DX Q3-12 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 September 30, 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 October 31, 2012, the registrant had 54,371,159 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)
 
September 30, 2012
 
December 31, 2011
ASSETS
(unaudited)
 
 
Agency MBS (including pledged of $3,506,618 and $1,879,831, respectively)
$
3,650,672

 
$
1,965,159

Non-Agency MBS (including pledged of $569,016 and $415,195, respectively)
586,931

 
421,096

Securitized mortgage loans, net
77,748

 
113,703

Other investments, net
896

 
1,018


4,316,247

 
2,500,976

Cash and cash equivalents
34,723

 
48,776

Principal receivable on investments
20,374

 
13,826

Accrued interest receivable
22,091

 
12,609

Other assets, net
11,595

 
6,006

Total assets
$
4,405,030

 
$
2,582,193

LIABILITIES AND SHAREHOLDERS’ EQUITY
 

 
 

Liabilities:
 

 
 

Repurchase agreements
$
3,670,972

 
$
2,093,793

Payable for securities pending settlement
12,567

 

Non-recourse collateralized financing
31,295

 
70,895

Derivative liabilities
46,496

 
27,997

Accrued interest payable
2,381

 
2,165

Accrued dividends payable
16,582

 
11,307

Other liabilities
6,806

 
4,687

 Total liabilities
3,787,099

 
2,210,844

Commitments and Contingencies (Note 12)
 
 
 
Shareholders’ equity:
 

 
 

Preferred stock, par value $.01 per share, 8.5% Series A Cumulative Redeemable; 8,000,000 shares authorized; 2,300,000 and no shares issued and outstanding, respectively ($57,500 aggregate liquidation preference)
55,407

 

Common stock, par value $.01 per share, 100,000,000 shares
authorized; 54,368,714 and 40,382,530 shares issued and outstanding, respectively
544

 
404

Additional paid-in capital
759,647

 
634,683

Accumulated other comprehensive income (loss)
55,890

 
(3,255
)
Accumulated deficit
(253,557
)
 
(260,483
)
 Total shareholders' equity
617,931

 
371,349

Total liabilities and shareholders’ equity
$
4,405,030

 
$
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
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Interest income:
 
 
 
 
 
 
 
Agency MBS
$
19,677

 
$
14,898

 
$
54,784

 
$
41,660

Non-Agency MBS
7,577

 
4,442

 
22,452

 
11,963

Securitized mortgage loans
1,299

 
1,773

 
4,330

 
5,953

Other investments
21

 
30

 
405

 
97

 
28,574

 
21,143

 
81,971

 
59,673

Interest expense:
 
 
 
 
 
 
 
Repurchase agreements
9,166

 
5,305

 
23,673

 
13,493

Non-recourse collateralized financing
308

 
1,278

 
1,043

 
3,856

 
9,474

 
6,583

 
24,716

 
17,349

 
 
 
 
 
 
 
 
Net interest income
19,100

 
14,560

 
57,255

 
42,324

Provision for loan losses
(110
)
 
(300
)
 
(170
)
 
(750
)
Net interest income after provision for loan losses
18,990

 
14,260

 
57,085

 
41,574

 
 
 
 
 
 
 
 
Litigation settlement and related costs

 
(8,240
)
 

 
(8,240
)
Loss on non-recourse collateralized financing

 
(1,970
)
 

 
(1,970
)
Gain on sale of investments, net
3,480

 
581

 
6,418

 
1,323

Fair value adjustments, net
(36
)
 
(662
)
 
(129
)
 
(657
)
Other income, net
(177
)
 
(102
)
 
350

 
84

General and administrative expenses:
 
 
 
 
 
 
 
Compensation and benefits
(1,699
)
 
(1,106
)
 
(5,276
)
 
(3,447
)
Other general and administrative
(1,391
)
 
(1,229
)
 
(3,959
)
 
(3,261
)
Net income
$
19,167

 
$
1,532

 
$
54,489

 
$
25,406

Preferred stock dividends
(814
)
 

 
(814
)
 

Net income to common shareholders
$
18,353

 
$
1,532

 
$
53,675

 
$
25,406

Weighted average common shares:
 
 
 
 
 
 
 
Basic
54,367

 
40,353

 
52,752

 
37,973

Diluted
54,368

 
40,353

 
52,752

 
37,974

Net income per common share:
 
 
 
 
 
 
 
Basic
$
0.34

 
$
0.04

 
$
1.02

 
$
0.67

Diluted
$
0.34

 
$
0.04

 
$
1.02

 
$
0.67

Dividends declared per common share
$
0.29

 
$
0.27

 
$
0.86

 
$
0.81

See notes to unaudited consolidated financial statements.



2




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


 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012

2011
 
2012
 
2011
Net income
$
19,167

 
$
1,532

 
$
54,489

 
$
25,406

Other comprehensive income:
 

 
 

 
 
 
 
Change in fair value of available-for-sale investments
44,905

 
7,145

 
80,671

 
13,310

Reclassification adjustment for amounts included in statement of income
(3,275
)
 
(581
)
 
(3,275
)
 
(1,323
)
Change in fair value of interest rate swaps
(11,073
)
 
(18,251
)
 
(28,853
)
 
(31,974
)
Reclassification adjustment for amounts included in statement of income
3,827

 
3,383

 
10,602

 
8,325

Other comprehensive income (loss)
34,384

 
(8,304
)
 
59,145

 
(11,662
)
Comprehensive income (loss)
53,551

 
(6,772
)
 
113,634

 
13,744

Dividends declared on preferred stock
(814
)
 

 
(814
)
 

Comprehensive income (loss) to common shareholders
$
52,737

 
$
(6,772
)
 
$
112,820

 
$
13,744


See notes to unaudited consolidated financial statements.


3



DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 (amounts in thousands)
 
Nine Months Ended
 
September 30,
 
2012
 
2011
Operating activities:
 
 
 
Net income
$
53,675

 
$
25,406

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

 
 

Increase in accrued interest receivable
(9,383
)
 
(6,248
)
Increase in accrued interest payable
216

 
161

Provision for loan losses
170

 
750

Gain on sale of investments, net
(6,418
)
 
(1,323
)
Loss on non-recourse collateralized financing

 
1,970

Fair value adjustments, net
129

 
657

Increase in litigation settlement and related costs reserve

 
7,861

Amortization and depreciation
58,999

 
22,312

Stock-based compensation expense
1,410

 
492

Cash payments on stock appreciation rights
(116
)
 

Net change in other assets and other liabilities
(2,348
)
 
1,564

Net cash and cash equivalents provided by operating activities
96,334

 
53,602

Investing activities:
 

 
 

Purchase of investments
(2,454,851
)
 
(1,440,594
)
Principal payments received on investments
34,038

 
344,649

Increase in principal receivable on investments
(6,548
)
 
(6,566
)
Proceeds from sales of investments
185,485

 
124,797

Principal payments received on securitized mortgage loans
459,380

 
32,655

Other investing activities
(3,001
)
 
77

Net cash and cash equivalents used in investing activities
(1,785,497
)
 
(944,982
)
Financing activities:
 

 
 

Borrowings under repurchase agreements, net
1,577,943

 
819,503

Deferred borrowing costs paid
(825
)
 

Principal payments on non-recourse collateralized financing
(39,773
)
 
(2,094
)
Proceeds from issuance of preferred stock
55,407

 

Proceeds from issuance of common stock
123,832

 
95,261

Dividends paid
(41,474
)
 
(29,970
)
Net cash and cash equivalents provided by financing activities
1,675,110

 
882,700

 
 
 
 
Net decrease in cash and cash equivalents
(14,053
)
 
(8,680
)
Cash and cash equivalents at beginning of period
48,776

 
18,836

Cash and cash equivalents at end of period
$
34,723

 
$
10,156

Supplemental Disclosure of Cash Activity:
 

 
 

Cash paid for interest
$
24,284

 
$
16,411

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 and nine months ended September 30, 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 September 30, 2012 and December 31, 2011, the Company did not have any investments in which it owned less than a 50% interest in the voting equity.

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 investment in 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 September 30, 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.  The Company accounts for its investment in non-Agency MBS in accordance with ASC Topic 320.  As of September 30, 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 the majority 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 cash flow models that utilize information such as the security’s coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected losses, credit enhancement, as well as certain other relevant information.

Other-than-Temporary Impairment. The Company evaluates all MBS 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 an investment in MBS with a fair value less than its amortized cost as of the balance sheet date of a reporting period, the MBS 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 MBS as of the balance sheet date. If the Company does not intend to sell the MBS, 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 MBS 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 MBS as of the balance sheet date is recognized in other comprehensive income.


6



In periods after the recognition of an other-than-temporary impairment loss for MBS, the Company shall account for the other-than-temporarily impaired MBS as if the MBS 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 MBS 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 MBS. For all other MBS, if upon subsequent evaluation, there is an increase in the cash flows expected to be collected or if actual cash flows are greater than cash flows previously expected, such changes shall be accounted for as a prospective adjustment to the accretable yield in accordance with Subtopic 310-30 even if the MBS would not otherwise be within the scope of that Subtopic. Subsequent increases and decreases in the fair value of the MBS 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. 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.

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.  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 pledged.  Repurchase agreement financing is recourse to the Company and the assets pledged.  Most of the Company’s repurchase agreements are based on the September 1996 version of the Bond Market Association Master Repurchase Agreement, which generally provides that the lender, as buyer, is responsible for obtaining collateral valuations from a generally recognized source agreed to by both the Company and the lender, or, in an instance when such source is not available, the value determination is made by the lender.

7



 
Derivative Instruments
 
The Company 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 documentation, with each individual counterparty. Since the effective date of ASC 820, management has monitored and measured credit risk and calculated credit valuation adjustments for its derivative transactions on the basis of its relationships at the counterparty portfolio level. Management receives reports from an independent third-party valuation specialist on a monthly basis providing the credit valuation adjustments at the counterparty portfolio level for purposes of reviewing and managing its credit risk exposures. Since the portfolio exception applies only to the fair value measurement and not to financial statement presentation, the portfolio-level adjustments are then allocated in a reasonable and consistent manner each period to the individual assets or liabilities that make up the group, in accordance with other applicable accounting guidance and the Company's accounting policy elections.
 
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 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.


8



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.
 
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 September 30, 2012.

In December 2011, FASB issued Accounting Standards Update ("ASU") No. 2011-11 which amends ASC Topic 210 to require an entity to disclose information about offsetting assets and liabilities and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. Offsetting, otherwise known as netting, is the presentation of assets and liabilities as a single net amount in the balance sheet. GAAP gives companies the option to present in their consolidated balance sheets, on a net basis, derivatives that are subject to a legally enforceable netting arrangement with the same party where rights of set-off are only available in the event of default or bankruptcy. This amendment is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods, and should be applied retrospectively for all comparative periods presented. The Company does not currently offset any of its assets and liabilities, and as such, does not anticipate that ASU No. 2011-11 will have a material impact on the Company's financial condition or results of operations.

9




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:
 
Three Months Ended
 
September 30,
 
2012
 
2011
 
 
Income
 
Weighted-Average Common Shares
 
 
Income
 
Weighted-
Average
Common
Shares
Net income to common shareholders
$
18,353

 
54,367,349

 
$
1,532

 
40,353,219

Effect of dilutive stock options

 
866

 

 
82

Diluted
$
18,353

 
54,368,215

 
$
1,532

 
40,353,301

Net income per common share:
 
 
 
 
 
 
 
Basic
 

 
$
0.34

 
 

 
$
0.04

Diluted (1)
 

 
$
0.34

 
 

 
$
0.04

(1)
For the three months ended September 30, 2011, 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.
 
Nine Months Ended
 
September 30,
 
2012
 
2011
 
 
Income
 
Weighted-Average Common Shares
 
 
Income
 
Weighted-
Average
Common
Shares
Net income to common shareholders
$
53,675

 
52,751,763

 
$
25,406

 
37,972,766

Effect of dilutive stock options

 

 

 
1,183

Diluted
$
53,675

 
52,751,763

 
$
25,406

 
37,973,949

Net income per common share:
 
 
 
 
 
 
 
Basic
 

 
$
1.02

 
 

 
$
0.67

Diluted (1)
 

 
$
1.02

 
 

 
$
0.67

(1)
For the nine months ended September 30, 2012 and September 30, 2011, 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.

10




NOTE 3 – AGENCY MBS
 
The following table presents the components of the Company’s investment in Agency MBS as of September 30, 2012 and December 31, 2011:
 
September 30, 2012
 
RMBS
 
CMBS
 
CMBS IO (1)
 
Total
Principal/par value
$
2,627,300

 
$
289,726

 
$

 
$
2,917,026

Unamortized premium
145,922

 
21,898

 
508,326

 
676,146

Unamortized discount
(14
)
 

 

 
(14
)
Amortized cost
2,773,208

 
311,624

 
508,326

 
3,593,158

Available for sale (recognized in statement of comprehensive income):
 
 
 
 
 
 
 
Gross unrealized gains
32,315

 
20,843

 
10,880

 
64,038

Gross unrealized losses
(5,428
)
 
(2
)
 
(3,693
)
 
(9,123
)
Trading (recognized in income statement):
 
 
 
 
 
 
 
Gross unrealized gains

 
2,599

 

 
2,599

Total Agency MBS fair value:
$
2,800,095

 
$
335,064

 
$
515,513

 
$
3,650,672

Weighted average coupon
3.73
%
 
5.20
%
 
0.96
%
 
 
(1)
The combined notional balance for the Agency CMBS IO securities is $9,251,338 as of September 30, 2012.

 
December 31, 2011
 
RMBS
 
CMBS
 
CMBS IO (1)
 
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
%
 
0.96
%
 
 
(1)
The combined notional balance for the Agency CMBS IO securities is $1,813,096 as of December 31, 2011.

The Company purchased $1,707,077 of Agency RMBS and $477,774 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.
    
As of September 30, 2012 and December 31, 2011, the amortized cost of Agency CMBS designated as trading was $27,687 and $28,119, respectively. The Company recognized a net unrealized gain for the three and nine months ended September 30, 2012 of $283 and $716 compared to $744 and $1,819 for the three and nine ended September 30, 2011, respectively, related to

11



changes in fair value, which is included within “fair value adjustments, net” in the Company's 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.

The following table presents certain information for those Agency MBS in an unrealized loss position as of September 30, 2012 and December 31, 2011:
 
September 30, 2012
 
December 31, 2011
 
Fair Value
 
Unrealized Loss
 
# of Securities
 
Fair Value
 
Unrealized Loss
 
# of Securities
Unrealized loss position for:
 
 
 
 
 
 
 
 
 
 
 
Less than one year
$
392,903

 
$
(4,281
)
 
42
 
$
680,101

 
$
(6,765
)
 
54
One year or more
323,732

 
(4,832
)
 
35
 
160,544

 
(1,684
)
 
27
 
$
716,635

 
$
(9,113
)
 
77
 
$
840,645

 
$
(8,449
)
 
81

Because the principal and interest related to Agency MBS are guaranteed by the government-sponsored entities Fannie Mae and Freddie Mac who have the implicit guarantee of the U.S. government, the Company does not consider any of the unrealized losses on its Agency MBS to be credit related. Although the unrealized losses are not credit related, the Company assesses its ability and intent to hold any Agency MBS with an unrealized loss until the recovery in its value. This assessment is based on the amount of the unrealized loss and significance of the related investment as well as the Company’s current leverage and anticipated liquidity.  Based on this analysis, the Company has determined that the unrealized losses on its Agency MBS as of September 30, 2012 and December 31, 2011 were temporary.

NOTE 4 – NON-AGENCY MBS
 
The following table presents the components of the Company’s non-Agency MBS as of September 30, 2012 and December 31, 2011:
 
September 30, 2012
 
RMBS
 
CMBS
 
CMBS IO (1)
 
Total
Principal/par value
$
15,007

 
$
452,975

 
$

 
$
467,982

Unamortized premium

 
2,726

 
93,096

 
95,822

Unamortized discount
(812
)
 
(20,732
)
 

 
(21,544
)
Amortized cost
14,195

 
434,969

 
93,096

 
542,260

Gross unrealized gains
470

 
41,507

 
4,317

 
46,294

Gross unrealized losses
(424
)
 
(1,194
)
 
(5
)
 
(1,623
)
Fair value
$
14,241

 
$
475,282

 
$
97,408

 
$
586,931

Weighted average coupon
4.38
%
 
4.64
%
 
0.69
%
 
 
(1)
The combined notional balance for the non-Agency CMBS IO securities is $2,252,064 as of September 30, 2012.


12



 
December 31, 2011
 
RMBS
 
CMBS
 
CMBS IO (1)
 
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
%
 
1.24
%
 
 
(1)
The combined notional balance for the non-Agency CMBS IO securities is $906,202 as of December 31, 2011.

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 has purchased $7,500 on non-Agency RMBS, $120,697 of non-Agency CMBS since December 31, 2011. In addition, the Company paid premiums of $48,812 for non-Agency CMBS IO securities.

The following table presents certain information for those non-Agency MBS that were in an unrealized loss position as of September 30, 2012 and December 31, 2011:
 
September 30, 2012
 
December 31, 2011
 
Fair Value
 
Unrealized Loss
 
# of Securities
 
Fair Value
 
Unrealized Loss
 
# of Securities
Unrealized loss position for:
 
 
 
 
 
 
 
 
 
 
 
Less than one year:
$
4,351

 
$
(120
)
 
3
 
$
153,974

 
$
(5,075
)
 
6
One year or more:
11,700

 
(1,504
)
 
9
 
2,993

 
(379
)
 
7
 
$
16,051

 
$
(1,624
)
 
12
 
$
156,967

 
$
(5,454
)
 
13

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 non-Agency MBS and the seasoning of the mortgage loans collateralizing these securities as well as the estimated future cash flows which include projected losses. The Company performed this evaluation for the non-Agency MBS in an unrealized loss position as of September 30, 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 September 30, 2012.

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 September 30, 2012 and December 31, 2011:


13



 
September 30, 2012
 
December 31, 2011
 
Commercial
 
Single-family
 
Total
 
Commercial
 
Single-family
 
Total
Principal/par value (1)
$
34,591

 
$
43,007

 
$
77,598

 
$
68,029

 
$
47,657

 
$
115,686

Unamortized premium, net

 
644

 
644

 

 
770

 
770

Unamortized discount, net
(77
)
 

 
(77
)
 
(254
)
 

 
(254
)
Amortized cost
34,514

 
43,651

 
78,165

 
67,775

 
48,427

 
116,202

Allowance for loan losses
(150
)
 
(267
)
 
(417
)
 
(2,268
)
 
(231
)
 
(2,499
)
 
$
34,364

 
$
43,384

 
$
77,748

 
$
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 $29,600.  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 69% of these securitized commercial mortgage loans are secured by multifamily properties. As of September 30, 2012 and December 31, 2011, the loan-to-value ratio based on original appraisal was 42% and 42%, respectively. There were no securitized commercial mortgage loans identified as seriously delinquent (60 or more days past due) and therefore on nonaccrual status on the Company's balance sheet as of September 30, 2012 compared to nonaccrual loans with an unpaid principal balance of $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 $4,438. 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 September 30, 2012 and December 31, 2011, the current loan-to-value ratio based on original appraisal was approximately 44% and 46%, respectively. The unpaid principal balance of the Company's securitized single-family mortgage loans identified as seriously delinquent as of September 30, 2012 is $3,382 compared 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
 
September 30,
 
2012
 
2011
 
Commercial
 
Single-family
 
Commercial
 
Single-family
Allowance at beginning of period
$
1,355

 
$
231

 
$
3,069

 
$
208

Provision for loan losses
(36
)
 
146

 
300

 

Credit losses, net of recoveries
(1,169
)
 
(110
)
 
(1,196
)
 

Allowance at end of period
$
150

 
$
267

 
$
2,173

 
$
208

 


14



 
Nine Months Ended
 
September 30,
 
2012
 
2011
 
Commercial
 
Single-family
 
Commercial
 
Single-family
Allowance at beginning of period
$
2,268

 
$
231

 
$
4,200

 
$
270

Provision for loan losses
24

 
146

 
750

 

Credit losses, net of recoveries
(2,142
)
 
(110
)
 
(2,777
)
 
(62
)
Allowance at end of period
$
150

 
$
267

 
$
2,173

 
$
208


The following table presents certain information on impaired securitized commercial and single-family mortgage loans as of September 30, 2012 and December 31, 2011:
 
September 30, 2012
 
December 31, 2011
 
Commercial
 
Single-family
 
Commercial
 
Single-family
Unpaid principal balance of impaired securitized loans
$

 
$
3,382

 
$
4,724

 
$
3,000

Basis adjustments related to impaired securitized loans

 
51

 
8

 
48

Amortized cost basis of impaired securitized loans

 
3,433

 
4,732

 
3,048

Allowance for loan losses
(150
)
 
(267
)
 
(2,268
)
 
(231
)
Investment in excess of allowance
$
(150
)
 
$
3,166

 
$
2,464

 
$
2,817


Although the Company does not currently have specific securitized commercial mortgage loans identified as impaired, the Company is maintaining a general allowance for commercial mortgage loan losses of $150 as indicated in the table above. The Company recognized $0 and $50 of interest income on impaired securitized commercial mortgage loans for the three and nine months ended September 30, 2012, respectively, compared to $27 and $83 of interest income for the three and nine months ended September 30, 2011, respectively.  The Company recognized $47 and $141 of interest income on impaired securitized single-family mortgage loans for the three and nine months ended September 30, 2012, respectively, compared to $49 and $146 of interest income for the three and nine months ended September 30, 2011, respectively.

NOTE 7 – DERIVATIVES
 
As of September 30, 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:  
 
 
September 30, 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
 
$
(43,802
)
 
$
1,485,000

 
1.50
%
 
$
(25,512
)
 
$
1,065,000

 
1.55
%
Trading instruments
 
(2,694
)
 
27,000

 
2.88
%
 
(2,485
)
 
27,000

 
2.88
%
 
Derivative liabilities
$
(46,496
)
 
 
 
 
 
$
(27,997
)
 
 
 
 

Included in the balance as of September 30, 2012 are seven forward-starting interest rate swaps with a combined notional balance of $275,000 and a weighted average pay-fixed rate of 1.62% which are not effective until 2013.

The following table summarizes the contractual maturities remaining for the Company’s outstanding interest rate swap agreements as of September 30, 2012:

15



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

 
445,000

 
472,000

 
16

 
1.60
%
Over 60 months

 
400,000

 
400,000

 
14

 
1.60
%
 
$
27,000

 
$
1,485,000

 
$
1,512,000

 
42

 
1.53
%

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 Gain (Loss) Recognized in Net Income (Ineffective Portion)
For the three months ended September 30, 2012:
 
Interest rate swaps
$(11,073)
Interest expense
$3,827
Other income, net
$(107)
For the three months ended September 30, 2011:
 
 
 
Interest rate swaps
$(18,251)
Interest expense
$3,383
Other income, net
$(31)
For the nine months ended September 30, 2012:
 
 
 
Interest rate swaps
$(28,853)
Interest expense
$10,602
Other income, net
$(38)
For the nine months ended September 30, 2011:
 
 
 
Interest rate swaps
$(31,974)
Interest expense
$8,325
Other income, net
$(55)

As of September 30, 2012, the Company estimates that $17,094 will be reclassified from AOCI 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
Three Months Ended
 
Nine Months Ended
 
 
September 30, 2012
 
September 30, 2011
 
September 30, 2012
 
September 30, 2011
Interest rate swaps
Fair value adjustments, net
$
(333
)
 
$
(1,446
)
 
$
(907
)
 
$
(2,649
)

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

16



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 September 30, 2012, the Company had derivatives in a net liability position with its derivative counterparties for which it had pledged Agency MBS with a fair value of $50,966 and cash of $38 as collateral.  If the Company had breached any of these agreements as of September 30, 2012, it could have been required to settle those derivatives at their estimated termination value of $47,115, which includes accrued interest but excludes any adjustment for nonperformance risk. As of September 30, 2012, the Company was in compliance with all covenants.
 
NOTE 8 – REPURCHASE AGREEMENTS
 
The Company uses repurchase agreements, which are recourse to the Company, to finance certain of its investments.  As of September 30, 2012, the Company had repurchase agreement borrowings outstanding with a weighted average rate of 0.63% with 21 of its 28 available repurchase agreement counterparties compared to a weighted average borrowing rate of 0.61% with 20 counterparties as of December 31, 2011. The Company had approximately 18% of its shareholders' equity at risk with one counterparty, Wells Fargo Securities, LLC, with whom the Company had $346,602 outstanding as of September 30, 2012. The shareholders' equity at risk did not exceed 10% for any of the Company's other counterparties.

The following tables present the components of the Company’s repurchase agreements as of September 30, 2012 and December 31, 2011 by the fair value and type of securities pledged as collateral to the repurchase agreements:
 
September 30, 2012
Collateral Type
Balance
 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
Agency RMBS
$
2,560,779

 
0.41
%
 
$
2,665,860

Agency CMBS and CMBS IOs
634,327

 
0.93
%
 
789,792

Non-Agency RMBS
11,042

 
1.82
%
 
12,761

Non-Agency CMBS and CMBS IOs
431,039

 
1.39
%
 
540,332

Securitization financing bonds
34,549

 
1.67
%
 
36,342

Deferred fees
(764
)
 
n/a

 
n/a

 
$
3,670,972

 
0.63
%
 
$
4,045,087


 
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 and CMBS IOs
290,362

 
0.59
%
 
329,612

Non-Agency RMBS
12,195

 
1.85
%
 
13,597

Non-Agency CMBS and CMBS IOs
283,266

 
1.54
%
 
336,124

Securitization financing bonds
60,462

 
1.65
%
 
67,872

 
$
2,093,793

 
0.61
%
 
$
2,268,312


The combined weighted average original term to maturity for the Company’s repurchase agreements was 52 days as of September 30, 2012 and 57 days as of December 31, 2011.  The following table provides a summary of the original maturities as of September 30, 2012 and December 31, 2011:


17



Original Maturity
September 30,
2012
 
December 31,
2011
30 days or less
$
1,663,679

 
$
180,387

31 to 60 days
898,021

 
880,491

61 to 90 days
472,705

 
496,509

Greater than 90 days
636,567

 
536,406

 
$
3,670,972

 
$
2,093,793


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 September 30, 2012.

NOTE 9 – NON-RECOURSE COLLATERIZED FINANCING
 
The following table summarizes information about the Company’s non-recourse collateralized financing for the periods indicated:
 
 
September 30, 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

 
$
15,923

Secured by single-family mortgage loans
1-month LIBOR plus 0.30%
 
3.1
 
16,826

 
17,768

Unamortized net bond premium and deferred costs
 
 
 
 
(531
)
 
n/a

 
 
 
 
 
$
31,295

 
$
33,691


18



 
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.


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 September 30, 2012, segregated by the hierarchy level of the fair value estimate:


19



 
 
 
Fair Value Measurements
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Agency MBS
$
3,650,672

 
$

 
$
3,650,672

 
$

Non-Agency MBS:
 

 
 

 
 

 
 

CMBS (including CMBS IO)
572,690

 

 
472,374

 
100,316

RMBS
14,241

 

 
5,640

 
8,601

Other investments
25

 

 

 
25

Total assets carried at fair value
$
4,237,628

 
$

 
$
4,128,686

 
$
108,942

Liabilities:
 

 
 

 
 

 
 

Derivative liabilities
$
46,496

 
$

 
$
46,496

 
$

Total liabilities carried at fair value
$
46,496

 
$

 
$
46,496

 
$


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 cash flow models using assumptions that are confirmed to the extent possible by third party dealers or other pricing indicators.  Significant inputs into those pricing models are Level 3 in nature due to the lack of readily available market quotes.  Information utilized in those pricing models include the security’s credit rating, coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected credit losses, and credit enhancement as well as certain other relevant information.  Significant increases (decreases) in any of 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 Level 3 non-Agency RMBS and CMBS during the three and nine months ended September 30, 2012:

 
Quantitative Information about Level 3 Fair Value Measurements(1)
 
Prepayment Speed
 
Default Rate
 
Severity
 
Discount Rate
Non-Agency CMBS
20 CPY

 
2.5
%
 
35.0
%
 
4.4
%
Non-Agency RMBS
5
 CPR
 
0.5
%
 
9.0
%
 
5.1
%
(1)
Data presented are weighted averages.

The following tables present the activity of the instruments fair valued at Level 3 for the three and nine months ended September 30, 2012:

20



 
For the Three Months Ended September 30, 2012
 
Level 3 Fair Values
 
Non-Agency CMBS
 
Non-Agency RMBS
 
Other
 
Total assets
Balance as of June 30, 2012
$
104,515

 
$
12,657

 
$
25

 
$
117,197

Total unrealized losses:
 

 
 

 
 

 
 

Included in other comprehensive income
90

 
41

 

 
131

Principal payments
(4,194
)
 
(4,108
)
 

 
(8,302
)
Amortization
(95
)
 
11

 

 
(84
)
Balance as of September 30, 2012
$
100,316

 
$
8,601

 
$
25

 
$
108,942


 
For the Nine Months Ended September 30, 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

Purchases

 
7,500

 

 
7,500

Transfers out to Level 2
(4,670
)
 

 

 
(4,670
)
Total unrealized losses:
 

 
 

 
 

 
 

Included in other comprehensive income
(1,934
)
 
117

 

 
(1,817
)
Principal payments
(16,409
)
 
(9,349
)
 

 
(25,758
)
Amortization
(374
)
 
37

 

 
(337
)
Balance as of September 30, 2012
$
100,316

 
$
8,601

 
$
25

 
$
108,942


The Company evaluates the availability and quality of valuation inputs for its Level 3 securities on a monthly basis. When it determines that there are sufficient observable market inputs for the same or similar securities, the securities are transferred to Level 2 at the end of the reporting period in which that determination is made. As shown in the tables above for the nine months ended September 30, 2012, the Company transferred two of its non-Agency CMBS from Level 3 to Level 2 during the second quarter of 2012. The liquidity for securities similar to these non-Agency CMBS improved such that the Company was able to obtain market discount rates and prepayment speeds which it used in establishing the fair value of these two non-Agency CMBS.

The following table presents the recorded basis and estimated fair values of the Company’s financial instruments as of September 30, 2012 and December 31, 2011:
 

21



 
September 30, 2012
 
December 31, 2011
 
Recorded Basis
 
Fair Value
 
Recorded Basis
 
Fair Value
Assets:
 
 
 
 
 
 
 
Agency MBS
$
3,650,672

 
$
3,650,672

 
$
1,965,159

 
$
1,965,159

Non-Agency CMBS
572,690

 
572,690

 
405,826

 
405,826

Non-Agency RMBS
14,241

 
14,241

 
15,270

 
15,270

Securitized mortgage loans, net
77,748

 
66,879

 
113,703

 
101,116

Other investments
896

 
842

 
1,018

 
892

Liabilities:
 

 
 

 
 

 
 

Repurchase agreements
$
3,670,972

 
$
3,670,972

 
$
2,093,793

 
$
2,093,793

Non-recourse collateralized financing
31,295

 
31,013

 
70,895

 
69,752

Derivative liabilities
46,496

 
46,496

 
27,997

 
27,997


There were no assets or liabilities which were measured at fair value on a non-recurring basis as of September 30, 2012 or December 31, 2011.
 

NOTE 11 – SHAREHOLDERS' EQUITY
 
Preferred Stock

On August 1, 2012, the Company closed an offering of 2,300,000 shares of 8.50% Series A Cumulative Redeemable Preferred Stock, par value of $0.01 per share and liquidation preference $25.00 per share. The Company received net proceeds before expenses of $55,689, including the additional proceeds from the underwriters' overallotment option which was fully exercised.

Common Stock

The following table presents a summary of the changes in the number of common shares outstanding for the periods indicated:
 
Nine Months Ended
 
September 30,
 
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
9,279

 
2,111

Common stock issued via public offering
13,332,748

 
9,200,000

Common stock issued or redeemed under Stock and Incentive Plans
241,663

 
426,031

Balance at end of period
54,368,714

 
40,380,276


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 nine months ended September 30, 2012, the Company received proceeds of $3,721, net of $57 in broker sales commission, for 402,494 shares of common stock sold under this program at an average price of $9.39.  The Company did not issue any common stock under this program during the three months ended September 30, 2012.


22



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 third quarter common stock dividend of $0.29 per share payable on October 31, 2012 to shareholders of record as of October 5, 2012. There is no dividend reinvestment discount for third quarter dividends reinvested through the DRIP.

In February 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 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, SARs, dividend equivalent rights, performance shares, and restricted stock units.  Of the 2,500,000 shares of common stock authorized for issuance under this plan, 1,805,276 shares remain available for issuance as of September 30, 2012.  

The following table presents a rollforward of the restricted stock activity for the periods presented:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Restricted stock at beginning of period
454,117

 
330,500

 
365,506

 
25,000

Restricted stock granted

 
35,006

 
220,821

 
358,006

Restricted stock vested
(2,917
)
 

 
(135,127
)
 
(17,500
)
Restricted stock outstanding at end of period
451,200

 
365,506

 
451,200

 
365,506


 As of September 30, 2012, the fair value of the Company’s outstanding restricted stock remaining to be amortized into compensation expense is $3,438.

During the three months ended September 30, 2012, 25,000 SARs were exercised with a weighted average exercise price of $6.61. During the nine months ended September 30, 2012, 31,875 SARs were exercised with a weighted average exercise price of $6.71. No SARs were granted, forfeited, or exercised during the three and nine months ended September 30, 2011. As of September 30, 2012, the Company has 27,500 SARs outstanding, all of which are vested and exercisable at an exercise price of $7.06 per share.  The remaining contractual term on these outstanding SARs as of September 30, 2012 is 15 months. As of September 30, 2012 and December 31, 2011, the fair value of the Company’s outstanding SARs of $103 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 and nine months ended September 30, 2012 was $490 and $1,410, respectively, compared to $139 and $492, respectively, for the three and nine months ended September 30, 2011.

Additional Paid-In Capital

     The following table presents a rollforward of the Company's changes in additional paid-in capital for the nine months ended September 30, 2012:

23



 
Additional Paid-In Capital
Balance as of January 1, 2012
$
634,683
 
Common stock issuances:
 
DRIP issuances
90
 
ATM issuances
3,674
 
Secondary offering
119,859
 
Incentive plans
192
 
Amortization of restricted stock
1,268
 
Capitalized expenses
(119
)
Balance as of September 30, 2012
$
759,647
 

Accumulated Other Comprehensive Income

Accumulated other comprehensive income as of September 30, 2012 and December 31, 2011 is comprised of the following items:
 
 
September 30, 2012
 
December 31, 2011
Available for sale investments:
 
 
 
Unrealized gains
$
110,332

 
$
36,091

Unrealized losses
(10,747
)
 
(13,902
)
 
99,585

 
22,189

Hedging instruments:
 

 
 

Unrealized losses
(43,695
)
 
(25,444
)
 
(43,695
)
 
(25,444
)
Accumulated other comprehensive income (loss)
$
55,890

 
$
(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 ("Allegheny County") 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, the Court refined the class to include only owners of real estate in Allegheny County who paid an attorneys' fee between 1996 and 2003 in connection with the forced collection of delinquent property tax receivables by GLS (gene