DX 2012 Q1 10Q


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC  20549
FORM 10-Q
  R
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended March 31, 2012
or
  £
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Commission File Number: 1-9819
DYNEX CAPITAL, INC.
(Exact name of registrant as specified in its charter)
Virginia
52-1549373
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)
 
 
4991 Lake Brook Drive, Suite 100, Glen Allen, Virginia
23060-9245
(Address of principal executive offices)
(Zip Code)
 
 
(804) 217-5800
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes           R           No           £

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

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

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

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

On May 4, 2012, the registrant had 54,344,362 shares outstanding of common stock, $0.01 par value, which is the registrant’s only class of common stock.




DYNEX CAPITAL, INC.
FORM 10-Q
INDEX
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 





PART I.
FINANCIAL INFORMATION

Item 1.
Financial Statements

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

 
March 31, 2012
 
December 31, 2011
ASSETS
(unaudited)
 
 
Agency MBS (including pledged of $2,456,815 and $1,893,209, respectively)
$
2,656,163

 
$
1,965,159

Non-Agency MBS (including pledged of $427,654 and $415,195, respectively)
465,711

 
421,096

Securitized mortgage loans, net
100,675

 
113,703

Other investments, net (including pledged of $23,925 and none, respectively)
53,621

 
1,018


3,276,170

 
2,500,976

Cash and cash equivalents
41,724

 
48,776

Derivative assets
89

 

Principal receivable on investments
9,408

 
13,826

Accrued interest receivable
15,979

 
12,609

Other assets, net
5,686

 
6,006

Total assets
$
3,349,056

 
$
2,582,193

LIABILITIES AND SHAREHOLDERS’ EQUITY
 

 
 

Liabilities:
 

 
 

Repurchase agreements
$
2,686,198

 
$
2,093,793

Payable for securities pending settlement
59,416

 

Non-recourse collateralized financing
32,237

 
70,895

Derivative liabilities
27,668

 
27,997

Accrued interest payable
1,697

 
2,165

Accrued dividends payable
15,215

 
11,307

Other liabilities
3,728

 
4,687

 Total liabilities
2,826,159

 
2,210,844

Commitments and Contingencies (Note 12)
 
 
 
Shareholders’ equity:
 

 
 

Common stock, par value $.01 per share, 100,000,000 shares
authorized; 54,338,367 and 40,380,276 shares issued and outstanding, respectively
543

 
404

Additional paid-in capital
758,652

 
634,683

Accumulated other comprehensive income (loss)
22,924

 
(3,255
)
Accumulated deficit
(259,222
)
 
(260,483
)
 Total shareholders' equity
522,897

 
371,349

Total liabilities and shareholders’ equity
$
3,349,056

 
$
2,582,193


See notes to unaudited consolidated financial statements.



1



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

 
Three Months Ended
 
March 31,
 
2012
 
2011
Interest income:
 
 
 
Agency MBS
$
16,926

 
$
11,518

Non-Agency MBS
7,537

 
3,691

Securitized mortgage loans
1,504

 
2,219

Other investments
305

 
33

Cash and cash equivalents

 
4

 
26,272

 
17,465

Interest expense:
 
 
 
Repurchase agreements
6,644

 
3,428

Non-recourse collateralized financing
481

 
1,306

 
7,125

 
4,734

 
 
 
 
Net interest income
19,147

 
12,731

Provision for loan losses
(60
)
 
(250
)
Net interest income after provision for loan losses
19,087

 
12,481

 
 
 
 
Gain on sale of investments, net
351

 

Fair value adjustments, net
(210
)
 
(126
)
Other income, net
369

 
43

General and administrative expenses:
 
 
 
Compensation and benefits
(1,798
)
 
(1,132
)
Other general and administrative
(1,323
)
 
(986
)
Net income
$
16,476

 
$
10,280

Weighted average common shares:
 
 
 
Basic
49,480

 
33,153

Diluted
49,481

 
33,157

Net income per common share:
 
 
 
Basic
$
0.33

 
$
0.31

Diluted
$
0.33

 
$
0.31

Dividends declared per common share
$
0.28

 
$
0.27

See notes to unaudited consolidated financial statements.



2




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


 
Three Months Ended
 
March 31,
 
2012

2011
Net income
$
16,476

 
$
10,280

Other comprehensive income:
 

 
 

Change in market value of available-for-sale investments
26,000

 
(6,631
)
Net unrealized gain on cash flow hedging instruments
179

 
2,957

Other comprehensive income (loss)
26,179

 
(3,674
)
Total comprehensive income
$
42,655

 
$
6,606


See notes to unaudited consolidated financial statements.


3



DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 (amounts in thousands)
 
Three Months Ended
 
March 31,
 
2012
 
2011
Operating activities:
 
 
 
Net income
$
16,476

 
$
10,280

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

 
 

Increase in accrued interest receivable
(3,261
)
 
(3,458
)
(Decrease) increase in accrued interest payable
(468
)
 
232

Provision for loan losses
60

 
250

Gain on sale of investments, net
(351
)
 

Fair value adjustments, net
210

 
126

Amortization and depreciation
13,257

 
4,385

Stock-based compensation expense
453

 
95

Net change in other assets and other liabilities
(2,053
)
 
2,042

Net cash and cash equivalents provided by operating activities
24,323

 
13,952

Investing activities:
 

 
 

Purchase of investments
(881,854
)
 
(769,785
)
Principal payments received on investments
117,231

 
84,366

Decrease (increase) in principal receivable on investments
4,418

 
(7,164
)
Proceeds from sales of investments
49,569

 

Principal payments received on securitized mortgage loans
13,745

 
9,065

Other investing activities
(534
)
 
(6
)
Net cash and cash equivalents used in investing activities
(697,425
)
 
(683,524
)
Financing activities:
 

 
 

Borrowings under repurchase agreements, net
592,405

 
614,700

Principal payments on non-recourse collateralized financing
(38,781
)
 
(1,138
)
Proceeds from issuance of common stock
123,733

 
95,206

Dividends paid
(11,307
)
 
(8,192
)
Net cash and cash equivalents provided by financing activities
666,050

 
700,576

 
 
 
 
Net (decrease) increase in cash and cash equivalents
(7,052
)
 
31,004

Cash and cash equivalents at beginning of period
48,776

 
18,836

Cash and cash equivalents at end of period
$
41,724

 
$
49,840

Supplemental Disclosure of Cash Activity:
 

 
 

Cash paid for interest
$
7,488

 
$
4,305


See notes to unaudited consolidated financial statements.


4



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

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Presentation

The accompanying consolidated financial statements of Dynex Capital, Inc. and its qualified real estate investment trust (“REIT”) subsidiaries and its taxable REIT subsidiary (together, “Dynex” or the “Company”) have been prepared in accordance with the instructions to the Quarterly Report on Form 10-Q and Article 10, Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission (the “SEC”).  Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements.  In the opinion of management, all significant adjustments, consisting of normal recurring accruals considered necessary for a fair presentation of the consolidated financial statements, have been included.  Operating results for the three months ended March 31, 2012 are not necessarily indicative of the results that may be expected for any other interim periods or for the entire year ending December 31, 2012.  The unaudited consolidated financial statements included herein should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, filed with the SEC.

Consolidation
 
The consolidated financial statements include the accounts of the Company, its qualified REIT subsidiaries and its taxable REIT subsidiary.  The consolidated financial statements represent the Company’s accounts after the elimination of intercompany balances and transactions.  The Company consolidates entities in which it owns more than 50% of the voting equity and control does not rest with others and variable interest entities in which it is determined to be the primary beneficiary in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 810-10.  The Company follows the equity method of accounting for investments with greater than a 20% and less than 50% interest in partnerships and corporate joint ventures or when it is able to influence the financial and operating policies of the investee but owns less than 50% of the voting equity. As of March 31, 2012 and December 31, 2011, the Company did not have any investments in which it owned less than a 50% interest.

In accordance with ASC Topic 810-10, the Company also consolidates certain trusts through which it has securitized mortgage loans. Additional information regarding the accounting policy for securitized mortgage loans is provided below under "Investments".

Use of Estimates
 
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reported period.  Actual results could differ from those estimates.  The most significant estimates used by management include but are not limited to fair value measurements of its investments, allowance for loan losses, other-than-temporary impairments, commitments and contingencies, and amortization of premiums and discounts. These items are discussed further below within this note to the consolidated financial statements.

Federal Income Taxes
 
The Company believes it has complied with the requirements for qualification as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”).  As such, the Company believes that it qualifies as a REIT for federal income tax purposes, and it generally will not be subject to federal income tax on the amount of its income or gain that is distributed as dividends to shareholders.  The Company uses the calendar year for both tax and financial reporting purposes.  There may be differences between taxable income and income computed in accordance with GAAP.


5



 Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less.
Investments
 
The Company’s investments include Agency MBS, non-Agency MBS, securitized mortgage loans, and other investments.

Agency MBS. The Company accounts for its Agency MBS in accordance with ASC Topic 320, which requires that investments in debt and equity securities be designated as either “held-to-maturity,” “available-for-sale” or “trading” at the time of acquisition.  As of March 31, 2012, the majority of the Company's Agency MBS are designated as available-for-sale with the remainder designated as trading.  Although the Company generally intends to hold its available-for-sale securities until maturity, it may, from time to time, sell any of these securities as part of the overall management of its business.  The available-for-sale designation provides the Company with this flexibility.

All of the Company’s Agency MBS are recorded at their fair value on the consolidated balance sheet. In accordance with ASC Topic 820, the Company determines the fair value of its Agency MBS based upon prices obtained from a third-party pricing service and broker quotes. The Company's application of ASC Topic 820 guidance is discussed further in Note 10.  Changes in the fair value of Agency MBS designated as trading are recognized in net income within “fair value adjustments, net”.   Gains (losses) realized upon the sale, impairment, or other disposal of a trading security are also recognized within “fair value adjustments, net”.  Alternatively, changes in the fair value of Agency MBS designated as available-for-sale are reported in other comprehensive income as unrealized gains (losses) until the security is collected, disposed of, or determined to be other than temporarily impaired.  Upon the sale of an available-for-sale security, any unrealized gain or loss is reclassified out of accumulated other comprehensive income (“AOCI”) into net income as a realized “gain (loss) on sale of investments, net” using the specific identification method.

Non-Agency MBS.  Like Agency MBS, the Company accounts for its non-Agency MBS in accordance with ASC Topic 320.  As of March 31, 2012, all of the Company’s non-Agency MBS are designated as available-for-sale and are recorded at their fair value on the consolidated balance sheet.   Changes in fair value are reported in other comprehensive income until the security is collected, disposed of, or determined to be other than temporarily impaired. Like Agency MBS, the Company generally intends to hold its investments in non-Agency MBS until maturity, but it may, from time to time sell any of these securities as part of the overall management of its business.  Upon the sale of an available-for-sale security, any unrealized gain or loss is reclassified out of AOCI into net income as a realized “gain (loss) on sale of investments, net” using the specific identification method.
 
In accordance with ASC Topic 820, the Company determines the fair value for certain of its non-Agency MBS based upon prices obtained from a third-party pricing service and broker quotes.  The remainder of the non-Agency MBS are valued by discounting the estimated future cash flows derived from pricing models that utilize information such as the security’s coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected losses, credit enhancement, as well as certain other relevant information.

Other-than-Temporary Impairment. The Company evaluates all debt securities in its investment portfolio for other-than-temporary impairments by applying the guidance prescribed in ASC Topic 320-10. If the Company has decided to sell a debt security with a fair value less than its amortized cost as of the balance sheet date of a reporting period, the debt security is considered to be other-than-temporarily impaired, and the Company will recognize an other-than-temporary impairment in the related period's income statement equal to the entire difference between the amortized cost basis and the fair value of the debt security as of the balance sheet date. If the Company does not intend to sell the debt security, the Company assesses whether it is more likely than not will be able to recover its entire amortized cost basis before it is sold. If the Company determines that it will not be able to recover the entire amortized cost basis of the debt security before it is sold, the Company recognizes in the related period's income statement the difference between the present value of cash flows expected to be collected and the amortized cost basis of the debt security as an other-than-temporary impairment related to credit loss, and the difference between the amortized cost basis and the fair value of the debt security as of the balance sheet date is recognized in other comprehensive income.

In periods after the recognition of an other-than-temporary impairment loss for debt securities, the Company shall account

6



for the other-than-temporarily impaired debt security as if the debt security had been purchased on the measurement date of the other-than-temporary impairment at an amortized cost basis equal to the previous amortized cost basis less the other-than-temporary impairment recognized in earnings. For debt securities for which other-than-temporary impairments were recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected shall be accreted into interest income using the effective interest method. The Company shall continue to estimate the present value of cash flows expected to be collected over the life of the debt security. For all other debt securities, if upon subsequent evaluation, there is a significant increase in the cash flows expected to be collected or if actual cash flows are significantly greater than cash flows previously expected, such changes shall be accounted for as a prospective adjustment to the accretable yield in accordance with Subtopic 310-30 even if the debt security would not otherwise be within the scope of that Subtopic. Subsequent increases and decreases in the fair value of available-for-sale securities that are not other-than-temporary shall be included in other comprehensive income.

Please see Note 10 for additional information related to the Company's evaluation for other-than-temporary impairments.

Securitized Mortgage Loans.  Securitized mortgage loans consist of loans pledged to support the repayment of securitization financing bonds that were issued by the Company prior to 2000. The associated securitization financing bonds are treated as debt of the Company and are presented as a portion of "non-recourse collateralized financing" on the consolidated balance sheet. The Company no longer securitizes any of its financial assets.  In accordance with ASC Topic 310-10, the Company's securitized mortgage loans are reported at amortized cost.  Securitized mortgage loans can only be sold subject to the lien of the respective securitization financing indenture. An allowance has been established for currently existing and probable losses on such loans as further discussed below.  

Other Investments.  Other investments include unsecuritized single-family and commercial mortgage loans which are carried at amortized cost in accordance with ASC Topic 310-10. An allowance has been established for currently existing and probable losses on these loans as further discussed below. Other investments as of March 31, 2012 include $55,000 in senior unsecured debt of Freddie Mac. These notes pay principal monthly based on the principal payment performance of a referenced Freddie Mac RMBS security and pay interest monthly in arrears based on a fixed interest rate. Similar to MBS, this investment is designated as available-for-sale and is carried at fair value on the Company's consolidated balance sheet with changes in fair value recorded in other comprehensive income. This investment was sold in the second quarter of 2012.

Allowance for Loan Losses. An allowance for loan losses has been estimated and established for currently existing and probable losses for securitized and unsecuritized mortgage loans that are considered impaired in accordance with ASC Topic 310-10.  Provisions made to increase the allowance are charged as a current period expense.  Commercial mortgage loans are secured by income-producing real estate and are evaluated individually for impairment when the debt service coverage ratio on the mortgage loan is less than 1:1 or when the mortgage loan is delinquent.  An allowance may be established for a particular impaired commercial mortgage loan.  Commercial mortgage loans not evaluated for individual impairment are evaluated for a general allowance.  Certain of the commercial mortgage loans are covered by mortgage loan guarantees that limit the Company’s exposure on these mortgage loans.  Single-family mortgage loans are considered homogeneous and are evaluated on a pool basis for a general allowance.

The Company considers various factors in determining its specific and general allowance requirements, including whether a loan is delinquent, the Company’s historical experience with similar types of loans, historical cure rates of delinquent loans, and historical and anticipated loss severity of the mortgage loans as they are liquidated.  The factors may differ by mortgage loan type (e.g., single-family versus commercial) and collateral type (e.g., multifamily versus office property).  The allowance for loan losses is evaluated and adjusted periodically by management based on the actual and estimated timing and amount of probable credit losses, using the above factors, as well as industry loss experience.

Repurchase Agreements
 
Repurchase agreements are treated as financings in accordance with the provision of ASC Topic 860 under which the Company pledges its securities as collateral to secure a loan, which is equal in value to a specified percentage of the estimated fair value of the pledged collateral. The Company retains beneficial ownership of the pledged collateral.  At the maturity of a repurchase agreement, the Company is required to repay the loan and concurrently receives back its pledged collateral from the lender or, with the consent of the lender, the Company may renew the agreement at the then prevailing financing rate.  A repurchase agreement lender may require the Company to pledge additional collateral in the event of a decline in the fair value of the collateral

7



pledged.  Repurchase agreement financing is recourse to the Company and the assets pledged.  The Company’s repurchase agreements are based on the September 1996 version of the Bond Market Association Master Repurchase Agreement, which generally provides that the lender, as buyer, is responsible for obtaining collateral valuations from a generally recognized source agreed to by both the Company and the lender, or, in an instance when such source is not available, the value determination is made by the lender.
 
Derivative Instruments
 
The Company may enter into interest rate swap agreements, interest rate cap agreements, interest rate floor agreements, financial forwards, financial futures and options on financial futures (“interest rate agreements”) to manage its sensitivity to changes in interest rates.  The Company accounts for its interest rate agreements under ASC Topic 815, designating each as either a cash flow hedging position or a trading position using criteria established therein.  In order to qualify as a cash flow hedge, ASC Topic 815 requires formal documentation to be prepared at the inception of the interest rate agreement that meets certain conditions.  If these conditions are not met, an interest rate agreement will be classified as a trading position.
 
For interest rate agreements designated as trading positions, the Company records these instruments at fair value on the Company’s balance sheet in accordance with ASC Topic 815.  Changes in their market value are measured at each reporting date and recognized in the current period’s consolidated statement of income within "fair value adjustments, net".
 
For interest rate agreements designated as cash flow hedges, the Company evaluates the effectiveness of these hedges against the financial instrument being hedged.  The effective portion of the hedge relationship on an interest rate agreement designated as a cash flow hedge is reported in AOCI and is later reclassified into the consolidated statement of income in the same period during which the hedged transaction affects earnings.  The ineffective portion of such hedge is immediately reported in the current period’s consolidated statement of income.  These derivative instruments are carried at fair value on the Company’s consolidated balance sheet in accordance with ASC Topic 815.  Cash posted to meet margin calls, if any, is included on the consolidated balance sheet in other assets.
 
In the event a hedging instrument is terminated, any basis adjustments or changes in the fair value of hedges recorded in AOCI are recognized into income or expense in conjunction with the original hedge or hedged exposure.
 
If the underlying asset, liability or commitment is sold or matures, the hedge is deemed partially or wholly ineffective, or if the criterion that was established at the time the hedging instrument was entered into no longer exists, the interest rate agreement no longer qualifies as a designated hedge.  Under these circumstances, such changes in the market value of the interest rate agreement are recognized in the current period’s statement of income.

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

Interest income is accrued based on the outstanding principal balance (or notional balance in the case of interest-only, or "IO", securities) on the Company's investment securities and their contractual terms. Premiums and discounts on Agency and non-Agency MBS and on loans are recognized over the expected life of the investment using the effective yield method in accordance with ASC Topic 310-20. Adjustments to premium amortization are made for actual prepayment activity as well as changes in

8



projected future cash flows. Interest income on non-Agency MBS that are rated lower than “AA” are recognized over the expected life as adjusted for the estimated prepayments and credit losses of the securities in accordance with ASC Topic 310-30.  Actual prepayment and credit loss experience is reviewed and effective yields are adjusted when projected prepayments and credit losses differ from the amounts actually received as well as for changes in anticipated future prepayments.

The Company's projections of future cash flows are based on input and analysis received from external sources and internal models, and includes assumptions about the amount and timing of credit losses, loan prepayment rates, fluctuations in interest rates, and other factors. On at least a quarterly basis, the Company reviews and makes any necessary adjustments to its cash flow projections and updates the yield recognized on these assets.

For securities, the accrual of interest is discontinued when, in the opinion of management, it is probable that all amounts contractually due will not be collected, and in certain instances, as a result of the other-than-temporary impairment analysis. For loans, the accrual of interest is discontinued when, in the opinion of management, the interest is not collectible in the normal course of business, when the loan is significantly past due or when the primary servicer of the loan fails to advance the interest and/or principal due on the loan.  Loans are considered past due when the borrower fails to make a timely payment in accordance with the underlying loan agreement.  All interest accrued but not collected for investments that are placed on a non-accrual status or are charged-off is reversed against interest income.  Interest on these investments is accounted for on the cash-basis or cost-recovery method until qualifying for return to accrual status.  Investments are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Stock-Based Compensation

Pursuant to the Company’s 2009 Stock and Incentive Plan ("SIP"), the Company may grant stock-based compensation to eligible employees, directors or consultants or advisers to the Company, including stock awards, stock options, stock appreciation rights (“SARs”), dividend equivalent rights, performance shares, and restricted stock units.  Currently, the Company's stock options and restricted stock issued under this plan may be settled only in shares of its common stock, and therefore are treated as equity awards with their fair value measured at the grant date as required by ASC Topic 718. Outstanding SARs issued by the Company may be settled only in cash, and therefore have been treated as liability awards with their fair value estimated at the grant date and remeasured at the end of each reporting period using the Black-Scholes option valuation model as required by ASC Topic 718.  Please see Note 11 for additional disclosures regarding the Company's SIP plan.
 
Contingencies
 
In the normal course of business, there are various lawsuits, claims, and other contingencies pending against the Company.  We evaluate whether to establish provisions for estimated losses from those matters in accordance with ASC Topic 450, which states that a liability is recognized for a contingent loss when: (a) the underlying causal event has occurred prior to the balance sheet date; (b) it is probable that a loss has been incurred; and (c) there is a reasonable basis for estimating that loss. A liability is not recognized for a contingent loss when it is only possible or remote that a loss has been incurred, however, possible contingent losses shall be disclosed. Please refer to Note 12 for details on the most significant matters currently pending.

Recent Accounting Pronouncements

There are no recently issued accounting pronouncements that are expected to materially impact the Company's financial condition or results of operations which are not effective as of the date of this Quarterly Report on Form 10-Q for the three months ended March 31, 2012.



NOTE 2 – NET INCOME PER COMMON SHARE
 
Net income per common share is presented on both a basic and diluted basis.  Diluted net income per common share assumes the exercise of stock options using the treasury stock method. The following table presents the calculation of the numerator and denominator for both basic and diluted net income per common share:

9



 
Three Months Ended
 
March 31,
 
2012
 
2011
 
 
Income
 
Weighted-Average Common Shares
 
 
Income
 
Weighted-
Average
Common
Shares
Net income
$
16,476

 
49,480,426

 
$
10,280

 
33,152,682

Effect of dilutive stock options

 
469

 

 
4,773

Diluted
$
16,476

 
49,480,895

 
$
10,280

 
33,157,455

Net income per common share:
 
 
 
 
 
 
 
Basic
 

 
$
0.33

 
 

 
$
0.31

Diluted (1)
 

 
$
0.33

 
 

 
$
0.31

(1)
For the three months ended March 31, 2012, the calculation of diluted net income per common share excludes the effect of 15,000 unexercised stock option awards because their inclusion would have been anti-dilutive.




NOTE 3 – AGENCY MBS
 
The following table presents the components of the Company’s investment in Agency MBS as of March 31, 2012 and December 31, 2011:
 
March 31, 2012
 
RMBS
 
CMBS
 
CMBS IO
 
Total
Principal/par value
$
1,964,359

 
$
283,574

 
$

 
$
2,247,933

Unamortized premium
109,472

 
22,546

 
251,479

 
383,497

Unamortized discount
(15
)
 

 

 
(15
)
Amortized cost
2,073,816

 
306,120

 
251,479

 
2,631,415

Available for sale (recognized in statement of comprehensive income):
 
 
 
 
 
 
 
Gross unrealized gains
14,692

 
11,952

 
4,959

 
31,603

Gross unrealized losses
(7,082
)
 
(16
)
 
(1,504
)
 
(8,602
)
Trading (recognized in income statement):
 
 
 
 
 
 
 
Gross unrealized gains

 
1,747

 

 
1,747

Total Agency MBS fair value:
$
2,081,426

 
$
319,803

 
$
254,934

 
$
2,656,163

Weighted average coupon
4.10
%
 
5.19
%
 
n/a
 
5.12
%

10



 
December 31, 2011
 
RMBS
 
CMBS
 
CMBS IO
 
Total
Principal/par value
$
1,488,397

 
$
266,952

 
$

 
$
1,755,349

Unamortized premium
85,488

 
21,627

 
86,358

 
193,473

Unamortized discount
(17
)
 

 

 
(17
)
Amortized cost
1,573,868

 
288,579

 
86,358

 
1,948,805

Available for sale (recognized in statement of comprehensive income):
 
 
 
 
 
 
 
Gross unrealized gains
10,787

 
11,746

 
350

 
22,883

Gross unrealized losses
(7,405
)
 

 
(1,043
)
 
(8,448
)
Trading (recognized in income statement):
 
 
 
 
 
 
 
Gross unrealized gains

 
1,919

 

 
1,919

Total Agency MBS fair value:
$
1,577,250

 
$
302,244

 
$
85,665

 
$
1,965,159

Weighted average coupon
4.54
%
 
5.20
%
 
n/a
 
4.64
%

The Company purchased $608,250 of Agency RMBS and $19,502 of Agency CMBS, consisting principally of CMBS IOs, since December 31, 2011. Agency CMBS IOs are secured by excess interest payments on pools of multifamily housing mortgage loans. As these securities have no principal associated with them, the interest payments received are based on the unpaid principal balance (often referred to as the notional amount) of the underlying pool of mortgage loans. The IO securities have prepayment protection in the form of lock-outs and/or yield maintenance associated with the underlying loans. The combined notional balance for the Agency CMBS IO securities is $3,924,736 and $1,813,096 as of March 31, 2012, and December 31, 2011, respectively.
    
As of March 31, 2012 and December 31, 2011, the amortized cost of Agency CMBS designated as trading was $27,976 and $28,119, respectively. The Company recognized a net unrealized (loss) gain for the three months ended March 31, 2012 and March 31, 2011 of $(136) and $119, respectively, related to changes in fair value, which is included within “fair value adjustments, net” in its consolidated statements of income. The Company also has derivatives designated as trading instruments, and the changes in their fair value are also included within "fair value adjustments, net". Please refer to Note 7 for additional information on these derivatives designated as trading instruments.


NOTE 4 – NON-AGENCY MBS
 
The following table presents the components of the Company’s non-Agency MBS as of March 31, 2012 and December 31, 2011:
 
March 31, 2012
 
RMBS
 
CMBS
 
CMBS IO
 
Total
Principal/par value
$
15,401

 
$
375,733

 
$

 
$
391,134

Unamortized premium

 
3,208

 
65,779

 
68,987

Unamortized discount
(897
)
 
(18,358
)
 

 
(19,255
)
Amortized cost
14,504

 
360,583

 
65,779

 
440,866

Gross unrealized gains
464

 
22,948

 
2,811

 
26,223

Gross unrealized losses
(772
)
 
(569
)
 
(37
)
 
(1,378
)
Fair value
$
14,196

 
$
382,962

 
$
68,553

 
$
465,711

Weighted average coupon
4.56
%
 
5.74
%
 
n/a
 
5.69
%


11



 
December 31, 2011
 
RMBS
 
CMBS
 
CMBS IO
 
Total
Principal/par value
$
17,119

 
$
359,853

 
$

 
$
376,972

Unamortized premium

 
3,646

 
51,239

 
54,885

Unamortized discount
(1,003
)
 
(17,511
)
 

 
(18,514
)
Amortized cost
16,116

 
345,988

 
51,239

 
413,343

Gross unrealized gains
507

 
11,806

 
893

 
13,206

Gross unrealized losses
(1,353
)
 
(3,724
)
 
(376
)
 
(5,453
)
Fair value
$
15,270

 
$
354,070

 
$
51,756

 
$
421,096

Weighted average coupon
4.41
%
 
5.91
%
 
n/a
 
5.85
%

All of the Company’s non-Agency MBS are designated as available-for-sale and are comprised primarily of investment-grade rated securities.  The Company purchased $22,061 of non-Agency CMBS since December 31, 2011, and $16,000 of that amount represents premiums paid for non-Agency CMBS IO securities. The combined notional balance for the non-Agency CMBS IO securities is $1,014,438 and $906,202 as of March 31, 2012, and December 31, 2011, respectively.


NOTE 5 – SECURITIZED MORTGAGE LOANS, NET
 
The Company's securitized mortgage loans are pledged as collateral for its associated securitization financing bonds, which are discussed further in Note 9. Please also refer to Note 6 for disclosures related to impaired securitized mortgage loans and the related allowance for loans losses. The following table summarizes the components of securitized mortgage loans as of March 31, 2012 and December 31, 2011:

 
March 31, 2012
 
December 31, 2011
 
Commercial
 
Single-family
 
Total
 
Commercial
 
Single-family
 
Total
Principal/par value (1)
$
55,988

 
$
45,727

 
$
101,715

 
$
68,029

 
$
47,657

 
$
115,686

Unamortized premium, net

 
694

 
694

 

 
770

 
770

Unamortized discount, net
(162
)
 

 
(162
)
 
(254
)
 

 
(254
)
Amortized cost
55,826

 
46,421

 
102,247

 
67,775

 
48,427

 
116,202

Allowance for loan losses
(1,341
)
 
(231
)
 
(1,572
)
 
(2,268
)
 
(231
)
 
(2,499
)
 
$
54,485

 
$
46,190

 
$
100,675

 
$
65,507

 
$
48,196

 
$
113,703

 (1)
Includes funds held by trustees.

The balance of the Company's securitized commercial mortgage loans has decreased since December 31, 2011 primarily due to principal payments, including amounts received on defeased loans, of $11,815.  The Company's securitized commercial mortgage loans were originated principally in 1996 and 1997 and are collateralized by first deeds of trust on income producing properties.  Approximately 77% of these securitized commercial mortgage loans are secured by multifamily properties. As of March 31, 2012 and December 31, 2011, the loan-to-value ratio based on original appraisal was 42% and 42%, respectively. The unpaid principal balance of the securitized commercial mortgage loans identified as seriously delinquent (60 or more days past due) and therefore on nonaccrual status is $12,007 as of March 31, 2012 compared to $14,997 as of December 31, 2011.

The balance of the Company's securitized single-family mortgage loans have decreased since December 31, 2011 due to principal payments on the loans of $1,930. These single-family mortgage loans are secured by first deeds of trust on residential real estate and were originated principally from 1992 to 1997.   As of March 31, 2012 and December 31, 2011, the current loan-to-value ratio based on original appraisal was approximately 44.8% and 46%, respectively. The unpaid principal balance of the Company's securitized single-family mortgage loans identified as seriously delinquent as of March 31, 2012 is $3,153 compared

12



to $3,366 as of December 31, 2011. The Company continues accruing interest on any seriously delinquent securitized single-family mortgage loan so long as the primary servicer continues to advance the interest and/or principal due on the loan.


NOTE 6 – ALLOWANCE FOR LOAN LOSSES
 
As discussed in Note 1, the Company estimates for currently existing and probable losses for its mortgage loans that are considered impaired. A loan can be considered impaired even if it is not delinquent. The following table summarizes the aggregate activity for the portion of the allowance for loan losses that relates to the securitized mortgage loan portfolio for the periods indicated:
 
Three Months Ended
 
March 31,
 
2012
 
2011
 
Commercial
 
Single-family
 
Commercial
 
Single-family
Allowance at beginning of period
2,268

 
231

 
4,200

 
270

Provision for loan losses
60

 

 
250

 

Credit losses, net of recoveries
(987
)
 

 
(213
)
 
(21
)
Allowance at end of period
$
1,341

 
$
231

 
$
4,237

 
$
249

 

The following table presents certain information on impaired securitized commercial and single-family mortgage loans as of March 31, 2012 and December 31, 2011:
 
March 31, 2012
 
December 31, 2011
 
Commercial
 
Single-family
 
Commercial
 
Single-family
Unpaid principal balance of impaired securitized loans
$
1,814

 
$
3,029

 
$
4,724

 
$
3,000

Basis adjustments related to impaired securitized loans

 
59

 
8

 
48

Amortized cost basis of impaired securitized loans
1,814

 
3,088

 
4,732

 
3,048

Allowance for loan losses
(1,341
)
 
(231
)
 
(2,268
)
 
(231
)
Investment in excess of allowance
$
473

 
$
2,857

 
$
2,464

 
$
2,817


The Company recognized $25 and $40 of interest income on impaired securitized commercial mortgage loans and single-family mortgage loans, respectively, for the three months ended March 31, 2012 compared to $86 and $42, respectively, of interest income for the three months ended March 31, 2011.  


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

As of March 31, 2012 and December 31, 2011, the Company’s derivative financial instruments are comprised entirely of interest rate swaps, and are designated as either hedging instruments or trading instruments.  The tables below summarize information about the Company’s derivative financial instruments on the balance sheet as of the dates indicated:  

13



 
 
March 31, 2012
 
December 31, 2011
Accounting Designation:
Balance Sheet Location:
Fair Value
 
Cumulative Notional Amount
 
Weighted-average
Fixed Rate Swapped
 
Fair Value
 
Cumulative Notional Amount
 
Weighted-average
Fixed Rate Swapped
Hedging instruments
Derivative assets
$
89

 
$
25,000

 
1.57
%
 
$

 
$

 
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Hedging instruments
 
$
(25,485
)
 
$
1,065,000

 
1.62
%
 
$
(25,512
)
 
$
1,065,000

 
1.55
%
Trading instruments
 
(2,183
)
 
27,000

 
2.88
%
 
(2,485
)
 
27,000

 
2.88
%
 
Derivative liabilities
$
(27,668
)
 
 
 
 
 
$
(27,997
)
 
 
 
 

The following table summarizes the contractual maturities remaining for the Company’s outstanding interest rate swap agreements as of March 31, 2012:
Remaining
Maturity
Notional Amount:
Trading
 
 
Notional Amount:
Hedging
 
 
Notional Amount:
Total
 
 
Number of Swaps
 
Weighted-Average
Fixed Rate Swapped
0-12 months
$

 
$
75,000

 
$
75,000

 
2

 
1.30
%
13-36 months

 
565,000

 
565,000

 
10

 
1.44
%
37-60 months
27,000

 
260,000

 
287,000

 
11

 
2.04
%
Over 60 months

 
190,000

 
190,000

 
5

 
1.81
%
 
$
27,000

 
$
1,090,000

 
$
1,117,000

 
28

 
1.65
%

With respect to hedging instruments, the Company’s objective for using interest rate swaps is to minimize its exposure to the risk of increased interest expense resulting from its existing and forecasted short-term, fixed-rate borrowings.  The Company continuously borrows funds via sequential fixed-rate, short-term repurchase agreement borrowings.  As each fixed-rate repurchase agreement matures, it is replaced with new fixed-rate agreements based on the market interest rate in effect at the time of such replacement.  This sequential rollover borrowing program creates a variable interest expense pattern.  The changes in the cash flows of the interest rate swaps are expected to be highly effective at offsetting changes in the interest portion of the cash flows expected to be paid at maturity of each borrowing.

The table below presents the effect of the derivatives designated as hedging instruments on the Company’s consolidated statement of comprehensive income for the periods indicated:
Type of Derivative Designated as Cash Flow Hedge
Amount of Gain (Loss) Recognized in OCI (Effective Portion)
Location of Amount Reclassified from OCI into Net Income (Effective Portion)
Amount Reclassified from OCI into Net Income (Effective Portion)
Location of
Loss
Recognized in
Net Income
(Ineffective Portion)
Amount of Loss Recognized in Net Income (Ineffective Portion)
For the three months ended March 31, 2012:
 
Interest rate swaps
$(3,087)
Interest expense
$3,266
Other income, net
$(62)
For the three months ended March 31, 2011:
 
 
 
Interest rate swaps
$1,088
Interest expense
$1,869
Other income, net
$(1)

The table below presents a rollforward of the activity in the Company’s AOCI related to its derivatives designated as hedging instruments for the periods presented:

14



 
2012
 
2011
Balance as of January 1,
$
(25,444
)
 
$
(2,820
)
Change in fair value of interest rate swaps
(3,087
)
 
1,088

Reclassification adjustment for amounts included in statement of income
3,266

 
1,869

Balance as of March 31,
$
(25,265
)
 
$
137


The Company estimates that $12,625 of the existing losses that are reported in AOCI as of March 31, 2012 is expected to be reclassified into earnings as an increase to interest expense within the next 12 months.

The Company’s objective for designating certain interest rate swaps as trading instruments is to offset the changes in market value for a portion of its Agency CMBS investments that are also designated as trading. The table below presents the effect of the derivatives designated as trading instruments on the Company’s consolidated statements of income for the periods indicated.
Type of Derivative Designated as Trading
Location On Income Statement
Amount of Loss Recognized in Net Income
For the Three Months Ended
 
 
March 31, 2012
 
March 31, 2011
Interest rate swaps
Fair value adjustments, net
$
74

 
$
333


These interest rate swap agreements contain various covenants related to the Company’s credit risk.  Specifically, if the Company defaults on any of its indebtedness, including those circumstances whereby repayment of the indebtedness has not been accelerated by the lender, or is declared in default of any of its covenants with any counterparty, then the Company could also be declared in default of its derivative obligations. Additionally, the agreements outstanding with its derivative counterparties allow those counterparties to require settlement of its outstanding derivative transactions if the Company fails to earn GAAP net income greater than one dollar as measured on a rolling two quarter basis.  These interest rate agreements also contain provisions whereby, if the Company fails to maintain a minimum net amount of shareholders’ equity, then the Company may be declared in default on its derivative obligations.  As of March 31, 2012, the Company had derivatives in a net liability position with its derivative counterparties totaling $28,173, inclusive of accrued interest but excluding any adjustment for nonperformance risk, for which it had pledged Agency MBS with a fair value of $30,976 and cash of $38 as collateral.  If the Company had breached any of these agreements as of March 31, 2012, it could have been required to settle those derivatives at their estimated termination value of $28,173.
 
NOTE 8 – REPURCHASE AGREEMENTS
 
The Company uses repurchase agreements, which are recourse to the Company, to finance certain of its investments.  As of March 31, 2012, the Company had repurchase agreement borrowings outstanding with a weighted average rate of 0.59% with 20 of its 26 available repurchase agreement counterparties compared to a weighted average borrowing rate of 0.61% with 20 counterparties as of December 31, 2011. The equity at risk with each counterparty did not exceed 10% of shareholders' equity as of March 31, 2012.

The following tables present the components of the Company’s repurchase agreements as of March 31, 2012 and December 31, 2011 by the type of securities collateralizing the repurchase agreement:

15



 
March 31, 2012
Collateral Type
Balance
 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
Agency RMBS
$
1,820,249

 
0.35
%
 
$
1,893,751

Agency CMBS
436,889

 
0.74
%
 
527,338

Non-Agency RMBS
10,761

 
1.84
%
 
12,603

Non-Agency CMBS
346,698

 
1.48
%
 
379,914

FHLMC unsecured note (1)
22,855

 
0.34
%
 
23,925

Securitization financing bonds (see Note 9)
48,746

 
1.68
%
 
57,545

 
$
2,686,198

 
0.59
%
 
$
2,895,076

(1)    See "Other Investments" in Note 1.
 
December 31, 2011
Collateral Type
Balance
 
Weighted
Average Rate
 
Fair Value of Collateral Pledged
Agency RMBS
$
1,447,508

 
0.38
%
 
$
1,521,107

Agency CMBS
290,362

 
0.59
%
 
329,612

Non-Agency RMBS
12,195

 
1.85
%
 
13,597

Non-Agency CMBS
283,266

 
1.54
%
 
336,124

Securitization financing bonds (see Note 9)
60,462

 
1.65
%
 
67,872

 
$
2,093,793

 
0.61
%
 
$
2,268,312


The combined weighted average term to original maturity for the Company’s repurchase agreements was 48 days as of March 31, 2012 and 57 days as of December 31, 2011.  The following table provides a summary of the original maturity as of March 31, 2012 and December 31, 2011:

Original Maturity
March 31,
2012
 
December 31,
2011
30 days or less
$
367,580

 
$
180,387

31 to 60 days
1,672,180

 
880,491

61 to 90 days
373,636

 
496,509

Greater than 90 days
272,802

 
536,406

 
$
2,686,198

 
$
2,093,793


Some of our repurchase agreement counterparties, as set forth in the master repurchase agreement with the counterparty, require us to comply with various customary operating and financial covenants, including, but not limited to, minimum net worth, maximum declines in net worth in a given period, and maximum leverage requirements as well as maintaining our REIT status.  In addition, some of the agreements contain cross default features, whereby default under an agreement with one lender simultaneously causes default under agreements with other lenders.  To the extent that we fail to comply with the covenants contained in our financing agreements or are otherwise found to be in default under the terms of such agreements, the counterparty has the right to accelerate amounts due under the master repurchase agreement. The Company was in compliance with all covenants as of March 31, 2012.

16




NOTE 9 – NON-RECOURSE COLLATERIZED FINANCING
 
The following table summarizes information about the Company’s non-recourse collateralized financing for the periods indicated:
 
 
March 31, 2012
 
 
Interest Rate
 
Weighted Average
Life Remaining
(in years)
 
Balance Outstanding
 
Value of
Collateral
Securitization financing:
 
 
 
 
 
 
 
Secured by non-Agency CMBS
6.2% fixed
 
1.7
 
$
15,000

 
$
16,242

Secured by single-family mortgage loans
1-month LIBOR
plus 0.30%
 
3.2
 
17,819

 
18,758

Unamortized net bond premium and deferred costs
 
 
 
 
(582
)
 
n/a

 
 
 
 
 
$
32,237

 
$
35,000


 
December 31, 2011
 
 
Interest Rate
 
Weighted Average
Life Remaining
(in years)
 
Balance Outstanding
 
Value of
Collateral
Securitization financing:
 
 
 
 
 
 
 
Secured by non-Agency CMBS
6.2% fixed
 
2.1
 
$
15,000

 
$
16,388

Secured by single-family mortgage loans
1-month LIBOR
plus 0.30%
 
3.2
 
18,928

 
19,843

TALF financing:(1)
 
 
 
 
 

 
 

Secured by non-Agency CMBS
2.7% fixed
 
1.2
 
37,672

 
49,087

Unamortized net bond premium and deferred costs
 
 
 
 
(705
)
 
n/a

 
 
 
 
 
$
70,895

 
$
85,318

(1)
Financing provided by the Federal Reserve Bank of New York under its Term Asset-Backed Securities Loan Facility (“TALF”). The balance as of December 31, 2011 was paid off during the first quarter of 2012.

The Company has redeemed securitization financing bonds that it has issued in the past, and in certain instances, the Company has kept the bond outstanding and used it as collateral for additional repurchase agreement borrowings (as shown in Note 8). These additional borrowings may have been used to either finance the bond redemption or to purchase additional investments.  Although these bonds are legally outstanding, the balances are eliminated in consolidation because the issuing trust is included in the Company’s consolidated financial statements. The following table summarizes information regarding all of the Company’s redeemed bonds that have an outstanding balance as of March 31, 2012
 
Collateral Type
Par Value
Outstanding
 
Fair Value
 
Repurchase
 Agreement Balance
Single-family mortgage loans
$
20,657

 
$
18,639

 
$
16,632

Commercial mortgage loans
38,651

 
38,906

 
32,114

 
$
59,308

 
$
57,545

 
$
48,746




17



NOTE 10 – FAIR VALUE OF FINANCIAL INSTRUMENTS
 
ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 clarifies that fair value should be based on the assumptions market participants would use when pricing as asset or liability and also requires an entity to consider all aspects of nonperformance risk, including the entity's own credit standing, when measuring fair value of a liability. ASC Topic 820 established a valuation hierarchy of three levels as follows:
 
Level 1 – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities as of the measurement date.
Level 2 – Inputs include quoted prices in active markets for similar assets or liabilities; quoted prices in inactive markets for identical or similar assets or liabilities; or inputs are either directly observable or indirectly observable through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.  The Company’s fair valued assets and liabilities that are generally included in this category are Agency MBS, certain non-Agency MBS, and derivatives.
Level 3 – Unobservable inputs are supported by little or no market activity. The unobservable inputs represent management’s best estimate of how market participants would price the asset or liability at the measurement date.  Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.  The Company’s fair valued assets and liabilities that are generally included in this category are certain non-Agency MBS.
The following table presents the fair value of the Company’s assets and liabilities measured at fair value on a recurring basis as of March 31, 2012, segregated by the hierarchy level of the fair value estimate:
 
 
 
 
Fair Value Measurements
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Agency MBS
$
2,656,163

 
$

 
$
2,656,163

 
$

Non-Agency MBS:
 

 
 

 
 

 
 

CMBS (including CMBS IO)
451,515

 

 
335,685

 
115,830

RMBS
14,196

 

 
5,569

 
8,627

Derivative assets
89

 

 
89

 

Other investments
25

 

 

 
25

Total assets carried at fair value
$
3,121,988

 
$

 
$
2,997,506

 
$
124,482

Liabilities:
 

 
 

 
 

 
 

Derivative liabilities
$
27,668

 
$

 
$
27,668

 
$

Total liabilities carried at fair value
$
27,668

 
$

 
$
27,668

 
$


The Company’s Agency MBS, as well a portion of its non-Agency CMBS, are substantially similar to securities that either are currently actively traded or have been recently traded in their respective market.  Their fair values are derived from an average of multiple dealer quotes and thus are considered Level 2 fair value measurements.
 
The Company’s remaining non-Agency CMBS and non-Agency RMBS are comprised of securities for which there are not substantially similar securities that trade frequently.  As such, the Company determines the fair value of those securities by discounting the estimated future cash flows derived from pricing models using assumptions that are confirmed to the extent possible by third party dealers or other pricing indicators.  Significant inputs into those pricing models are Level 3 in nature due to the lack of readily available market quotes.  Information utilized in those pricing models include the security’s credit rating, coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected credit losses, and credit enhancement as well as certain other relevant information.  Significant increases (decreases) in any of

18



these inputs in isolation would result in a significantly lower (higher) fair value measurement. A change in the assumption used for the probability of default may be accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.

The table below presents information about the significant unobservable inputs used in the fair value measurement for the Company's non-Agency RMBS and CMBS:
 
Quantitative Information about Level 3 Fair Value Measurements(1)
 
Prepayment Speed
 
Default Rate
 
Severity
 
Discount Rate
Non-Agency CMBS
19 CPY
 
2.4
%
 
33.5
%
 
4.6
%
Non-Agency RMBS
5 CPR
 
0.5
%
 
9.8
%
 
5.8
%
(1)
Data presented are weighted averages.

The following tables present the activity of the instruments fair valued at Level 3 for the three months ended March 31, 2012
 
Level 3 Fair Values
 
Non-Agency CMBS
 
Non-Agency RMBS
 
Other
 
Total assets
Balance as of December 31, 2011
$
123,703

 
$
10,296

 
$
25

 
$
134,024

Total unrealized losses:
 

 
 

 
 

 
 

Included in other comprehensive income
(537
)
 
30

 

 
(507
)
Principal payments
(7,211
)
 
(1,707
)
 

 
(8,918
)
Amortization
(125
)
 
8

 

 
(117
)
Balance as of March 31, 2012
$
115,830

 
$
8,627

 
$
25

 
$
124,482


The following table presents the recorded basis and estimated fair values of the Company’s financial instruments as of March 31, 2012 and December 31, 2011:
 
 
March 31, 2012
 
December 31, 2011
 
Recorded Basis
 
Fair Value
 
Recorded Basis
 
Fair Value
Assets:
 
 
 
 
 
 
 
Agency MBS
$
2,656,163

 
$
2,656,163

 
$
1,965,159

 
$
1,965,159

Non-Agency CMBS
451,515

 
451,515

 
405,826

 
405,826

Non-Agency RMBS
14,196

 
14,196

 
15,270

 
15,270

Securitized mortgage loans, net
100,675

 
90,439

 
113,703

 
101,116

Other investments
53,621

 
53,560

 
1,018

 
892

Derivative assets
89

 
89

 

 

Liabilities:
 

 
 

 
 

 
 

Repurchase agreements
$
2,686,198

 
$
2,686,198

 
$
2,093,793

 
$
2,093,793

Non-recourse collateralized financing
32,237

 
31,107

 
70,895

 
69,752

Derivative liabilities
27,668

 
27,668

 
27,997

 
27,997


There were no assets or liabilities which were measured at fair value on a non-recurring basis as of March 31, 2012 or December 31, 2011.
 
The Company held investments in 318 Agency MBS and 52 non-Agency MBS as of March 31, 2012 compared to 266

19



Agency MBS and 44 non-Agency MBS as of December 31, 2011. The following table presents certain information for those Agency MBS and non-Agency MBS that were in an unrealized loss position as of March 31, 2012 and December 31, 2011:
 
March 31, 2012
 
December 31, 2011
 ($ in thousands)
Fair Value
 
Unrealized Loss
 
# of Securities
 
Fair Value
 
Unrealized Loss
 
# of Securities
Unrealized loss position for:
 
 
 
 
 
 
 
 
 
 
 
Less than one year:
 
 
 
 
 
 
 
 
 
 
 
Agency MBS
$
689,284

 
$
(4,961
)
 
60
 
$
680,101

 
$
(6,765
)
 
54
Non-Agency MBS
24,438

 
(1,029
)
 
18
 
153,974

 
(5,075
)
 
6
One year or more:
 

 
 

 
 
 
 

 
 

 
 
Agency MBS
284,738

 
(3,642
)
 
15
 
160,544

 
(1,684
)
 
27
Non-Agency MBS
2,957

 
(350
)
 
7
 
2,993

 
(379
)
 
7
 
$
1,001,417

 
$
(9,982
)
 
100
 
$
997,612

 
$
(13,903
)
 
94

Because the principal and interest related to Agency MBS are guaranteed by the government-sponsored entities Fannie Mae and Freddie Mac who have the implicit guarantee of the U.S. government, the Company does not consider any of the unrealized losses on its Agency MBS to be credit related. Although the unrealized losses are not credit related, the Company has assessed its ability to hold any Agency MBS with an unrealized loss until the recovery in its value. This assessment is based on the amount of the unrealized loss and significance of the related investment as well as the Company’s current leverage and anticipated liquidity.  Based on this analysis, the Company has determined that the unrealized losses on its Agency MBS as of March 31, 2012 are temporary.

The Company reviews any non-Agency MBS in an unrealized loss position to evaluate whether any decline in fair value represents an other-than-temporary impairment. The evaluation includes a review of the credit ratings of these MBS and the seasoning of the mortgage loans collateralizing these securities as well as the estimated future cash flows which include projected losses. The Company performed this evaluation for the non-Agency MBS in an unrealized loss position as of March 31, 2012 and has determined that there have not been any adverse changes in the timing or amount of estimated future cash flows that necessitate a recognition of other-than-temporary impairment amounts as of March 31, 2012.

NOTE 11 – SHAREHOLDERS' EQUITY
 
Common Stock

The following table presents a summary of the changes in the number of common shares outstanding for the periods indicated:
 
Three Months Ended
 
March 31,
 
2012
 
2011
Balance at beginning of period
40,382,530

 
30,342,897

Common stock issued under ATM program
402,494

 
409,237

Common stock issued under DRIP
3,932

 

Common stock issued via public offering
13,332,748

 
9,200,000

Common stock issued under 2009 Stock and Incentive Plan
216,663

 
356,025

Balance at end of period
54,338,367

 
40,308,159


The Company has a continuous equity placement program (also known as an "at the market" program, or "ATM") whereby the Company may offer and sell through its sales agent, JMP Securities LLC, up to 8,000,000 shares of its common stock.  During the three months ended March 31, 2012, the Company received proceeds of $3,721, net of $56.7 in broker sales commission, for

20



402,494 shares of common stock sold under this program at an average price of $9.39.  

The Company has a Dividend Reinvestment and Share Purchase Plan ("DRIP") which allows registered shareholders to automatically reinvest some or all of their quarterly dividends in shares of the Company’s stock and provides an opportunity for investors to purchase shares of the Company’s stock, potentially at a discount to the prevailing market price. The Company declared a first quarter common stock dividend of $0.28 per share payable on April 30, 2012 to shareholders of record as of April 5, 2012; however there is no Dividend Reinvestment Discount for first quarter dividends reinvested through the DRIP.

During the three months ended March 31, 2012, the Company closed a secondary offering of 13,332,748 shares of its common stock which includes 832,487 shares issued pursuant to an option to purchase additional shares that was exercised by the underwriters, at a public offering price of $9.12 per share for total net proceeds of approximately $119,992 after deduction of underwriters' compensation and estimated expenses.

Incentive Plans.     Pursuant to the Company’s 2009 Stock and Incentive Plan, the Company may grant stock-based compensation to eligible employees, directors or consultants or advisers to the Company, including stock awards, stock options, stock appreciation rights, dividend equivalent rights, performance shares, and restricted stock units.  Of the 2,500,000 shares of common stock authorized for issuance under this plan, 1,825,276 shares remain available for issuance as of March 31, 2012.  

The following table presents a rollforward of the restricted stock activity for the periods presented:
 
Three Months Ended
 
March 31,
 
2012
 
2011
Restricted stock at beginning of period
365,506

 
25,000

Restricted stock granted
200,821

 
303,000

Restricted stock vested
(109,293
)
 
(7,500
)
Restricted stock outstanding at end of period
457,034

 
320,500


 As of March 31, 2012, the fair value of the Company’s outstanding restricted stock remaining to be amortized into compensation expense is $4,154.
    
As of March 31, 2012, the Company has 59,375 SARs outstanding, all of which are vested and exercisable at a weighted average price of $6.87 .  The weighted average remaining contractual term on these outstanding SARs as of March 31, 2012 is 16 months, and 25,000 of the outstanding SARs are set to expire if they are not exercised on or before December 31, 2012.   No SARs were granted, forfeited, or exercised during the three months ended March 31, 2012 or March 31, 2011. As of March 31, 2012 and December 31, 2011, the fair value of the Company’s outstanding SARs of $159 and $77, respectively, are recorded as liabilities on its consolidated balance sheet for the respective periods.  

Total stock-based compensation expense recognized by the Company for the three months ended March 31, 2012 and March 31, 2011 was $453 and $95, respectively.

Additional Paid-In Capital

     The following table presents a rollforward of the Company's changes in additional paid-in capital for the three months ended March 31, 2012:

21



 
Additional Paid-In Capital
Balance as of January 1, 2012
$
634,683
 
Common stock issuances:
 
DRIP issuances
37
 
ATM issuances
3,674
 
Secondary offering
119,859
 
Incentive plans
147
 
Amortization of restricted stock
371
 
Capitalized expenses
(119
)
Balance as of March 31, 2012
$
758,652
 

Accumulated Other Comprehensive Income

Accumulated other comprehensive income as of March 31, 2012 and December 31, 2011 is comprised of the following items:
 
 
March 31, 2012
 
December 31, 2011
Available for sale investments:
 
 
 
Unrealized gains
$
58,170

 
$
36,091

Unrealized losses
(9,981
)
 
(13,902
)
 
48,189

 
22,189

Hedging instruments:
 

 
 

Unrealized gains
89

 

Unrealized losses
(25,354
)
 
(25,444
)
 
(25,265
)
 
(25,444
)
Accumulated other comprehensive (loss) income
$
22,924

 
$
(3,255
)

Due to the Company’s REIT status, the items comprising other comprehensive income do not have related tax effects.



NOTE 12 – COMMITMENTS AND CONTINGENCIES
 
The Company and its subsidiaries are parties to various legal proceedings, including those described below.  Although the ultimate outcome of these legal proceedings cannot be ascertained at this time, and the results of legal proceedings cannot be predicted with certainty, the Company believes, based on current knowledge, that the resolution of any of these proceedings, including those described below, will not have a material effect on the Company’s consolidated financial condition or liquidity.  However, the resolution of any of the proceedings described below could have a material impact on consolidated results of operations or cash flows in a given future reporting period as the proceedings are resolved.
 
One of the Company's subsidiaries, GLS Capital, Inc. (“GLS”), and the County of Allegheny, Pennsylvania are defendants in a class action lawsuit filed in 1997 in the Court of Common Pleas of Allegheny County, Pennsylvania (the “Court”).  Between 1995 and 1997, GLS purchased from Allegheny County delinquent property tax receivables for properties located in the County.  The plaintiffs in this matter have alleged that GLS improperly recovered or sought recovery for certain fees, costs, interest, and attorneys' fees and expenses in connection with GLS' collection of the property tax receivables.   The Court granted class action status in this matter in August 2007.  In February 2011, as a result of motions filed by GLS, the Court refined the class to

22



include only owners of real estate in the County of Allegheny who paid an attorneys' fee between 1996 and 2003 in connection with the forced collection of delinquent property tax receivables by GLS (generally through the initiation of a foreclosure action).  As a result, the Court dismissed certain claims against GLS and narrowed the issues being litigated to whether attorneys' fees and related expenses charged by GLS in connection with the collection of the receivables was reasonable.  Such attorneys' fees and related expenses were assessed by GLS in its collection efforts pursuant to prevailing County ordinance.  On April 23, 2012, as a result of a petition to discontinue filed by the plaintiff, the Court dismissed the remaining claims against GLS. The claims made by plaintiff that can be appealed include the legality of charging and recovering attorney fees and lien revival and filing costs from the class members. Plaintiffs have 30-days to file an appeal. Plaintiffs have not enumerated their damages in this matter.

Dynex Capital, Inc. and Dynex Commercial, Inc., a former affiliate of the Company and now known as DCI Commercial, Inc. ("DCI"), are appellees (or respondents) in the matter of Basic Capital Management, Inc. et al.  (collectively, “BCM” or the “Plaintiffs”) versus DCI et al. currently pending in the Fifth Court of Appeals in Dallas.  The matter was initially filled in the state court in Dallas County, Texas in April 1999 against DCI, and in March 2000, BCM amended the complaint and added the Company as a defendant. The appeal seeks to overturn a judgment rendered by the trial court in the favor of the Company and DCI. Specifically, Plaintiffs are seeking reversal of the trial court's judgment and rendition of judgment against the Company for alleged breach of loan agreements for tenant improvements in the amount of $250. They also seek reversal of the trial court's judgment and rendition of judgment against DCI in favor of BCM under two mutually exclusive damage models, for $2,200 and $25,600, respectively, related to the alleged breach by DCI of a $160,000 “master” loan commitment. Plaintiffs also seek reversal and rendition of a judgment in their favor for attorneys' fees in the amount of $2,100. Alternatively, Plaintiffs seek a new trial. Even if Plaintiffs were to be successful on appeal, management does not believe the Company would be obligated for any amounts awarded against DCI.

Dynex Capital, Inc., MERIT Securities Corporation, a subsidiary of Dynex ("MERIT"), and the former President/Chief Executive Officer and current Chief Operating Officer/Chief Financial Officer of Dynex Capital, Inc., (together, the "Defendants") are defendants in a class action brought by the Teamsters Local 445 Freight Division Pension Fund (the "Teamsters") in the United States District Court for the Southern District of New York (the "District Court").  The original complaint alleging violations of the federal securities laws was filed on February 7, 2005, and was purportedly brought on behalf of a class of purchasers between February 2000 and May 2004 of MERIT Series 12-1 and MERIT Series 13 securitization financing bonds (the "Bonds"), which are collateralized by manufactured housing loans.  After a series of court rulings, the case proceeded to discovery on the basis of a second amended complaint filed August 6, 2008. The amended complaint sought unspecified damages and alleged, among other things, fraud and misrepresentation in connection with the issuance of and subsequent reporting related to the Bonds.  On March 7, 2011, the District Court granted the Teamsters' motion to certify a class of purchasers of the Bonds from February 2000 through May 2004. In December 2011, the Defendants entered into a definitive settlement agreement with the Teamsters to settle all claims asserted in the action, as well as any claims that could have been asserted in the action, for $7,500. The Company funded an escrow account for this agreed amount for the benefit of the class in December 2011. During the first quarter of 2012, the District Court approved the settlement and the escrow account will be released to members of the class proportionate to their claims.

NOTE 13 – SUBSEQUENT EVENTS

Management has evaluated events and circumstances occurring as of and through the date this Quarterly Report on Form 10-Q was filed with the SEC and made available to the public and has determined that there have been no significant events or circumstances that qualify as recognized or nonrecognized “subsequent events” as defined by ASC Topic 855.




23



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

 
The following discussion and analysis is provided to increase understanding of, and should be read in conjunction with, our unaudited consolidated financial statements and accompanying notes included in this Quarterly Report on Form 10-Q and our audited Annual Report on Form 10-K for the year ended December 31, 2011.  References herein to “Dynex,” the “company,” “we,” “us,” and “our” include Dynex Capital, Inc. and its consolidated subsidiaries, unless the context otherwise requires. In addition to current and historical information, the following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our future business, financial condition or results of operations. For a description of certain factors that may have a significant impact on our future business, financial condition or results of operations, see “Forward-Looking Statements” at the end of this discussion and analysis.


EXECUTIVE OVERVIEW

Company Overview

We are an internally managed mortgage real estate investment trust, or mortgage REIT, which invests in mortgage assets on a leveraged basis.  Our objective is to provide attractive risk-adjusted returns to our shareholders over the long term that are reflective of a leveraged, high quality fixed income portfolio with a focus on capital preservation.  We seek to provide returns to our shareholders through regular quarterly dividends and through capital appreciation.

We were formed in 1987 and commenced operations in 1988.  Beginning with our inception through 2000, our operations largely consisted of originating and securitizing various types of loans, principally single-family and commercial mortgage loans and manufactured housing loans.  Since 2000, we have been an investor in Agency and non-Agency mortgage-backed securities (“MBS”). Agency MBS consist of residential MBS (“RMBS”) and commercial MBS (“CMBS”), which come with a guaranty of payment by the U.S. government or a U.S. government-sponsored entity such as Fannie Mae and Freddie Mac.  Non-Agency MBS (also consisting of RMBS and CMBS) have no such guaranty of payment. 

The Company’s Agency RMBS are comprised primarily of hybrid Agency adjustable-rate mortgage loans ("ARMs") and Agency ARMs.  Hybrid Agency ARMs are MBS collateralized by hybrid adjustable-rate mortgage loans which are loans that have a fixed rate of interest for a specified period (typically three to ten years) and which then adjust their interest rate at least annually to an increment over a specified interest rate index as further discussed below.  Agency ARMs are MBS collateralized by adjustable-rate mortgage loans which have interest rates that generally will adjust at least annually to an increment over a specified interest rate index.  Agency ARMs also include hybrid Agency ARMs that are past their fixed-rate periods or within twelve months of their initial reset period.

Interest rates on the adjustable-rate mortgage loans collateralizing hybrid Agency ARMs or Agency ARMs are based on specific index rates, such as the one-year constant maturity treasury rate, or CMT, the London Interbank Offered Rate, or LIBOR, the Federal Reserve U.S. 12-month cumulative average one-year CMT, or MTA, or the 11th District Cost of Funds Index, or COFI.  These loans will typically have interim and lifetime caps on interest rate adjustments, or interest rate caps, limiting the amount that the rates on these loans may reset in any given period.

The Company’s Agency and non-Agency CMBS are typically comprised of fixed-rate securities collateralized by first mortgage loans on multifamily properties that are usually either locked out of prepayment options or have yield maintenance provisions which provide the Company protection against prepayment of the investment. A portion of the Company's Agency and non-Agency CMBS also include interest only securities ("IOs") which represent the right to receive excess interest payments (but not principal cash flows) based on the underlying unpaid principal balance of the underlying pool of mortgage loans.

Our primary source of income is net interest income, which is the excess of the interest income earned on our investments over the cost of financing these investments.  Our investment strategy as approved by our Board of Directors is a diversified investment strategy that targets higher credit quality, shorter duration investments in Agency MBS and non-Agency MBS.  Investments considered to be of higher credit quality have less or limited exposure to loss of principal while investments which have shorter durations have less exposure to changes in interest rates. We currently target an overall investment portfolio

24



composition of 60%-80% in Agency MBS with the balance in non-Agency MBS and securitized mortgage loans. Our securitized mortgage loans are single-family and commercial mortgage loans which were originated or purchased by us during the 1990s. We are not actively originating, purchasing, or securitizing mortgage loans.

In executing our investment strategy, we seek to balance the various risks of owning mortgage assets, such as interest rate, credit, prepayment, and liquidity risk with the earnings opportunity on the investment.  We believe our strategy of investing in Agency and non-Agency mortgage assets provides superior diversification of these risks across our investment portfolio and therefore provides ample opportunities to generate attractive risk-adjusted returns while preserving our shareholders’ capital. We also believe that our shorter duration strategy will provide less volatility in our results and in our book value per common share than strategies which invest in longer duration assets with that may be more exposed to interest rate risk.

For further discussion of the Company, its operating policies and restrictions, its investment philosophy and strategy, and its financing and hedging strategy, see the Company's Annual Report on Form 10-K for the year ended December 31, 2011.

Factors that Affect Our Results of Operations and Financial Condition
 
The performance of our investment portfolio will depend on many factors, many of which are beyond our control, including interest rates, trends of interest rates, the steepness of interest rate curves, prepayment rates on our investments, competition for investments, economic conditions and their impact on the credit performance of our investments, and actions taken by the U.S. government, including the U.S. Federal Reserve and the United States Department of the Treasury (the "Treasury"). In addition, our business model may be impacted by other factors such as the state of the overall credit markets, which could impact the availability and costs of financing.  Reductions in the availability of financing for our investments could significantly impact our business and force us to sell assets that we otherwise would not sell, potentially at losses or at amounts below their true fair value.

Investing in mortgage-related securities on a leveraged basis subjects us to liquidity risk and interest rate risk which are discussed in further detail in Item 3, "Quantitative and Qualitative Disclosures About Market Risk" and in the "Liquidity and Capital Resources" section of this Item 2. With respect to interest rate risk, such risk arises from changes in the absolute level of rates (e.g., the level of LIBOR or Treasury securities rates), changes in relationships between rate indices (e.g., LIBOR versus Treasury securities rates), and changes in the relationships between short-term and long-term rates (e.g., the 2-year Treasury securities rate versus the 10-year Treasury securities rate).  Interest rate risk also arises from changes in market spreads reflecting the perceived riskiness of assets (e.g., swap rates and mortgage rates relative to the Treasury securities rates).  Because we leverage our capital, changes in interest rates can be disproportionately favorable or unfavorable on our results of operations and our book value. We attempt to manage our exposure to changes in interest rates by investing in shorter duration instruments and managing our investment portfolio within risk tolerances set by our Board of Directors.  Our current goal is to maintain a portfolio duration target (a measure of interest rate risk) within a range of 0.5 to 1.5 years.  Our portfolio duration could drift outside of our target range due to changes in market conditions, interest rates, market spreads, and activity in our investment portfolio.  We will use interest rate swaps to help manage our interest rate risk and, where practical, we will attempt to fund our assets with financings that have similar terms as the related investments.  

The interest rates on our assets will generally reset less frequently than the interest rates on our liabilities, particularly our repurchase agreement financing.  As such, during periods of rising interest rates, we may experience a reduction in our net interest income, notwithstanding our efforts to manage interest rate risk.  This reduction in net interest income will be larger when short-term interest rates are rising rapidly.  With the maturities of our assets generally of longer term than those of our liabilities, interest rate increases will also tend to decrease the market value of our assets. We seek to minimize the decrease in net interest income and the market value of our assets by using interest rate swaps or other hedging instruments such as interest rate swaptions or interest rate caps.

Many of our investments are purchased at premiums to their par balance.  Because we amortize premiums based on contractual payments as well as actual and expected future principal prepayments on the investments, changes in actual and expected prepayment rates will impact our yield on these investments.  Principal prepayments on our investments are influenced by changes in market interest rates and a variety of economic, geographic, and other factors beyond our control.  In addition, actions taken by the U.S. government could increase prepayments as discussed further below under “Trends and Recent Market Impacts”.  Increasing prepayments on premium assets will reduce their overall yield, negatively impacting our results.  We attempt to manage the risks of purchasing assets at a premium by purchasing assets with protection from prepayments (e.g., Agency CMBS) and by purchasing

25



assets which we believe will have less susceptibility to prepayments (e.g., hybrid Agency ARMs collateralized by interest-only loans).

Trends and Recent Market Impacts

The following marketplace conditions and prospective trends have impacted and may continue to impact our future results of operations and our financial condition. For additional information about risks that may be posed by these trends, please refer to "Risk Factors" contained within Item 3 of this Quarterly Report on Form 10-Q and Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011 as well as "Quantitative and Qualitative Disclosures about Market Risk" contained within Item 3 of this Quarterly report on Form 10-Q.

Credit Markets and Liquidity Risk

Our business model requires that we have access to leverage, principally the repurchase agreement market.  Repurchase agreement financing is uncommitted financing and as such, there can be no guarantee that we will always have access to this financing.  During periods of sustained volatility in the credit markets, such as was experienced in 2008, or other disruptions to the credit and financing markets, access to repurchase agreement financing may be limited as liquidity providers reduce their exposure to the short term funding credit markets.  In an attempt to manage this risk, we seek to diversify our exposure to repurchase agreement counterparties and seek to extend the maturity dates of our repurchase agreements where practicable.  We believe the diversification of counterparties reduces, but does not eliminate, our liquidity risk resulting from the exit or failure of one or more of our repurchase agreement counterparties.  For additional information regarding liquidity risk, please refer to “Quantitative and Qualitative Disclosures about Market Risk” within Part I, Item 3 of this Quarterly Report on Form 10-Q, as well Item 1A “Risk Factors” contained within the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

Short-term Interest Rates

In response to the volatility and lack of liquidity in the credit markets in 2008, the Federal Open Market Committee of the Federal Reserve ("FOMC") lowered the Federal Funds Target Rate (the rate at which U.S. banks may borrow from each other) from 4.25% at the beginning of 2008 to its current targeted rate of 0.25%.  While the credit markets are functioning more normally and liquidity has generally returned, economic activity in the U.S. has remained muted, as measured by gross domestic product, low rates of capacity utilization and high rates of unemployment.  As a result, the FOMC has pledged to keep the Federal Funds Target Rate at the historically low target range of 0% to 0.25% until late 2014 given the above concerns and the subdued outlook for inflation over the medium term. As economic activity improves, the Federal Reserve may decide to increase the Federal Funds Target Rate.  Such an increase would likely increase our funding costs because our repurchase agreement financing is based on LIBOR, which typically closely tracks the Federal Funds Target Rate.
 
Yield Curve and Credit Spreads
 
As of March 31, 2012, the spread between the two-year Treasury security and the ten-year Treasury security was 1.88% versus 1.64% as of December 31, 2011 and 2.65% as of March 31, 2011. During the first quarter of 2012, the yields on the ten-year Treasury increased 0.33% while the yield on the two-year Treasury increased by .09%, resulting in a steepening of the yield curve. Management believes the tightening of these spreads resulted from generally better economic data in the U.S. and from an improving outlook with respect to the Eurozone's economic and fiscal challenges. Management also believes that the increase in the value of our CMBS investments was due primarily to the tightening of the credit spreads (in excess of the increase in Treasury yields). While our borrowing costs are based on short-term market rates such as LIBOR and the Federal Funds Target Rate, our asset yields more closely correlate with longer-term Treasury rates and longer-term swap rates.  As discussed previously, we hedge our exposure to changes in interest rates on our repurchase agreements principally by entering into pay-fixed interest rate swaps. A steepening of the yield curve will generally result in a reduction in value of our MBS and an increase in value of our interest rate swaps, although not a one-to-one correlation. During the first quarter of 2012, our interest rate swaps were generally unchanged in value and our MBS investments, particularly our CMBS investments, increased in value by approximately $26 million.

Prepayments and Agency MBS

We have continued to experience favorable prepayment activity on our Agency RMBS due in large part to the inability

26



of borrowers to refinance their mortgages.  Our average constant prepayment rate, or CPR, for our Agency RMBS during the first quarter of 2012 was 21.4% versus 25.4% for the fourth quarter of 2011, 23.9% for the third quarter of 2011, 23.4% for the second quarter of 2011, and 21.9% for the first quarter of 2011.  As of March 31, 2012, the weighted average coupon on the mortgage loans underlying our Agency RMBS was 4.58%, while the average for the past twelve months of the 30-year fixed mortgage rate and the 5-year hybrid ARM mortgage rate, as published by Freddie Mac, were 4.23% and 3.10%, respectively.  Generally, this type of interest rate environment encourages the average borrower to refinance their mortgage loans at lower rates.  However, today in many cases, obstacles exist to refinancing, including but not limited to, the lack of borrower’s equity in the underlying real estate and the lack of an acceptable level of income.  These obstacles are currently contributing to the limited refinancing of loans in our Agency RMBS portfolio and are keeping prepayment speeds low relative to expectations and to historic prepayment rates in such a low interest rate environment. Notwithstanding, given the continued low level of interest rates, the changes to the Home Affordable Refinance Program, commonly known as HARP, and the commitment by the Federal Reserve to keep long-term interest rates low through Operation Twist, we continue to expect increased prepayment speeds during the balance of 2012. As discussed above, increased prepayments impact our net interest income by increasing the amortization expense on any investments we own at premiums to their par balance.

GSE Reform

On February 11, 2011, the Treasury released proposals to limit or potentially wind down the role that Fannie Mae and Freddie Mac play in the mortgage market. Similar proposals to limit or wind down the role of Fannie Mae and Freddie Mac were proposed during 2011 by a number of other parties. Any such proposals, if enacted, may have broad adverse implications for the MBS market and our business, results of operations, and financial condition. We expect such proposals to be the subject of significant discussion, and it is not yet possible to determine whether such proposals will be enacted.  We do not believe the ultimate reform of Fannie Mae and Freddie Mac will occur in 2012. However, it is possible that new types of Agency MBS could be proposed and sold by Fannie Mae and Freddie Mac that are structured differently from current Agency MBS. This may have the effect of reducing the amount of available investment opportunities for the Company. No such new structures have as yet been proposed.

Financial Regulatory Reform and Other Government Activity

In July 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was enacted into law. This legislation aims to restore responsibility and accountability to the financial system. It is unclear how this legislation may impact the borrowing environment, the investing environment for Agency and non-Agency MBS, or interest rate swaps and other derivatives because much of the Dodd-Frank Act’s implementation has not yet been defined by regulators.

In addition to the lowering of the Federal Funds Target Rate discussed above, the Federal Reserve also responded to market instability and economic weakness by purchasing Agency MBS and Treasury securities. From January 2009 through June 2011 the Federal Reserve purchased approximately $1.25 trillion of Agency MBS and $600 billion in Treasury securities of varying maturities. In September 2011, the FOMC announced its intention to sell shorter-term Treasury securities and purchase longer-term Treasury securities in response to weakening economic conditions in a policy operation which has become known as "Operation Twist". The stated intention of the FOMC in Operation Twist is to put downward pressure on longer-term interest rates and to help make broader financial conditions more accommodative. The targeted date for the discontinuation of Operation Twist is by the end of June 2012, at which point the FOMC is expected to have purchased $400 billion of longer-term Treasuries. At this time, it is unclear what impact the discontinuation of Operation Twist will have on interest rates and whether the Federal Reserve will institute a new or similar program.

The U.S. government is providing homeowners with assistance in avoiding residential mortgage loan foreclosures. The programs may involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans, the rate of interest payable on the loans, or to extend the payment terms of the loans. While the effect of these programs has not been as extensive as originally expected, the government may change them or add new programs in the future.  The GSEs have proposed changes to HARP that are designed to make it easier for borrowers to refinance residential mortgages, which could increase prepayment rates on mortgage loans underlying our investment securities. The impact of these programs may have the effect of increasing prepayment rates and reducing the principal or interest payments on residential mortgage loans held by certain types of borrowers. The effect of such programs for holders of Agency RMBS could be that such holders would experience changes in the anticipated yields of their Agency RMBS due to increased prepayment rates and lower interest and principal payments.


27



On August 31, 2011, the SEC issued a concept release relating to the exclusion from registration as an investment company provided to mortgage companies by Section 3(c)5(C) of the Investment Company Act of 1040 (the "1940 Act"). This release raises concerns regarding the ability of mortgage REITs to continue to rely on the exclusion in the future. In particular, the release states the SEC is concerned that certain types of mortgage-related pools today appear to resemble in many respects investment companies such as closed-end funds and may not be the kinds of companies that were intended to be excluded from regulation under the 1940 Act by Section 3(c)5(C). The outcome of the review by the SEC at this time is not determinable. For a discussion of the uncertainties and risks related to the SEC's review, please refer to "Risk Factors" contained within Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011.

Highlights of the First Quarter and Second Quarter Outlook

During the first quarter of 2012, we reported net income of $16.5 million, or $0.33 per common share, and net interest income of $19.1 million. We also issued approximately 14.0 million shares, raising $123.7 million in equity capital which we used to partially finance additional investment purchases, primarily in Agency RMBS and CMBS IOs. As a result, our average investments and our net interest income increased during the first quarter of 2012 versus the fourth quarter of 2011 while our net interest spread on our investment portfolio declined for the first quarter of 2012 to 2.41% from 2.56% for the fourth quarter of 2011. The decline in net interest spread is due principally to the lower yielding Agency MBS added to the portfolio.

Our shareholders' equity increased to $522.9 million as of March 31, 2012, or $9.62 per common share, from $371.3 million, or $9.20 per common share as of December 31, 2011. The increase in shareholders' equity resulted from the capital raised during the quarter as well as from an increase in accumulated other comprehensive income. The increase in accumulated other comprehensive income was mostly due to an approximately $15.4 million increase in the fair value of our non-Agency CMBS and CMBS IO. These securities increased in fair value from changing market expectations on performance of these securities and their liquidity which we believe may be related to the perceived improvement in economic conditions in the U.S. and stabilizing conditions in the Eurozone.

As of March 31, 2012, our Agency MBS constituted 81% of our investment portfolio compared to 79% of our investment portfolio as of December 31, 2011. As we are currently above our targeted Agency MBS portfolio composition, we expect to reduce our overall Agency MBS investments over the balance of the year as we move toward our targeted investment mix of 60% to 80% in Agency MBS with the balance in non-Agency MBS and securitized mortgage loans.

We believe that the outlook for our business model is favorable given the economic backdrop, despite the uncertainty regarding government policy and its potential affects on prepayments of our investments, and the uncertainty in Europe and its potential impact on the U.S. credit markets. In recent quarters we have expanded our investment portfolio to include Agency CMBS IO and non-Agency CMBS and CMBS IO given the attractive risk-adjusted return and prepayment protection profile of these investments. With respect to non-Agency CMBS and CMBS IO, we have purchased higher quality securities ('A'-rated CMBS and 'AAA'-rated CMBS IO) which will have higher yields than Agency CMBS and CMBS IO but which carry higher financing risks and costs and can exhibit more price volatility. We intend to continue with our goal of constructing a portfolio that minimizes prepayment risk, credit risk, and extension risk.


CRITICAL ACCOUNTING POLICIES
 
The discussion and analysis of our financial condition and results of operations are based in large part upon our consolidated financial statements, which have been prepared in accordance with GAAP.  The preparation of these financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities.  We base these estimates and judgments on historical experience and assumptions believed to be reasonable under current facts and circumstances.  Actual results, however, may differ from the estimated amounts we have recorded.

Our accounting policies that require the most significant management estimates, judgments, or assumptions and considered most critical to our results of operations or financial position relate to amortization of premiums on our investments, other-than-temporary impairments, allowance for loan losses, derivatives, and fair value measurements.  Our critical accounting policies are discussed in our Annual Report on Form 10-K for the year ended December 31, 2011 under “Management’s Discussion and

28



Analysis of Financial Condition and Results of Operations – Critical Accounting Policies” and in Note 1 of the Notes to the Unaudited Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.  There have been no significant changes in our critical accounting policies discussed in our Annual Report on Form 10-K for the year ended December 31, 2011.
 

FINANCIAL CONDITION
 
The following discussion addresses our items from our Consolidated Balance Sheet that had significant activity during the past three months and should be read in conjunction with the Notes to the Unaudited Consolidated Financial Statements contained within Item 1 of Part I of this Quarterly Report on Form 10-Q.

Agency MBS

 Activity related to our Agency MBS for the three months ended March 31, 2012 is as follows:

 
March 31, 2012
(amounts in thousands)
RMBS
 
CMBS
 
CMBS IO
 
Total
Beginning balance
$
1,577,250

 
$
302,244

 
$
85,665

 
$
1,965,159

Purchases
608,250

 
19,502

 
169,879

 
797,631

Principal payments
(103,133
)
 
(1,011
)
 

 
(104,144
)
Sales

 

 

 

Change in net unrealized gain
4,224

 
25

 
4,171

 
8,420

Net amortization
(5,165
)
 
(957
)
 
(4,781
)
 
(10,903
)
Ending balance
$
2,081,426

 
$
319,803

 
$
254,934

 
$
2,656,163


Our investments in Agency CMBS IO securities are issued and guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae and secured by excess interest payments on pools of multifamily housing mortgage loans. These securities have no principal associated with them; rather, the interest payments we receive are based on the unpaid principal balance (often referred to as the notional amount) of the underlying pool of mortgage loans. The combined notional balance of our investment in Agency CMBS IO securities as of March 31, 2012 was $3.9 billion. These CMBS IO securities have prepayment protection in the form of lock-outs and/or yield maintenance associated with the underlying loans.

The following table presents the fair value of our Agency MBS portfolio as of March 31, 2012 and December 31, 2011 by government issuer and type of security:
 
March 31, 2012
(amounts in thousands)
Fannie Mae
 
Freddie Mac
 
Ginnie Mae
 
Total
Hybrid ARMs
$
1,180,511

 
$
392,657

 
$

 
$
1,573,168

ARMs
221,420

 
204,878

 
23

 
426,321

Interest only
23,896

 
160,880

 
70,159

 
254,935

Fixed rate
340,910

 

 
60,829

 
401,739

 
$
1,766,737

 
$
758,415

 
$
131,011

 
$
2,656,163

 
December 31, 2011
(amounts in thousands)
Fannie Mae
 
Freddie Mac
 
Ginnie Mae
 
Total
Hybrid ARMs
$
835,061

 
$
379,605

 
$

 
$
1,214,666

ARMs
178,036

 
162,793

 

 
340,829

Interest only
3,459

 
82,206

 

 
85,665

Fixed rate
302,300

 
21,699

 

 
323,999

 
$
1,318,856

 
$
646,303

 
$

 
$
1,965,159



29



The following table presents the weighted average coupon (“WAC”) based on the par value of our Agency MBS portfolio as of March 31, 2012 and December 31, 2011 by weighted average months-to-reset (“MTR”):
 
 
March 31, 2012
 
December 31, 2011
MTR
Par Value (1)
 
WAC (1)(2)
 
Par Value (1)
 
WAC (1)(3)
(amounts in thousands)
 
 
 
 
 
 
 
0-12 months
$
400,216

 
4.35
%
 
$
321,942

 
4.32
%
13-24 months
287,715

 
4.98
%
 
384,184

 
5.09
%
25-36 months
119,043

 
4.61
%
 
142,321

 
4.78
%
Over 36 months
1,080,255

 
3.73
%
 
618,318

 
4.33
%
Fixed rate
360,704

 
4.93
%
 
288,584

 
5.00
%
 
$
2,247,933

 
4.24
%
 
$
1,755,349

 
4.64
%
(1)
The par value and WAC presented exclude our IO investments.
(2)
As of March 31, 2012, approximately 2% of our Agency ARMs and hybrid ARMs reset based upon the level of six month LIBOR, 92% reset based on the level of one-year LIBOR and 6% reset based on the level of one-year CMT.
(3)
As of December 31, 2011, approximately 2% of our Agency ARMs and hybrid ARMs reset based upon the level of six month LIBOR, 89% reset based on the level of one-year LIBOR and 9% reset based on the level of one-year CMT.

Please also refer to “Net Interest Income – Agency MBS” contained within “Results of Operations” of this Item 2 as well as Note 3 of the Notes to the Unaudited Consolidated Financial Statements contained within Item 1 of Part I of this Quarterly Report on Form 10-Q for additional information relating to our Agency MBS.

Non-Agency MBS

Activity related to our non-Agency MBS for the three months ended March 31, 2012 is as follows:
 
March 31, 2012
(amounts in thousands)
RMBS
 
CMBS
 
CMBS IO
 
Total
Beginning balance
$
15,270

 
$
354,070

 
$
51,756

 
$
421,096

Purchases

 
22,061

 
16,000