 million from the acquisition price.

We have entered into Eurodollar futures to mitigate the interest rate sensitivity which directly impacts our cost of borrowing and the market value of our agency-backed MBS. The Eurodollar futures mature through June 30, 2017 and have a lifetime weighted-average rate of 3.12%, as compared to a lifetime weighted-average market rate of 1.07% as of June 30, 2012. The value of these five-year hedge instruments is expected to fluctuate inversely relative to the agency-backed MBS portfolio and decrease in value during periods of declining interest rates and/or widening mortgage spreads. Conversely, during periods of increasing rates and/or tightening mortgage spreads, these instruments are expected to increase in value. The cost of these Eurodollar hedges will increase over their five-year term.
 
As of June 30, 2012, our private-label MBS portfolio consisted of $271.1 million in face value with an amortized cost basis of $139.0 million and was fair valued at $172.9 million. The unamortized net discount on our private-label MBS portfolio was $132.0 million as of June 30, 2012. During the quarter ended June 30, 2012, we recognized net interest income of $6.2 million, representing a 17.4% annualized yield, including coupon and accretion of purchase discount based on the current accretable yield rate, from our private-label MBS portfolio. We also recognized $4.5 million in other-than-temporary impairment charges during the quarter ended June 30, 2012 related to changes in expected credit performance of our available-for-sale, private-label MBS. The other-than-temporary impairment charge is a non-cash charge representing a reversal of the cumulative non-cash discount accretion previously recorded on certain of our private-label MBS. This charge does not affect non-GAAP core operating income or book value, but does reduce our net income and lowers the accounting basis used to record future discount accretion, which should more closely reflect future cash flows.
 
Our private-label MBS are primarily senior and re-REMIC tranches in securitization trusts issued between 2005 and 2010. The senior securities represent interests in securitizations that have the first right to cash flows and absorb losses last. The re-REMIC securities represents interests in re-securitizations of senior MBS and pro-rata mezzanine securities. For re-REMIC securities, the cash flows from, and any credit losses absorbed by, the underlying MBS are allocated among the re-REMIC securities issued in the re-securitization transactions based on the re-REMIC structure. For example, prime and non-prime residential senior securities have been resecuritized to create a two-tranche structure with a re-REMIC senior security and a re-REMIC subordinated security. In these re-REMIC securities, all principal payments from the underlying securities are directed to the re-REMIC senior security until the face value is fully paid off. Thereafter, all principal payments are directed to the re-REMIC subordinated security. For pro-rata mezzanine securities, principal payments from the underlying MBS are typically allocated concurrently and proportionally to the mezzanine securities along with senior securities. The re-REMIC subordinated and mezzanine securities absorb credit losses, if any, first; however, these credit losses occur only when credit losses exceed the credit protection provided to the underlying securities. Senior, re-REMIC, and mezzanine securities receive interest while any face value is outstanding. Our private-label MBS have approximately 6% credit enhancement on a weighted-average basis, which provides protection to our invested capital in addition to our purchase discount.
 
We generally purchased the private-label MBS in our portfolio at a discount to face value. We estimate, at least on a quarterly basis, the future expected cash flows based on our observation of current information and events and by applying a number of assumptions related to prepayment rates, interest rates, default rates, discount rates and the timing and amount of cash flows and credit losses. These assumptions, which are disclosed in note 2 to our financial statements, are difficult to predict as they are subject to uncertainties and contingencies related to future events that may impact our estimates and interest income.
 
We recognize interest income on our private-label MBS based on each security’s expected effective interest rate. At acquisition, the accretable yield is calculated as the difference between the undiscounted expected cash flows and the purchase price which is expected to be accreted into interest income over the remaining life of the security on a level-yield basis. The difference between the contractually required payments and the undiscounted expected cash flows represents the non-accretable difference. Based on actual payment activities and changes in estimates of undiscounted expected future cash flows, the accretable yield and the non-accretable difference can change over time. Significant increases in the amount or timing of undiscounted expected future cash flows are recognized prospectively as an adjustment to the accretable yield. As a result, we may recognize higher non-cash interest income over the security’s holding period and may not realize the level of interest income recognized using the higher accretion rates. In addition, we may be subject to more frequent and higher non-cash other-than-temporary-impairment charges than actual losses realized on the security as a result.
 
 
19

 
We evaluate available-for-sale securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. In general, when the fair value of an available-for-sale security is less than its amortized cost at the reporting date, the security is considered impaired. In evaluating these available-for-sale securities for other-than-temporary impairment, consideration is given to (1) the length of time and the extent to which the fair value has been lower than carrying value, (2) the severity of the decline in fair value, (3) the financial condition and near-term prospects of the issuer, (4) our intent to sell, and (5) whether it is more likely than not we would be required to sell the security before anticipated recovery.
 
For available-for-sale, agency-backed MBS securities, if it is determined that the impairment is other-than-temporary, then the amount that the fair value is below its amortized cost basis is recorded as an impairment charge and recorded through earnings. For unrealized losses that are determined to be temporary, a further evaluation is performed to determine the credit portion of the other-than-temporary impairment and the credit portion is recorded through our statement of comprehensive income.
 
For available-for-sale, private-label MBS securities that have been acquired at discounts to face value due in part to credit deterioration since origination, we re-evaluate the undiscounted expected future cash flows and the changes in cash flows from those originally projected at the time of purchase or last revised.  For those securities in an unrealized loss position, the difference between the carrying value and the net present value of expected future cash flows discounted using current expected rate of return is recorded as other-than-temporary impairment charges through our statement of comprehensive income. The other-than-temporary impairment charges that related to other factors other than credit are recorded in other comprehensive income, net of applicable taxes.
 
Continued expectations of stabilization and improvement in the housing market, increased liquidity and available leverage have stabilized prices for our private-label MBS, particularly among re-REMIC mezzanine securities. Our re-REMIC securities are predominantly held in the subordinate tranches. We will continue to closely monitor the performance of these securities. We believe we have constructed a private-label MBS portfolio with attractive characteristics and will continue to monitor relative value between the various classes of MBS, including agency-backed MBS, and may re-allocate our portfolio at any time based on management’s view of the market. We will continue to seek to identify potential opportunities to strengthen our position and to maximize return to our shareholders.

We have been evaluating, and will continue to evaluate, the opportunities across the spectrum in the mortgage industry and seek the highest risk-adjusted returns for our capital. We evaluate and prioritize the risk-adjusted return we expect to receive on every asset based upon a current cash yield perspective as well as from a total yield perspective that includes expected reflation, which is defined as an increase in value between the amortized cost basis and the par value of the security. Historically, based on market conditions, we believe our MBS assets have provided us with higher relative risk-adjusted rates of return than most other portfolio opportunities we have evaluated. Consequently, we have maintained a high allocation of our assets and capital in this sector. We intend to continue to evaluate acquisition opportunities against the returns available in each of our asset alternatives and endeavor to allocate our assets and capital with an emphasis toward what we believe will generate the highest risk-adjusted return available. This strategy may cause us to have different allocations of capital in different environments. We believe we have constructed a private-label MBS portfolio with attractive characteristics and will continue to monitor relative value between the various classes of MBS.

The following is a summary of our net income for the periods indicated (dollars in thousands):
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
(Dollars in thousands)
 
2012
   
2011
   
2012
   
2011
 
Net interest income
  $ 14,914     $ 12,670     $ 27,460     $ 24,733  
Other (loss) income, net
    (8,681 )     (8,488 )     (5,877 )     2,733  
Other expenses
    3,710       3,745       7,856       6,773  
Income before income taxes
    2,523       437       13,727       20,693  
Income tax provision
    379       346       821       817  
Net income
  $ 2,144     $ 91     $ 12,906     $ 19,876  

For the three months ended June 30, 2012, our net income was $2.1 million compared to net income of $0.1 million for the three months ended June 30, 2011. Our net income includes net interest income of $14.9 million and other net loss of $8.7 million for the three months ended June 30, 2012 compared to net interest income of $12.7 million and other net loss of $8.5 million for the three months ended June 30, 2011. The increase in net interest income is due primarily to an increase in the average balance of our agency-backed MBS portfolio. Our other net loss remained consistent during the three months ended June 30, 2012 and 2011 and is discussed below.  Our other expenses remained consistent at $3.7 million during the three months ended June 30, 2012 and 2011.
 
 
For the six months ended June 30, 2012, our net income was $12.9 million compared to net income of $19.9 million for the three months ended June 30, 2011. Our net income includes net interest income of $27.5 million and other net loss of $5.9 million for the six months ended June 30, 2012 compared to net interest income of $24.7 million and other net income of $2.7 million for the six months ended June 30, 2011. The increase in net interest income is due primarily to an increase in the average balance of our agency-backed MBS portfolio. The decrease in other net income is due primarily to limited MBS sales activity during the six months ended June 30, 2012 as compared to $12.6 million in net gain recognized from the MBS sales activity during the six months ended June 30, 2011. Our other expenses increased to $7.9 million during the six months ended June 30, 2012 compared to $6.8 million for the six months ended June 30, 2011, primarily as a result of increases in legal expenses offset by a decrease in variable compensation and related expenses.

 
20


Principal Investing Portfolio

The following table summarizes our principal investing portfolio including principal receivable on MBS, as of June 30, 2012 (dollars in thousands):

 
 
Face Amount
 
 
Fair Value
 
Trading
 
 
 
 
 
 
Agency-backed MBS
 
 
 
 
 
 
Fannie Mae
 
$
587,239
 
 
$
639,581
 
Freddie Mac
 
 
346,985
 
 
 
378,241
 
Available-for-sale
 
 
 
 
 
 
 
 
Agency-backed MBS
 
 
 
 
 
 
 
 
Fannie Mae
 
 
87
 
 
 
94
 
Private-label MBS
 
 
 
 
 
 
 
 
Senior securities
 
 
13,043
 
 
 
8,498
 
Re-REMIC securities
 
 
258,011
 
 
 
164,450
 
Other mortgage related assets
 
 
109,844
 
 
 
935
 
Total
 
$
1,315,209
 
 
$
1,191,799
 

Operating Income

Our operating income consists primarily of net interest income, net investment gain and investment fund earnings.

Expenses

Interest expense includes the costs of our repurchase agreement borrowings and long-term debt securities. Interest expense also includes costs of subordinated credit lines, bank deposits and other financing, when used.

Compensation and benefits expense includes base salaries as well as incentive compensation. Salaries, payroll taxes and employee benefits are relatively fixed in nature. In addition, compensation and benefits expense includes estimated performance-based incentive compensation, including the discretionary component that is more likely-than not to be paid and non-cash expenses associated with all stock-based awards granted to employees.
 
Professional services expense includes accounting, legal and consulting fees. Many of these expenses, such as legal fees, are to a large extent variable related to level of transactions, ongoing litigation and initiatives.
 
Business development expense includes primarily travel and entertainment expenses.
 
Occupancy and equipment expense includes rental costs for our facilities and depreciation and amortization of equipment and software. These expenses are largely fixed in nature.
 
Communications expenses include voice, data and internet service fees, and data processing costs.
 
Other operating expenses include professional liability and property insurance, directors fees including cash and stock awards, printing and copying, business licenses and taxes, offices supplies, penalties and fees, charitable contributions and other miscellaneous office expenses.
 
 
21


Results of Operations

Three months ended June 30, 2012 compared to three months ended June 30, 2011

We reported net income of $2.1 million for the three months ended June 30, 2012 compared to net income of $0.1 million for the three months ended June 30, 2011 which included the following results for the periods indicated (dollars in thousands):

 
 
Three Months Ended June 30,
 
 
 
2012
 
 
2011
 
Interest income
 
$
16,031
 
 
$
13,262
 
Interest expense
 
 
1,117
 
 
 
592
 
Net interest income
 
 
14,914
 
 
 
12,670
 
Other loss, net
 
 
 
 
 
 
 
 
Investment loss, net
 
 
(8,677
)
 
 
(8,484
)
Other loss
 
 
(4
)
 
 
(4
)
Total other loss, net
 
 
(8,681
)
 
 
(8,488
)
Other expenses
 
 
3,710
 
 
 
3,745
 
Income before income taxes
 
 
2,523
 
 
 
437
 
Income tax provision
 
 
379
 
 
 
346
 
Net income
 
$
2,144
 
 
$
91
 

Net income increased $2.0 million from $0.1 million for the three months ended June 30, 2011 to net income of $2.1 million for the three months ended June 30, 2012 due to the following changes:
 
 
Net interest income increased $2.2 million (17.3%) from $12.7 million for the three months ended June 30, 2011 to $14.9 million for the three months ended June 30, 2012. The increase is the result of the increase in our investable capital on a leveraged basis to our MBS portfolio.
 
 
 
Investment loss, net, increased $0.2 million (2.4%) from a loss of $8.5 million for the three months ended June 30, 2011 to a loss of $8.7 million for the three months ended June 30, 2012. See below for additional discussion on the results of our principal investing portfolio.

The following table summarizes the components of income from our principal investment activities, net of related interest expense, for the periods indicated (dollars in thousands):

   
Three Months Ended June 30,
 
   
2012
   
2011
 
Net interest income
  $ 15,037     $ 12,785  
Investment loss, net
    (8,677 )     (8,484 )
 
The components of net interest income from our MBS related portfolio is summarized in the following table (dollars in thousands):

 
 
Three Months Ended June 30,
 
 
 
2012
 
 
2011
 
 
 
Average
Balance
 
 
Income
(Expense)
 
 
Yield
(Cost)
 
 
Average
Balance
 
 
Income
(Expense)
 
 
Yield
(Cost)
 
Agency-backed MBS
 
$
915,318
 
 
$
9,600
 
 
 
4.20
%
 
$
632,427
 
 
$
7,083
 
 
 
4.48
%
Private-label MBS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior securities
 
 
8,292
 
 
 
352
 
 
 
17.00
%
 
 
10,158
 
 
 
354
 
 
 
13.93
%
Re-REMIC securities
 
 
134,498
 
 
 
6,046
 
 
 
17.98
%
 
 
136,785
 
 
 
5,648
 
 
 
16.52
%
Other investments
 
 
1,064
 
 
 
32
 
 
 
12.02
%
 
 
1,193
 
 
 
36
 
 
 
11.87
%
 
 
$
1,059,172
 
 
 
16,030
 
 
 
6.05
%
 
$
780,563
 
 
 
13,121
 
 
 
6.72
%
Other(1)
 
 
 
 
 
 
1
 
 
 
 
 
 
 
 
 
 
 
141
 
 
 
 
 
 
 
 
 
 
 
 
16,031
 
 
 
 
 
 
 
 
 
 
 
13,262
 
 
 
 
 
Repurchase agreements
 
$
892,659
 
 
 
(994
)
 
 
(0.44
)%
 
$
617,825
 
 
 
(477
)
 
 
(0.31
)%
Net interest income/spread
 
 
 
 
 
$
15,037
 
 
 
5.61
%
 
 
 
 
 
$
12,785
 
 
 
6.41
%
 

(1)
Includes interest income on cash and other miscellaneous interest-earning assets.

 
22

 
The change in the composition of our MBS portfolio and related increase in net interest income by $2.3 million from the three months ended June 30, 2011 to the three months ended June 30, 2012 were primarily due to the repositioning of the MBS portfolio by reallocating capital from private-label MBS to agency-backed MBS on a leveraged basis and from the deployment of capital raised from our public offering during the three months ended March 31, 2012 primarily into our agency-backed MBS portfolio. Interest income from other investments represents interest on interest-only MBS securities.
 
As discussed above, we realized net investment loss of $8.7 million for the three months ended June 30, 2012 compared to a net investment loss of $8.5 million for the three months ended June 30, 2011. The following table summarizes the components of net investment loss (dollars in thousands):
 
 
 
Three Months Ended June 30,
 
 
 
2012
 
 
2011
 
Realized gains on sale of available-for-sale investments, net
 
$
 
 
$
1,472
 
Available-for-sale and cost method securities – other-than-temporary impairment charges
 
 
(4,531
)
 
 
 
Gains on trading investments, net
 
 
12,720
 
 
 
11,613
 
Losses from derivative instruments, net
 
 
(16,609
)
 
 
(21,569
)
Other, net
 
 
(257
)
 
 
 
Investment loss, net
 
$
(8,677
)
 
$
(8,484
)
 
We recorded other-than-temporary impairment charges of $4.5 million for the three months ended June 30, 2012 related to changes in expected credit performance on available-for-sale, private-label MBS with a cost basis of $12.4 million. We recorded no other-than-temporary impairment charges on MBS during the three months ended June 30, 2011.
 
There were no sales of available-for-sale investments during the three months ended June 30, 2012. During the three months ended June 30, 2011, the Company received $11.3 million from the sales of $22.6 million in face value of MBS recognizing a net gain of $1.5 million.

The gains on trading investments, net, recognized for the three months ended June 30, 2012 were primarily the result of net mark-to-market gain adjustments of $12.6 million and net gains of $0.1 million from sales of trading investments.  The gains on trading investments, net, recognized for the three months ended June 30, 2012, also reflects net realized gains of $2.2 million on the sold securities from the acquisition price and changes in net unrealized mark-to-market gain adjustments of $10.5 million during the three months ended June 30, 2012. The gain on trading investments, net, recognized for the three months ended June 30, 2011 were primarily the result of net mark-to-market gain adjustments of $10.7 million and net gains of $0.9 million from sales of trading investments. The gain on trading investments, net, recognized for the three months ended June 30, 2011, also reflects net realized gains of $0.7 million on the sold securities from the acquisition price and changes in net unrealized mark-to-market gain adjustments of $10.9 million during the same time period.
 
Losses from derivative instruments recognized for the three months ended June 30, 2012 were the result of net realized gains of $0.5 million and net unrealized mark-to-market loss adjustments of $17.1 million. Losses from derivative instruments recognized for the three months ended June 30, 2012 also reflects net losses of $0.8 million from disposed derivative instruments from the acquisition price and changes in net unrealized mark-to-market loss adjustments of $15.8 million during the three months ended June 30, 2012. Losses from derivative instruments recognized for the three months ended June 30, 2011 were primarily the result of net realized gains of $0.1 million offset by unrealized mark-to-market loss adjustments of $21.6 million. The value of our hedge instruments is expected to fluctuate inversely relative to the change in value of the agency-backed MBS portfolio.  The mark-to-market loss adjustments reflect the impact of declining interest rates and/or widening mortgage spreads during 2011 and 2012.

Other, net primarily reflects unrealized mark-to-market loss adjustments related to our securities sold but not yet purchased.

Interest expense unrelated to our principal investing activity relates to long-term debt. These costs increased to $123.1 thousand for the three months ended June 30, 2012 from $114.9 thousand for the three months ended June 30, 2011.

Other expenses remained consistent at $3.7 million for the three months ended June 30, 2011 and 2012.
 
 
Total income tax provision increased $0.1 million (33.3%) from a provision of $0.3 million for the three months ended June 30, 2011 to $0.4 million for the three months ended June 30, 2012. Our effective tax rate was 15.0% for the three months ended June 30, 2012 as compared to 79.2% for the same period in 2011. During the three months ended June 30, 2012, ordinary taxable income was subject to alternative minimum tax. Our effective tax rates during these periods differed from statutory rates primarily due to the expected use of federal and state net operating losses (NOLs) to offset our taxable income earned during those periods. Our NOLs had been recorded as deferred tax assets subject to a valuation allowance. We recorded an expected tax liability for these periods due to taxable income for the three months ended June 30, 2012 and 2011 that is anticipated to be subject to the alternative minimum tax. Limitations prevent us from using our NOLs to fully offset our taxable income for alternative minimum tax purposes. Further, the discrete period reporting of accrued interest and penalties on unrecognized tax positions as of June 30, 2012 remains a major contributor of the total tax expense.

 
23


Six months ended June 30, 2012 compared to six months ended June 30, 2011

We reported net income of $12.9 million for the six months ended June 30, 2012 compared to net income of $19.9 million for the six months ended June 30, 2011 which included the following results for the periods indicated (dollars in thousands):

 
 
Six Months Ended June 30,
 
 
 
2012
 
 
2011
 
Interest income
 
$
29,394
 
 
$
25,757
 
Interest expense
 
 
1,934
 
 
 
1,024
 
Net interest income
 
 
27,460
 
 
 
24,733
 
Other (loss) income, net
 
 
 
 
 
 
 
 
Investment (loss) gain, net
 
 
(5,869
)
 
 
2,740
 
Other loss
 
 
(8
)
 
 
(7
)
Total other (loss) income, net
 
 
(5,877
)
 
 
2,733
 
Other expenses
 
 
7,856
 
 
 
6,773
 
Income before income taxes
 
 
13,727
 
 
 
20,693
 
Income tax provision
 
 
821
 
 
 
817
 
Net income
 
$
12,906
 
 
$
19,876
 

Net income decreased $7.0 million (35.2%) from $19.9 million for the six months ended June 30, 2011 to $12.9 million for the six months ended June 30, 2012 due to the following changes:
 
 
Net interest income increased $2.8 million (11.3%) from $24.7 million for the six months ended June 30, 2011 to $27.5 million for the six months ended June 30, 2012. The increase is the result of the increase in our investable capital on a leveraged basis to our MBS portfolio.
 
 
Investment gain, net, decreased $8.6 million from net investment gain of $2.7 million for the six months ended June 30, 2011 to a net investment loss of $5.9 million for the six months ended June 30, 2012. See below for additional discussion on the results of our principal investing portfolio.
 
The following table summarizes the components of income from our principal investment activities, net of related interest expense, for the periods indicated (dollars in thousands):
 
   
Six Months Ended June 30,
 
   
2012
   
2011
 
Net interest income
  $ 27,708     $ 24,963  
Investment (loss) gain, net
    (5,869 )     2,740  
 
 
24


The components of net interest income from our MBS-related portfolio is summarized in the following table (dollars in thousands):

 
 
Six Months Ended June 30,
 
 
 
2012
 
 
2011
 
 
 
Average
Balance
 
 
Income
(Expense)
 
 
Yield
(Cost)
 
 
Average
Balance
 
 
Income
(Expense)
 
 
Yield
(Cost)
 
Agency-backed MBS
 
$
772,436
 
 
$
16,637
 
 
 
4.31
%
 
$
476,311
 
 
$
10,651
 
 
 
4.47
%
Private-label MBS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior securities
 
 
8,339
 
 
 
707
 
 
 
16.97
%
 
 
18,786
 
 
 
1,445
 
 
 
15.39
%
Re-REMIC securities
 
 
133,793
 
 
 
11,983
 
 
 
17.91
%
 
 
140,695
 
 
 
13,290
 
 
 
18.89
%
Other investments
 
 
1,078
 
 
 
66
 
 
 
12.24
%
 
 
4,222
 
 
 
207
 
 
 
9.88
%
 
 
$
915,646
 
 
 
29,393
 
 
 
6.42
%
 
$
640,014
 
 
 
25,593
 
 
 
8.00
%
Other(1)
 
 
 
 
 
 
1
 
 
 
 
 
 
 
 
 
 
 
164
 
 
 
 
 
 
 
 
 
 
 
 
29,394
 
 
 
 
 
 
 
 
 
 
 
25,757
 
 
 
 
 
Repurchase agreements
 
$
769,064
 
 
 
(1,686
)
 
 
(0.43
)%
 
$
469,838
 
 
 
(794
)
 
 
(0.34
)%
Net interest income/spread
 
 
 
 
 
$
27,708
 
 
 
5.99
%
 
 
 
 
 
$
24,963
 
 
 
7.66
%
 

(1)
Includes interest income on cash and other miscellaneous interest-earning assets.

The change in the composition of our MBS portfolio and related increase in net interest income by $2.7 million from the six months ended June 30, 2011 to the six months ended June 30, 2012 were primarily due to the repositioning of the MBS portfolio by reallocating capital from private-label MBS to agency-backed MBS on a leveraged basis and from the deployment of capital raised from our public offering during the three months ended March 31, 2012 primarily into our agency-backed MBS portfolio. Interest income from other investments represents interest on interest-only MBS securities.

 As discussed above, we realized a net investment loss of $5.9 million for the six months ended June 30, 2012 compared to a net investment gain of $2.7 million for the six months ended June 30, 2011. The following table summarizes the components of net investment (loss) gain (dollars in thousands):
 
 
 
Six Months Ended June 30,
 
 
 
2012
 
 
2011
 
Realized gains on sale of available-for-sale investments, net
 
$
 
 
$
14,018
 
Available-for-sale and cost method securities – other-than-temporary impairment charges
 
 
(4,531
)
 
 
 
Gains on trading investments, net
 
 
15,787
 
 
 
12,923
 
Losses from derivative instruments, net
 
 
(16,994
)
 
 
(24,116
)
Other, net
 
 
(131
)
 
 
(85
)
Investment (loss) gain, net
 
$
(5,869
)
 
$
2,740
 
 
We recorded other-than-temporary impairment charges of $4.5 million for the six months ended June 30, 2012 related to changes in expected credit performance on available-for-sale, private-label MBS with a cost basis of $12.4 million. We recorded no other-than-temporary impairment charges on MBS during the six months ended June 30, 2011.
 
There were no sales of available-for-sale investments during the six months ended June 30, 2012. During the six months ended June 30, 2011, the Company received $73.3 million from the sale of $111.5 million in face value of MBS recognizing a net gain of $12.2 million and realized net gains from the sale of other investments of $1.8 million.

The gains on trading investments, net, recognized for the six months ended June 30, 2012 were primarily the result of net mark-to-market gain adjustments of $15.7 million and net gains of $0.1 million from sales of trading investments.  The gains on trading investments, net, recognized for the six months ended June 30, 2012, also reflects net realized gains of $2.7 million on the sold securities from the acquisition price and changes in net unrealized mark-to-market gain adjustments of $13.1 million during the six months ended June 30, 2012. The gain on trading investments, net, recognized for the six months ended June 30, 2011 were primarily the result of net gains of $0.4 million from sales and net mark-to-market gain adjustments of $12.5 million. The gain on trading investments, net, recognized for the six months ended June 30, 2011, also reflects net realized losses of $0.2 million on the sold securities from the acquisition price and changes in net unrealized mark-to-market gain adjustments of $13.1 million during the same time period.
 
 
25

 
Losses from derivative instruments recognized for the six months ended June 30, 2012 were the result of net realized gains of $0.9 million and net unrealized mark-to-market loss adjustments of $17.9 million. Losses from derivative instruments recognized for the six months ended June 30, 2012 also reflects net losses of $0.4 million from disposed derivative instruments from the acquisition price and changes in net unrealized mark-to-market loss adjustments of $16.6 million during the six months ended June 30, 2012. Losses from derivative instruments recognized for the six months ended June 30, 2011 were primarily the result of net realized losses of $1.4 million and net unrealized mark-to-market loss adjustments of $22.7 million. The value of our hedge instruments is expected to fluctuate inversely relative to the change in value of the agency-backed MBS portfolio.  The mark-to-market loss adjustments reflect the impact of declining interest rates and/or widening mortgage spreads during 2011 and 2012.

Other, net primarily reflects unrealized mark-to-market loss adjustments related to our securities sold but not yet purchased and our losses from investments in proprietary investment partnerships and other managed investments.

Interest expense unrelated to our principal investing activity relates to long-term debt. These costs increased to $248.5 thousand for the six months ended June 30, 2012 from $229.3 thousand for the six months ended June 30, 2011.

Other expenses increased by $1.1 million (16.2%) from $6.8 million for the six months ended June 30, 2011 to $7.9 million for the six months ended June 30, 2012, primarily as a result of increases in legal expenses offset by a decrease in variable compensation and related expenses.

Total income tax provision remained consistent at a provision of $0.8 million for the six months ended June 30, 2011 and 2012. Our effective tax rate was 6.0% for the six months ended June 30, 2012 as compared to 3.9% for the same period in 2011. During the three months ended June 30, 2012, ordinary taxable income was subject to alternative minimum tax. Our effective tax rates during these periods differed from statutory rates primarily due to the expected use of federal and state NOLs to offset our taxable income earned during those periods. Our NOLs had been recorded as deferred tax assets subject to a valuation allowance. We recorded an expected tax liability for these periods due to taxable income for the three months ended June 30, 2012 and 2011 that is anticipated to be subject to the alternative minimum tax. Limitations prevent us from using our NOLs to fully offset our taxable income for alternative minimum tax purposes. Further, the discrete period reporting of accrued interest and penalties on unrecognized tax positions as of June 30, 2012 remains a major contributor of the total tax expense.

Liquidity and Capital Resources

Liquidity is a measurement of our ability to meet potential cash requirements including ongoing commitments to repay borrowings, fund investments, and for other general business purposes. Our primary sources of funds for liquidity consist of short-term borrowings (e.g., repurchase agreements), principal and interest payments on MBS and proceeds from sales of MBS. Other sources of liquidity include proceeds from the offering of common stock, preferred stock, debt securities or other securities registered pursuant to our effective shelf registration statement filed with the SEC. Pursuant to our shelf registration statement, on March 26, 2012, we completed a public offering of 1,755,000 shares of Class A common stock, at a public offering price of $23.90 per share, for net proceeds of $40.2 million, after deducting underwriting discounts and commissions and expenses.  In addition, on April 18, 2012, we completed the issuance and sale of 263,250 additional shares of Class A common stock pursuant to the full exercise of the underwriters’ over-allotment option, at a public offering price of $23.90 per share less the $0.875 per share dividend declared on March 16, 2012 pursuant to the Underwriting Agreement dated March 22, 2012, for net proceeds of $5.9 million, net of underwriting discounts and commissions and expenses.

Liquidity, or ready access to funds, is essential to our business. Liquidity is of particular importance to our business and perceived liquidity issues may affect our counterparties’ willingness to engage in transactions with us. Our liquidity could be impaired due to circumstances that we may be unable to control, such as a general market disruption or an operational problem that affects us or third parties. Further, our ability to sell assets may be impaired if other market participants are seeking to sell similar assets at the same time. If we cannot obtain funding from third parties or from our subsidiaries, our results of operations could be negatively impacted.

Potential future sources of liquidity for us include existing cash balances, borrowing capacity through margin accounts and repurchase agreements and cash flows from operations, future issuances of common stock, preferred stock, debt securities or other securities registered pursuant to our shelf registration statement. Funding for agency-backed MBS through repurchase agreements continues to be available to us at rates we consider to be attractive from multiple counterparties, and we have observed increased availability for funding for private-label MBS through repurchase agreements. Although the availability of the third-party sources of liquidity has improved, we have observed that market conditions are still constraining access to debt capital relative to pre-crisis levels of 2007. As a result, the availability of certain short-term liquidity such as commercial paper borrowings was still limited as of June 30, 2012.

Cash Flows

As of June 30, 2012, our cash and cash equivalents totaled $21.1 million, representing a net increase in the balance of $1.1 million from $20.0 million as of December 31, 2011. The cash provided by operating activities of $9.8 million was attributable primarily to net income. The cash used in investing activities of $354.7 million relates primarily to purchases of MBS, net of proceeds from the sales of MBS. The cash provided by financing activities of $346.0 million relates primarily to proceeds from repurchase agreements used to finance a portion of the MBS portfolio and the completed public offering of Class A common stock.

 
26

 
Sources of Funding

We believe that our existing cash balances, investments in private-label MBS, net investments in agency-backed MBS, cash flows from operations, borrowing capacity and other sources of liquidity will be sufficient to meet our cash requirements for at least the next 12 months. We have obtained, and believe we will be able to continue to obtain, short-term financing in amounts and at interest rates consistent with our financing objectives. We may, however, seek debt or equity financings, in public or private transactions, to provide capital for corporate purposes and/or strategic business opportunities, including possible acquisitions, joint ventures, alliances or other business arrangements which could require substantial capital outlays. Our policy is to evaluate strategic business opportunities, including acquisitions and divestitures, as they arise. There can be no assurance that we will be able to generate sufficient funds from future operations, or raise sufficient debt or equity on acceptable terms, to take advantage of investment opportunities that become available. Should our needs ever exceed these sources of liquidity, we believe that most of our investments could be sold, in most circumstances, to provide cash. However, we may be required to sell our assets in such instances at depressed prices.

As of June 30, 2012, our liabilities totaled $1.2 billion. In addition to other payables and accrued expenses, our indebtedness consisted of repurchase agreements and long-term debentures. These long-term debentures accrue and require payments of interest quarterly at annual rates of three-month LIBOR plus 2.25% to 3.00%, mature between 2033 and 2035 and are currently redeemable by us, in whole or in part, without penalty. As of June 30, 2012, we had $15.0 million of total long-term debt.  As of June 30, 2012, our debt-to-equity leverage ratio was 4.4 to 1.

We also have short-term financing facilities that are structured as repurchase agreements with various financial institutions to primarily fund our portfolio of agency-backed MBS. As of June 30, 2012, the weighted-average interest rate under these agreements was 0.47%. Our repurchase agreements include provisions contained in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association and may be amended and supplemented in accordance with industry standards for repurchase facilities. Our repurchase agreements include financial covenants, with which the failure to comply would constitute an event of default under the applicable repurchase agreement. Similarly, each repurchase agreement includes events of insolvency and events of default on other indebtedness. As provided in the standard master repurchase agreement as typically amended, upon the occurrence of an event of default or termination event the applicable counterparty has the option to terminate all repurchase transactions under such counterparty’s repurchase agreement and to demand immediate payment of any amount due from us to the counterparty.

Under our repurchase agreements, we may be required to pledge additional assets to our repurchase agreement counterparties in the event the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral (i.e., a margin call), which may take the form of additional securities or cash. Margin calls on repurchase agreements collateralized by our MBS investments primarily result from events such as declines in the value of the underlying mortgage collateral caused by factors such as rising interest rates or prepayments.

To date, we have not had any margin calls on our repurchase agreements that we were not able to satisfy with either cash or additional pledged collateral. However, should we encounter increases in interest rates or prepayments, margin calls on our repurchase agreements could result in a material adverse change in our liquidity position.
 
In the event that market conditions are such that we are unable to obtain financing for our investments in MBS in amounts and at interest rates consistent with our financing objectives, to the extent deemed appropriate, we may use cash to finance our investments or we may liquidate such investments. Accordingly, depending on market conditions, we may incur significant losses on any such sales of MBS.
 
The following table provides information regarding our outstanding repurchase agreement borrowings as of the dates and periods indicated (dollars in thousands):

 
 
June 30, 2012
 
 
December 31, 2011
 
Outstanding balance
 
$
963,051
 
 
$
647,977
 
Weighted-average rate
 
 
0.47
%
 
 
0.49
%
Weighted-average term to maturity
 
12.6 days
 
 
13.1 days
 
Maximum amount outstanding at any month-end during the period
 
$
963,051
 
 
$
659,459
 

 
27

 
Assets

Our principal assets consist of MBS, cash and cash equivalents, receivables, deposits and long-term investments. As of June 30, 2012, liquid assets consisted primarily of cash and cash equivalents of $21.1 million and net investments in MBS of $227.8 million. Cash equivalents consist primarily of money market funds invested in debt obligations of the U.S. government. Our total assets increased from $1.0 billion at December 31, 2011 to $1.4 billion as of June 30, 2012. The increase in total assets reflects additional investments made in the agency-backed MBS portfolio during the six months ended June 30, 2012.

As of June 30, 2012, the total par and fair value of the MBS portfolio was $1.2 billion. As of June 30, 2012, the weighted-average coupon of the portfolio was 4.52%.

Dividends

Pursuant to our variable dividend policy, our Board of Directors evaluates dividends on a quarterly basis and, in its sole discretion, approves the payment of dividends. Our dividend payments, if any, may vary significantly from quarter to quarter. The Board of Directors has approved and we have declared the following dividends to date in 2012:

Quarter Ended
 
Dividend Amount
 
Declaration Date
 
Record Date
 
Pay Date
June 30
 
$
0.875
 
June 15
 
June 29
 
July 31
March 31
 
 
0.875
 
March 16
 
March 26
 
April 30

The Board of Directors approved and we declared and paid the following dividends for 2011:

Quarter Ended
 
Dividend Amount
 
Declaration Date
 
Record Date
 
Pay Date
December 31
 
$
0.875
 
December 21
 
December 31
 
January 31, 2012
September 30
 
 
0.875
 
September 19
 
September 30
 
October 31
June 30
 
 
0.875
 
June 23
 
July 5
 
July 29
March 31
 
 
0.750
 
March 24
 
April 4
 
April 29

 
28

 

Market risk generally represents the risk of loss through a change in realizable value that can result from a change in the prices of securities, a change in the value of financial instruments as a result of changes in interest rates, a change in the volatility of interest rates or a change in the credit rating of an issuer. We monitor market and business risk, including credit, interest rate, equity, operations, liquidity, compliance, legal, reputational, and equity ownership risks through a number of control procedures designed to identify and evaluate the various risks to which our business and assets are exposed.  See “Item 1—Business” in our Annual Report on Form 10-K for the year ended December 31, 2011 for a discussion of our risk management strategies.
 
We are exposed to the following market risks as a result of our investments in MBS and equity investments.

Credit Risk

Although we do not expect to encounter credit risk in our agency-backed MBS portfolio assuming Fannie Mae and Freddie Mac remain solvent, we are exposed to credit risk in our private-label MBS portfolio. With respect to our private-label MBS, credit support contained in these MBS deal structures provides a level of protection from losses, as do the discounted purchase prices in the event of the return of less than 100% of par. We also evaluate the impact of credit risk on our investments through a comprehensive investment review and selection process, which is predominantly focused on quantifying and pricing credit risk. We review our private-label MBS based on quantitative and qualitative analysis of the risk-adjusted returns on such investments. Through modeling and scenario analysis, we seek to evaluate each investment’s credit risk. Credit risk is also monitored through our ongoing asset surveillance. Despite these measures to manage credit risk, unanticipated credit losses could nevertheless occur, which could adversely impact our operating results.

Our private-label MBS are generally purchased at a discount. We estimate the future expected cash flows based on our observation of current information and events and applying a number of assumptions related to prepayment rates, interest rates, default rates, and the timing and amount of credit losses. These assumptions are difficult to predict as they are subject to uncertainties and contingencies related to future events that may impact our estimates and interest income.

The following table represents certain statistics of our private-label MBS portfolio as of and for the three months ended June 30, 2012:

 
 
Senior
Securities
 
 
Re-REMIC
Securities
 
 
Total
Private-
Label
Securities
 
Yield (% of amortized cost)
 
 
17.0
%
 
 
18.0
%
 
 
17.9
%
Average cost (% of face value)
 
 
61.7
%
 
 
48.6
%
 
 
49.3
%
Weighted-average coupon
 
 
3.8
%
 
 
5.3
%
 
 
5.2
%
Delinquencies greater than 60 plus days
 
 
38.1
%
 
 
18.5
%
 
 
19.4
%
Credit enhancement
 
 
4.3
%
 
 
5.7
%
 
 
5.6
%
Severity (three months average)
 
 
54.1
%
 
 
48.5
%
 
 
48.8
%
Constant prepayment rate (three months average)
 
 
14.8
%
 
 
16.9
%
 
 
16.8
%

Key credit and prepayment measures in our private-label MBS portfolio reflected a slight improvement during the three months ended June 30, 2012. Total 60-day plus delinquencies in our private-label MBS portfolio decreased to 19.4% at June 30, 2012 from 20.5% at March 31, 2012 and trailing three month average loss severities on liquidated loans decreased to 48.8% at June 30, 2012 from 50.5% at March 31, 2012. We will continue to monitor the performance of each security in our portfolio and assess the impact on the overall performance of the portfolio.

The table that follows shows the expected change in fair value for our current private-label MBS related to our principal investing activities under several hypothetical credit loss scenarios. Our private-label MBS are classified as Level 3 assets of the fair value hierarchy as they are valued using present value techniques based on estimated cash flows of the security taking into consideration various assumptions derived by management and used by other market participants. These assumptions include, among others, interest rates, prepayment rates, discount rates, credit loss rates, and the timing of cash flows and credit losses. Credit default and loss severity rates can significantly affect the prices of private-label MBS. While it is impossible to project exact amount of changes in value, the table below illustrates the impact a 10% increase and a 10% decrease in the credit default and loss severity rates from those used as our valuation assumptions would have on the value of our total assets and our book value as of June 30, 2012. The changes in rates are assumed to occur instantaneously. Actual changes in market conditions are likely to be different from these assumptions (dollars in thousands, except per share amounts).
 
 
29

 
 
June 30, 2012
 
 
Value
 
 
Value
with
10%
Increase
in
Default
Rate
 
 
Percent
Change
 
 
Value
with 10%
Decrease
in
Default
Rate
 
 
Percent
Change
 
 
Value
with
10%
Increase
in
Loss
Severity
Rate
 
 
Percent
Change
 
 
Value
with 10%
Decrease
in
Loss
Severity
Rate
 
 
Percent
Change
 
Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
MBS
$
1,190,864
 
 
$
1,187,255
 
 
 
(0.30
)%
 
$
1,194,557
 
 
 
0.31
%
 
$
1,185,074
 
 
 
(0.49
)%
 
$
1,196,537
 
 
 
0.48
%
Other
 
188,601
 
 
 
188,601
 
 
 
 
 
 
188,601
 
 
 
 
 
 
188,601
 
 
 
 
 
 
188,601
 
 
 
 
Total assets
$
1,379,465
 
 
$
1,375,856
 
 
 
(0.26
)%
 
$
1,383,158
 
 
 
0.27
%
 
$
1,373,675
 
 
 
(0.42
)%
 
$
1,385,138
 
 
 
0.41
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
$
1,158,373
 
 
$
1,158,373
 
 
 
 
 
$
1,158,373
 
 
 
 
 
$
1,158,373
 
 
 
 
 
$
1,158,373
 
 
 
 
Equity
 
221,092
 
 
 
217,483
 
 
 
(1.63
)%
 
 
224,785
 
 
 
1.67
%
 
 
215,302
 
 
 
(2.62
)%
 
 
226,765
 
 
 
2.57
%
Total liabilities and equity
$
1,379,465
 
 
$
1,375,856
 
 
 
(0.26
)%
 
$
1,383,158
 
 
 
0.27
%
 
$
1,373,675
 
 
 
(0.42
)%
 
$
1,385,138
 
 
 
0.41
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Book value per share
$
22.58
 
 
$
22.21
 
 
 
(1.63
)%
 
$
22.96
 
 
 
1.67
%
 
$
21.99
 
 
 
(2.62
)%
 
$
23.16
 
 
 
2.57
%

In addition, discount rate, also referred to as loss adjusted return yield, is also related to exposure to credit risk. The credit risk embedded in the private-label MBS also impacts the loss adjusted return yield expected by an investor.  A 100 basis point increase in discount rate could decrease the fair value of our private-label MBS by $10.4 million to $162.5 million and a 100 basis point decrease in discount rate could increase the fair value by $11.6 million to $184.5 million, holding all other assumptions constant, as compared to $172.9 million reported as of June 30, 2012.

A change in fair value may also impact the outcome of the other-than-temporary impairment analysis, if the fair value is less than the carrying value of the private-label MBS. During the second quarter ended June 30, 2012, we recorded $4.5 million in other-than-temporary impairment charges.  As related to the discount rate sensitivity analysis discussed above, a 100 basis point decrease in discount rate would have resulted in $3.7 million in other-than-temporary impairment charges and a 100 basis point increase in discount rate would have resulted in $9.7 million in other-than-temporary impairment charges.  Whereas, if discount rates for all of the bonds in our private-label MBS portfolio were arbitrarily held constant from those at March 31, 2012, the other-than-temporary impairment charge could have been $7.7 million.

As discussed above, the other-than-temporary impairment charge is a non-cash charge representing primarily a reversal of the cumulative non-cash discount accretion previously recorded on certain of our private-label MBS. This charge does not affect non-GAAP core operating income or book value, but does reduce our net income and lowers the accounting basis used to record future discount accretion, which should more closely reflect future cash flows.

Interest Rate Risk

Leveraged MBS

We are also subject to interest rate risk in our MBS portfolio. Some of our MBS positions are financed with repurchase agreements, which are interest rate sensitive financial instruments. We are exposed to interest rate risk that fluctuates based on changes in the level or volatility of interest rates and mortgage prepayments and in the shape and slope of the yield curve. We attempt to hedge a portion of our exposure to interest rate fluctuations through the use of Eurodollar futures and U.S. Treasury note futures. The counterparties to our derivative agreements at June 30, 2012 are U.S. financial institutions. We assess and monitor the counterparties’ non-performance risk and credit risk on a regular basis.

Our primary risk is related to changes in both short- and long-term interest rates, which affect us in several ways. As interest rates increase, the market value of the MBS may be expected to decline, prepayment rates may be expected to go down, and duration may be expected to extend. An increase in interest rates is beneficial to the market value of our derivative instruments. For example, for interest rate swap positions, the cash flows from receiving the floating rate portion increase and the fixed-rate paid remains the same under this scenario. If interest rates decline, the reverse is true for MBS, paying fixed and receiving floating interest rate swaps, interest rate caps, and Eurodollar and U.S. Treasury futures and MBS put option contracts.

The table that follows shows the expected change in fair value for our current MBS and derivatives related to our principal investing activities under several hypothetical interest-rate scenarios. Interest rates are defined by the U.S. Treasury yield curve. The changes in rates are assumed to occur instantaneously. It is further assumed that the changes in rates occur uniformly across the yield curve and that the level of LIBOR changes by the same amount as the yield curve. Actual changes in market conditions are likely to be different from these assumptions.

 
30

 
Changes in value are measured as percentage changes from their respective values presented in the column labeled “Value.” Management’s estimate of change in value for MBS is based on the same assumptions it uses to manage the impact of interest rates on the portfolio. Actual results could differ significantly from these estimates. For MBS, the estimated change in value of the MBS reflects an effective duration of 3.58 in a rising interest rate environment and 1.47 in a declining interest rate environment.
 
The effective durations are based on observed market value changes, as well as management’s own estimate of the effect of interest rate changes on the fair value of the investments including assumptions regarding prepayments based, in part, on age of and interest rate on the mortgages underlying the MBS, prior exposure to refinancing opportunities, and an overall analysis of historical prepayment patterns under a variety of past interest rate conditions (dollars in thousands, except per share amounts).
 
 
 
 
June 30, 2012
 
 
 
Value
 
 
Value
with 100
Basis Point
Increase in
Interest
Rates
 
 
Percent
Change
 
 
Value
with 100
Basis Point
Decrease in
Interest
Rates
 
 
Percent
Change
 
Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
MBS
 
$
1,190,864
 
 
$
1,148,243
 
 
 
(3.58
)%
 
$
1,208,408
 
 
 
1.47
 %
Derivative asset
 
 
1,899
 
 
 
(7,114
)
 
 
(474.62
)%
 
 
3,560
 
 
 
87.47
 %
Other
 
 
186,702
 
 
 
186,702
 
 
 
 
 
 
186,702
 
 
 
 
Total assets
 
$
1,379,465
 
 
$
1,327,831
 
 
 
(3.74
)%
 
$
1,398,670
 
 
 
1.39
 %
Liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
 
$
963,051
 
 
$
963,051
 
 
 
 
 
$
963,051
 
 
 
 
Derivative liability
 
 
81,028
 
 
 
36,590
 
 
 
(54.84
)%
 
 
121,046
 
 
 
49.39
 %
Securities sold but not yet purchased
   
70,965
     
69,223
     
(2.45
)%
   
70,707
     
(0.36
)%
Other
 
 
43,329
 
 
 
43,329
 
 
 
 
 
 
43,329
 
 
 
 
Total liabilities
 
 
1,158,373
 
 
 
1,112,193
 
 
 
(3.99
)%
 
 
1,198,133
 
 
 
3.43
 %
Equity
 
 
221,092
 
 
 
215,638
 
 
 
(2.47
)%
 
 
200,537
 
 
 
(9.30
)%
Total liabilities and equity
 
$
1,379,465
 
 
$
1,327,831
 
 
 
(3.74
)%
 
$
1,398,670
 
 
 
1.39
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Book value per share
 
$
22.58
 
 
$
22.03
 
 
 
(2.47
)%
 
$
20.48
 
 
 
(9.30
)%

Equity Price Risk

Although limited, we are exposed to equity price risk as a result of our investments in equity securities and investment partnerships. Equity price risk changes as the volatility of equity prices changes or the values of corresponding equity indices change.
 
While it is impossible to exactly project what factors may affect the prices of equity sectors and how much the effect might be, the table below illustrates the impact a 10% increase and a 10% decrease in the price of the equities held by us would have on the value of our total assets and our book value as of June 30, 2012 (dollars in thousands, except per share amounts).

 
 
June 30, 2012
 
 
 
Value
 
 
Value with 10%
Increase
in Price
 
 
Percent
Change
 
 
Value with 10%
Decrease
in Price
 
 
Percent
Change
 
Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Equity and cost method investments
 
$
1,996
 
 
$
2,196
 
 
 
10.00
%
 
$
1,796
 
 
 
(10.00
)%
Other
 
 
1,377,469
 
 
 
1,377,469
 
 
 
 
 
 
1,377,469
 
 
 
 
Total assets
 
$
1,379,465
 
 
$
1,379,665
 
 
 
0.01
%
 
$
1,379,265
 
 
 
(0.01
)%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
$
1,158,373
 
 
$
1,158,373
 
 
 
 
 
$
1,158,373
 
 
 
 
Equity
 
 
221,092
 
 
 
221,292
 
 
 
0.09
%
 
 
220,892
 
 
 
(0.09
)%
Total liabilities and equity
 
$
1,379,465
 
 
$
1,379,665
 
 
 
0.01
%
 
$
1,379,265
 
 
 
(0.01
)%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Book value per share
 
$
22.58
 
 
$
22.60
 
 
 
0.09
%
 
$
22.56
 
 
 
(0.09
)%

Except to the extent that we sell our equity securities or other investments, or a decrease in their fair value is deemed to be other-than-temporary, an increase or decrease in the fair value of those assets will not directly affect our earnings; however, an increase or decrease in the value of equity method investments will directly affect our earnings.
 
Inflation Risk

Virtually all of our assets and liabilities are interest rate sensitive in nature. As a result, interest rates and other factors influence our performance far more than inflation.  Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates.  Our financial statements are prepared in accordance with GAAP and our distributions are determined by our Board of Directors in its sole discretion pursuant to our variable dividend policy; in each case, our activities and balance sheet are measured with reference to fair value without considering inflation.

 
31

 
Item 4.
Controls and Procedures

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

As of the end of the period covered by this Quarterly Report on Form 10-Q, our management, with the participation of our Chief Executive Officer, Eric F. Billings, and our Chief Financial Officer, Kurt R. Harrington, carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined under Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) pursuant to Rule 13a-15(b) of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding disclosure.

Changes in Internal Control Over Financial Reporting

There has been no change in our internal control over financial reporting during the quarter ended June 30, 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Cautionary Statement About 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 Exchange Act and, as such, may involve known and unknown risks, uncertainties and assumptions. The forward-looking statements we make in this Quarterly Report on Form 10-Q include, but are not limited to, statements about the following:

 
the availability and terms of, and our ability to deploy, capital and our ability to grow our business through a strategy focused on acquiring primarily residential mortgage-backed securities (MBS) that are either issued by U.S. government agencies or guaranteed as to principal and interest by U.S. government agencies or U.S. government sponsored agencies (agency-backed MBS), and MBS issued by private organizations (private-label MBS);
 
our ability to forecast our tax attributes, which are based upon various facts and assumptions, and our ability to protect and use our net operating losses (NOLs), and net capital losses (NCLs), to offset future taxable income and gains;
 
our investment, hedging and financing strategies and the success of these strategies;
 
the effect of changes in prepayment rates, interest rates and default rates on our portfolio;
 
the outcome of contingencies, including pending legal and regulatory proceedings;
 
our ability to quantify and manage risk;
 
our ability to realize any reflation of our assets;
 
our liquidity;
 
our asset valuation policies;
 
our decisions with respect to, and ability to make, future dividends;
 
our ability to maintain our exclusion from the definition of “investment company” under the Investment Company Act of 1940, as amended (1940 Act); and
 
the effect of government regulation and of general economic conditions on our business.
 
Forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking into account information currently in our possession.  These beliefs, assumptions and expectations may change as a result of many possible events or factors, not all of which are known to us or are within our control.  If a change occurs, the performance of our portfolio and our business, financial condition, liquidity and results of operations may vary materially from those expressed, anticipated or contemplated in our forward-looking statements.  You should carefully consider these risks, along with the following factors that could cause actual results to vary from our forward-looking statements, before making an investment in our securities:
 
 
effects of regulatory proceedings, litigation and contractual claims against us, our officers and our directors;
 
the overall environment for interest rates, changes in interest rates, interest rate spreads, the yield curve and prepayment rates;
 
current conditions and further adverse developments in the residential mortgage market and the overall economy;
 
potential risk attributable to our mortgage-related portfolios, including changes in fair value;
 
our use of leverage and our dependence on repurchase agreements and other short-term borrowings to finance our mortgage-related holdings;
 
 
32

 
 
the availability of certain short-term liquidity sources;
 
the federal conservatorship of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) and related efforts, along with any changes in laws and regulations affecting the relationship between Fannie Mae and Freddie Mac and the federal government;
 
mortgage loan prepayment activity, modification programs and future legislative action;
 
changes in our acquisition, hedging and leverage strategies, changes in our asset allocation and changes in our operational policies, all of which may be changed by us without shareholder approval;
 
competition for investment opportunities, including competition from the U.S. Department of Treasury (U.S. Treasury), for investments in agency-backed MBS;
 
failure of sovereign or municipal entities to meet their debt obligations or a downgrade in the credit rating of such debt obligations;
 
fluctuating quarterly operating results;
 
changes in laws and regulations and industry practices that may adversely affect our business; and
 
volatility of the securities markets and activity in the secondary securities markets.

These and other risks, uncertainties and factors, including those described elsewhere in this Quarterly Report on Form 10-Q, 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.

 
33

 
PART II
OTHER INFORMATION


Nothing to report under this item.

Item 1A.

As of June 30, 2012, there have been no material changes in our risk factors as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011.


Purchases of Equity Securities by the Issuer

During the three months ended June 30, 2012, we did not repurchase any shares of our Class A common stock.


Not applicable.
 
 
34

 
Item 6.

Exhibit Number
 
Exhibit Title
3.1
 
Amended and Restated Articles of Incorporation of the Company, as amended (incorporated by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q filed on November 9, 2009).
 
 
 
3.2
 
Amended and Restated Bylaws of the Company, as amended (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on July 28, 2011).
 
 
 
12.01
 
Computation of Ratio of Earnings to Fixed Charges.*
 
 
 
31.01
 
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended, adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
 
 
 
31.02
 
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended, adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
 
 
 
32.01
 
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.**
 
 
 
32.02
 
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.**
 
 
 
101.INS
 
INSTANCE DOCUMENT***
101.SCH
 
SCHEMA DOCUMENT***
101.CAL
 
CALCULATION LINKBASE DOCUMENT***
101.LAB
 
LABELS LINKBASE DOCUMENT***
101.PRE
 
PRESENTATION LINKBASE DOCUMENT***
101.DEF
 
DEFINITION LINKBASE DOCUMENT***


*
Filed herewith.
**
Furnished herewith.
***
Submitted electronically herewith. Attached as Exhibit 101 are the following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2012, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets at June 30, 2012 and December 31, 2011; (ii) Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2012 and 2011; (iii) Consolidated Statements of Changes in Equity for the Six Months Ended June 30, 2012 and the Year Ended December 31, 2011; and (iv) Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2011. Pursuant to Rule 406T of Regulation S-T this data 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.

 
35



Pursuant to the requirements of Section 13 or 15(d) 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.

 
ARLINGTON ASSET INVESTMENT CORP.
 
 
 
 
By:
/s/ KURT R. HARRINGTON
 
 
Kurt R. Harrington
 
 
Executive Vice President, Chief Financial Officer, and
    Chief Accounting Officer
 
 
(Principal Financial Officer)
 
 
 
Date: August 3, 2012
 
 

 
36


EXHIBIT INDEX

Exhibit Number
 
Exhibit Title
3.1
 
Amended and Restated Articles of Incorporation of the Company, as amended (incorporated by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q filed on November 9, 2009).
 
 
 
3.2
 
Amended and Restated Bylaws of the Company, as amended (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on July 28, 2011).
 
 
 
 
Computation of Ratio of Earnings to Fixed Charges.*
 
 
 
 
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended, adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
 
 
 
 
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended, adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
 
 
 
 
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.**
 
 
 
 
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.**
 
 
 
101.INS
 
INSTANCE DOCUMENT***
101.SCH
 
SCHEMA DOCUMENT***
101.CAL
 
CALCULATION LINKBASE DOCUMENT***
101.LAB
 
LABELS LINKBASE DOCUMENT***
101.PRE
 
PRESENTATION LINKBASE DOCUMENT***
101.DEF
 
DEFINITION LINKBASE DOCUMENT***


*
Filed herewith.
**
Furnished herewith.
***
Submitted electronically herewith. Attached as Exhibit 101 are the following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2012, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets at June 30, 2012 and December 31, 2011; (ii) Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2012 and 2011; (iii) Consolidated Statements of Changes in Equity for the Six Months Ended June 30, 2012 and the Year Ended December 31, 2011; and (iv) Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2011. Pursuant to Rule 406T of Regulation S-T this data 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.
 
 
37