UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
| x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the annual period ended December 31, 2015
OR
| ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number 001-35151
AG MORTGAGE INVESTMENT TRUST, INC.
(Exact name of registrant as specified in its charter)
| Maryland | 27-5254382 |
| (State or Other Jurisdiction of Incorporation or Organization) |
(I.R.S. Employer Identification No.) |
| 245 Park Avenue, 26th Floor New York, New York |
10167 |
| (Address of Principal Executive Offices) | (Zip Code) |
(212) 692-2000
(Registrant’s Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Securities Exchange Act of 1934:
|
Title of each class: |
Name of exchange on which registered: | |
|
Common Stock, $0.01 par value per share 8.25% Series A Cumulative Redeemable Preferred Stock 8.00% Series B Cumulative Redeemable Preferred Stock |
New York Stock Exchange (NYSE) New York Stock Exchange (NYSE) New York Stock Exchange (NYSE) |
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No x
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 and Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
| Large Accelerated filer | ¨ | Accelerated filer | x |
| Non-Accelerated filer | ¨ (Do not check if a smaller reporting company) | Smaller reporting company | ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The aggregate market value of the registrant’s common stock held by non-affiliates was $476,733,064 based on the closing sales price on the New York Stock Exchange on June 30, 2015.
As of February 17, 2016, there were 28,288,534 outstanding shares of common stock of AG Mortgage Investment Trust, Inc.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement with respect to its 2016 Annual Meeting of Stockholders to be filed not later than 120 days after the end of the registrant’s fiscal year are incorporated by reference into Part III, Items 10,11,12,13 and 14 hereof as noted therein.
AG MORTGAGE INVESTMENT TRUST, INC.
TABLE OF CONTENTS
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Forward-Looking Statements
We make forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), in this report that are subject to substantial known and unknown risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our business, financial condition, liquidity, results of operations, plans, objectives, the composition of our portfolio, actions by governmental entities, including the Federal Reserve, and the potential effects of actual and proposed legislation on us. When we use the words “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” or similar expressions, we intend to identify forward-looking statements.
These forward-looking statements are based upon information presently available to our management and are inherently subjective, uncertain and subject to change. There can be no assurance that actual results will not differ materially from our expectations. Some, but not all, of the factors that might cause such a difference include, but are not limited to, changes in interest rates, changes in the yield curve, changes in prepayment rates, the availability and terms of financing, changes in the market value of our assets, general economic conditions, conditions in the market for Agency RMBS, Non-Agency RMBS, ABS and CMBS securities and loans, and legislative and regulatory changes that could adversely affect us. We caution investors not to rely unduly on any forward-looking statements, which speak only as of the date made, and urge you to carefully consider the risks noted above and identified under the captions “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K and any subsequent filings. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. New risks and uncertainties arise from time to time, and it is impossible for us to predict those events or how they may affect us. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. All forward-looking statements that we make, or that are attributable to us, are expressly qualified by this cautionary notice.
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In this Annual Report on Form 10-K, or this “report,” we refer to AG Mortgage Investment Trust, Inc. as “we,” “us,” “the Company,” or “our,” unless we specifically state otherwise or the context indicates otherwise. We refer to our external manager, AG REIT Management, LLC, as our “Manager,” and we refer to the parent company of our Manager, Angelo, Gordon & Co., L.P. as “Angelo, Gordon.”
Our company
We are a Maryland corporation focused on investing in, acquiring and managing a diversified portfolio of residential mortgage assets, other real estate-related securities and financial assets, which we refer to as our target assets. We conduct our operations to qualify and be taxed as a real estate investment trust, or REIT, for U.S. federal income tax purposes. Accordingly, we generally will not be subject to U.S. federal income taxes on our taxable income that we distribute currently to our stockholders as long as we maintain our intended qualification as a REIT. We also operate our business in a manner that permits us to maintain our exemption from registration under the Investment Company Act of 1940, as amended, or the Investment Company Act.
Our Portfolio
The majority of our portfolio is comprised of mortgage-backed securities, specifically residential mortgage-backed securities, or RMBS. Certain of the assets in our RMBS portfolio have an explicit guarantee of principal and interest by a U.S. government agency such as the Government National Mortgage Association, or Ginnie Mae, or a government-sponsored entity such as the Federal National Mortgage Association, or Fannie Mae, or the Federal Home Loan Mortgage Corporation, or Freddie Mac ( collectively, “GSEs”). We refer to these securities as Agency RMBS. Our Agency RMBS investments include mortgage pass-through securities, securities entitling the holder only to the interest payments made on the mortgages underlying certain MBS (“interest-only strips”), collateralized mortgage obligations (“CMOs”), and certain Agency RMBS for which the underlying collateral is not identified until shortly (generally two days) before the purchase or sale settlement date (“TBAs”).
Our portfolio also includes a significant portion of RMBS that are not issued or guaranteed by Ginnie Mae or a GSE, which we refer to as Non-Agency RMBS. Our Non-Agency RMBS investments may include investment grade and non-investment grade fixed- and floating-rate securities. We categorize our Non-Agency RMBS by credit score at origination into Prime, Alt-A and Subprime. Our RMBS Interest Only securities (Non-Agency RMBS backed by interest-only strips), CRTs (defined below), RPL/NPL MBS, (described below), and Securitized Whole Loans, (described below) represent our Non-Agency RMBS not categorized by credit score at origination.
Credit Risk Transfer securities (“CRTs”) are unguaranteed and unsecured mezzanine, junior mezzanine and first loss securities issued by Fannie Mae and Freddie Mac to decrease their exposure to mortgage default risk. The securities reference a pool of recently acquired single family mortgages from a specified time period. The risk of loss on the reference pool of mortgages is transferred to investors who may experience losses when credit events such as defaults, liquidations or delinquencies occur. The notes pay an uncapped floating rate spread over one-month LIBOR.
RPL/NPL MBS are mortgage-backed securities collateralized by re-performing mortgage loans (“RPL”) or non-performing mortgage loans (“NPL”). The RPL/NPL MBS that we own represent the senior and mezzanine tranches in such securitizations. These RPL/NPL MBS are structured with significant credit enhancement (typically approximately 50% to the senior tranche and 40% to the mezzanine tranche) to mitigate our exposure to credit risk on these securities. “Credit enhancement” refers to the amount of subordination available to absorb all credit losses prior to losses being allocated to more senior tranches. Subordinate tranches typically receive no cash flow (interest or principal) until the senior and mezzanine tranches are paid off. In addition, the RPL/NPL MBS that we own typically contain an “interest rate step-up” feature, whereby the interest rate or “coupon” on the senior tranche increases by typically 300 basis points or typically 400 basis points in the case of mezzanine tranches (a “step up”) that begin to take effect if the security that we hold has not been redeemed or repurchased by the issuer within 36 months of issuance. We expect that the combination of the priority cash flow of the senior tranche and the 36-month step-up will result in these securities exhibiting short average lives and, accordingly, reduced interest rate sensitivity.
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Securitized Whole Loans are residential mortgage loans (generally RPLs or NPLs) in securitized form that we purchase from a related party or parties. The securitizations typically take the form of various classes of notes and a trust certificate. Securitized Whole Loans do not include RPLs or NPLs that we hold through interests in certain consolidated trusts.
We have also invested in other target assets, including asset backed securities, or ABS, and commercial mortgage-backed securities, or CMBS. Our CMBS portfolio includes CMBS interest only securities (CMBS backed by interest-only strips) and Freddie Mac K-Series CMBS (described below).
Freddie Mac K-Series CMBS (“K-Series CMBS”) include CMBS, CMBS interest only and CMBS principal only securities which are regularly-issued structured pass-through securities backed by multifamily mortgage loans. K-Series CMBS feature a wide range of investor options which include guaranteed senior and interest only bonds as well as unguaranteed mezzanine, subordinate and interest only bonds which are issued by Freddie Mac. Our K-Series CMBS portfolio includes unguaranteed senior, mezzanine, subordinate and interest only bonds. In Item 7, we have categorized Freddie Mac K-Series CMBS interest only bonds as part of our “CMBS Interest Only” assets.
We have also invested in residential and commercial mortgage loans, including RPLs and NPLs, as well as excess mortgage servicing rights (“MSRs”). We have the discretion to invest in other target assets such as other real estate structured finance products, other real estate-related loans and securities and interests in certain types of real estate. Non-Agency RMBS, ABS, CMBS, MSRs and residential and commercial mortgage loans are referred to as our “credit portfolio”, or “credit investments”, and residential and commercial mortgage loans are collectively referred to as loans. We use the term “credit securities” to refer to our credit portfolio excluding loans and MSRs. Additionally, we use the term “real estate securities” or “securities” to refer to our Agency RMBS portfolio and our credit securities.
As of December 31, 2015 and per our GAAP consolidated balance sheet, we have a $2.8 billion investment portfolio comprised of real estate securities, loans and MSRs, which consists of $1.2 billion, or 43.4%, of Agency RMBS and $1.6 billion, or 56.6%, of assets in our credit portfolio. Our investment portfolio including TBAs in the Agency RMBS category and inclusive of investments held within affiliated entities in the credit investments category is $2.9 billion, which consists of $1.3 billion, or 44.2%, of Agency RMBS and $1.6 billion, or 55.8%, of assets in our credit portfolio. Refer to Note 3 in Item 8 of this Annual Report on Form 10-K for the year ending December 31, 2015 (“Annual Report”) for a discussion of investments held within affiliated entities. We utilize multiple hedging instruments as a means to mitigate interest rate risk. As of December 31, 2015 we had entered into $1.0 billion notional amount of interest rate swaps and $226.0 million notional amount of long positions in U.S. Treasury securities. This compares with a $3.3 billion investment portfolio as of December 31, 2014, comprised of real estate securities, loans, and MSRs, which consisted of $1.8 billion, or 55.2%, of Agency RMBS and $1.5 billion, or 44.8%, of assets in our credit portfolio per our GAAP consolidated balance sheet. Our investment portfolio including TBAs in the Agency RMBS category and gross of linked transactions and investments held within affiliated entities in the credit investments category was $3.7 billion, which consisted of $2.0 billion, or 55.4% of Agency RMBS and $1.7 billion, or 44.6%, of assets in our credit portfolio as of December 31, 2014. We had entered into $1.4 billion notional amount of interest rate swaps as of December 31, 2014. The Company had no positions in U.S. Treasury securities on December 31, 2014.
Our stock
We were incorporated in Maryland on March 1, 2011, and commenced operations in July 2011 when we successfully completed our initial public offering, or IPO. Concurrently with the consummation of our IPO, we completed a private placement offering of units to a limited number of investors qualifying as “accredited investors” under Rule 501 of Regulation D promulgated under the Securities Act. Each unit consisted of one share of common stock (“private placement share”) and a warrant (“private placement warrant”) to purchase 0.5 of a share of common stock. Each private placement warrant had an exercise price of $20.50 per share (as adjusted for reorganizations, reclassifications, consolidations, mergers, sales, transfers or other dispositions). Collectively, we received net proceeds from our IPO, the private placement and the exercise of the underwriters’ over-allotment option of approximately $198.1 million after subtracting expenses incurred.
In 2012 we raised (i) approximately $353.5 million in net proceeds from sales of common stock through public offerings, our equity distribution program, and the exercise of warrants and (ii) approximately $161.2 million in net proceeds from two preferred stock offerings. In 2013 we raised approximately $33.2 million in net proceeds from sales of common stock through our equity distribution program and upon the exercise of warrants. We did not sell any additional shares of common stock in 2014 or 2015 through public offerings. We did not issue any additional classes of preferred stock during 2013, 2014 or 2015.
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In November 2015, our board of directors authorized a stock repurchase program (the “Repurchase Program”) to repurchase up to $25.0 million of our outstanding common stock. The Repurchase Program does not have an expiration date. As of December 31, 2015, we repurchased 126,715 shares of common stock at a total cost of approximately $1.7 million and at an average cost per share of $13.19. As of December 31, 2015, approximately $23.3 million of common stock remained authorized for future share repurchases under the Repurchase Program. See Item 5 for more detail.
Our common stock is traded on the New York Stock Exchange, or NYSE, under the ticker symbol MITT. Our 8.25% Series A Cumulative Redeemable Preferred Stock and our 8.00% Series B Cumulative Redeemable Preferred Stock trade on the NYSE under the ticker symbols MITT-PA and MITT-PB, respectively.
Our manager
We are externally managed and advised by AG REIT Management, LLC, a subsidiary of Angelo, Gordon. Angelo, Gordon was founded in 1988 and is an SEC-registered investment adviser with approximately $25 billion under management as of December 31, 2015. Currently, the firm's investment disciplines encompass six principal areas: (i) distressed debt and non-investment grade corporate credit, (ii) direct lending, (iii) real estate private equity, real estate debt and net lease real estate, (iv) residential and consumer debt, (v) private equity and special situations and (vi) multi-strategy hedge funds. Angelo, Gordon employs over 380 employees, including more than 140 investment professionals, and is headquartered in New York, with associated offices in Amsterdam, Chicago, Houston, Los Angeles, London, Hong Kong, Seoul, Sydney and Tokyo.
Pursuant to the terms of our management agreement with AG REIT Management LLC, our Manager provides us with our management team, including our officers, along with appropriate support personnel. All of our officers are employees of Angelo, Gordon or its affiliates. We do not have any employees. Our Manager is at all times subject to the supervision and oversight of our board of directors and has only such functions and authority as our board of directors delegates to it. Our Manager, pursuant to a delegation agreement dated as of June 29, 2011, has delegated to Angelo, Gordon the overall responsibility with respect to our Manager’s day-to-day duties and obligations arising under our management agreement.
Market and interest rate trends
Residential market opportunities
Inclusive of distressed sales, home prices nationwide increased by 6.3 percent on a year-over-year basis in December 2015 as compared with December 2014, according to data released by CoreLogic. This marks the 46th consecutive monthly increase year-over-year in national home prices. The housing market remains strong, however, given the duration and strength of the recovery, additional over-performance is expected to be somewhat muted for the rest of 2016. The U.S. government agencies and central bank policy sponsorship of housing via lower mortgage rates and potential loosening of credit available to potential homeowners, coupled with a stable broader domestic economy, have provided some support for the housing market recovery.
According to CoreLogic, the percent of all residential properties with a mortgage that was in a negative equity position, or underwater, decreased in the third quarter of 2015 to 8.1%, or 4.1 million homes, from 8.7%, or 4.4 million homes, in the prior quarter. A homeowner with negative equity means that such homeowner owes more on the home than the home is worth, which is also referred to as being underwater. For much of the country, the negative equity epidemic that developed during the 2008-2009 recession is lifting due to the rise in home prices over the past three years. CoreLogic predicts home prices will rise an additional 5.0% in 2016. If this occurs, 800,000 homeowners could regain positive equity. Additionally, credit performance in terms of serious delinquencies and subsequent default rates continued to improve in 2015 and is anticipated to remain positive in the near future. We believe that current prices for certain Non-Agency RMBS offer attractive risk-adjusted returns. We believe Angelo, Gordon’s granular credit-centric approach and deep understanding of government public policy initiatives will provide our Manager strong insight into both Non-Agency and Agency RMBS performance drivers.
During the fourth quarter of 2014, the Federal Open Market Committee (“FOMC”) officially exited its large scale asset purchase program, commonly referred to as quantitative easing (QE). However, it continued to maintain its existing policy of reinvesting principal payments from its holdings of Agency RMBS into new purchases of Agency RMBS and of rolling over maturing U.S. Treasury securities at auction through an unspecified date in the future.
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In December 2015, the FOMC decided to raise interest rates by 0.25%, marking the end of a seven year period where the federal funds rate was held near zero to support the recovery of the economy from the financial crisis. The FOMC stated that the process of normalizing interest rates is likely to proceed gradually and future policy actions depend on how the economy evolves relative to the FOMC’s objectives of maximum employment and 2% inflation. In the aftermath of the FOMC’s announcement, increases in funding costs put downward pressure on net interest margin.
The Federal Reserve (the “Fed”), in its December 16, 2015 announcement, cautioned capital markets to anticipate the possibility of one or more additional increases in the Federal funds rate in 2016, depending on future growth in inflation and other economic indicators. Fed Chair Janet Yellen, in her remarks following the December FOMC policy meeting, stated that monetary policy remains “accommodative” following the initial rise in the Federal funds rate. Together with increasingly negative economic data reported to date in 2016, many market participants are increasingly skeptical of additional increases in the Federal funds rate in the foreseeable future. Ultimately, the nature of the economic data we receive in the coming quarters, and the market’s interpretation of the Federal Reserve’s response to that data will drive direction, magnitude and volatility of benchmark interest rates and the related fixed income markets.
The initial reading on fourth quarter GDP decelerated to 0.7% as compared to 2.0% in the third quarter. Weighing on activity was a modest slowdown in personal consumption expenditures, continued weakness in fixed investment due to sharp declines in the oil and gas industry, and the ongoing decline in private inventory growth rates in response to the excess accumulation of inventories in prior periods. On a positive note, residential fixed investment continues to grow at a healthy rate (8.1% annual rate in Q4) in response to modestly robust housing demand and relatively low levels of housing inventory.
In December 2015, non-farm payrolls expanded at 292,000 jobs per month, increasing the three month moving average to 284,000 per month. Most indicators of housing activity continue to show slow but steady progress. While the consumption component of GDP data in recent quarters has been encouraging, fourth quarter retail sales readings have lost momentum. Consumption came in softer at 2.2% in the fourth quarter versus 3.0% in the third quarter. Generally, consumption appears to be on solid footing but overall GDP growth is being constrained by a lack of investment and a slowing inventory growth rate. Manufacturing activity and exports continue to suffer from dollar strength and weigh down overall activity in the fourth quarter. On the inflation front, core Personal Consumption Expenditures (“PCE”) and average hourly earnings continue to fall short of where the Fed would like to see them.
Credit markets experienced a tough fourth quarter of 2015, and it was a disappointing second half of 2015 for RMBS and ABS assets. Credit concerns, underperformance and lack of liquidity in other credit markets overwhelmed the mortgage and asset backed sectors. MBS and ABS credit spreads widened during the quarter as fears of a global contagion from China’s economic slowdown accelerated, the price of oil continued to slide and a lack of liquidity spread across most capital markets. Primary issuance of MBS was anemic and many issuers were forced to postpone new offerings until the market demand improved. By December the majority of market participants were relatively inactive for the rest of the year, with scant interest in positioning securities or making markets.
Agency MBS had a difficult fourth quarter versus swap hedges. Continuing the trend that began in the third quarter of 2015, interest rate swaps used for interest rate hedging by most mortgage and ABS investors outperformed both MBS and credit securities. As a result, the spread on MBS and ABS assets, relative to our interest rate swap hedges widened, during the quarter, driving a decline in book value. The driving forces behind swap spread outperformance of both benchmark treasuries and spread products continued to be corporate bond issuance, global cross border capital movements and related selling of US dollar denominated reserve assets to holders that are more likely to require bank balance sheet funding.
Non-mortgage consumer credit experienced some divergence in performance between credit card delinquencies, which remained at historical lows, and defaults on auto, equipment and student loans, which increased modestly. Consumer mortgage credit continued its pattern of stable to modest improvement in borrower performance. Home prices also continued to modestly rise and inventory levels remain light to tight in many major markets. Consumer appetite for housing continued to remain stable with expanding mortgage credit availability taking hold in the markets.
The rise in savings rates since the financial crisis, continued low interest rates, steady employment gains and most recently a decline in energy costs have all contributed to significant improvement in the consumer’s balance sheet. This continues to fuel our optimism about the prospects of further housing recovery and longer term moderate home price appreciation. The U.S. housing market still benefits from favorable supply/demand dynamics, historically low mortgage rates and willingness on the part of federal regulators at the Federal Housing Finance Agency (“FHFA”) to further credit expansion and assist household formation. However, we expect that, without an increase in median income, the pace of home price appreciation is likely to moderate over the coming years.
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The market movements outlined above have had a meaningful impact on our existing portfolio and may also have a significant impact on our operating results going forward. We believe current market dynamics may impact the availability and cost of financing.
We expect that overall market conditions will continue to impact our operating results and will cause us to adjust our investment and financing strategies over time as new opportunities emerge and risk profiles of our business change.
Recent government activity
On January 12, 2016, the FHFA issued RIN 2590-AA39, Members of Federal Home Loan Banks (the “Final Rule”). The Final Rule, among other things, expressly excludes captive insurance companies, such as MITT Insurance Company LLC (“MITT Insurance”), from being eligible for membership in the Federal Home Loan Bank (the “FHLB”) system. Under the Final Rule, there is a one-year transition period from the effective date, February 19, 2016 (the “Effective Date”) within which the FHLB must wind down its relationships with any captive insurance companies that had been admitted to membership in the FHLB on or after September 12, 2014, including MITT Insurance (“Excluded Captives”). The Final Rule also prevents the FHLB from making any new advances or extending any existing advances to Excluded Captives after the Effective Date. In addition, upon the termination of membership, the FHLB must liquidate all outstanding advances to Excluded Captives, settle all other business transactions, and repurchase or redeem all FHLB stock held by the terminated Excluded Captive in accordance with the Final Rule. Therefore, MITT Insurance, along with all other Excluded Captives, must completely wind down all business relationships with the FHLB, including the repayment of all outstanding advances, prior to or simultaneously with the termination of MITT Insurance’s membership with the Federal Home Loan Bank of Cincinnati (the “FHLBC”) where it is a member.
The adopting release for the Final Rule expressly invited Congress to address the treatment of Excluded Captives with respect to membership in the FHLB. In October 2015, Reps. Blaine Luetkemeyer (R-Mo.), Denny Heck (D-Wash.), Patrick McHenry (R-N.C.) and John Carney (D-Del.) introduced H.R. 3808, a bill that would have preemptively prevented the FHFA from adopting the Final Rule. There can be no way of predicting if any subsequent legislation addressing the status of Excluded Captives with respect to the FHLB will be proposed in either house of Congress, the likelihood of passage of any such legislation, or the ultimate effects, if any, on the availability of short-term, low-cost funding provided by the FHLBs to Excluded Captives subsequent to the enactment of any such legislation.
Housing finance reform proposals relating to Fannie Mae, Freddie Mac and Ginnie Mae are expected to remain prominent topics during the 114th U.S. Congress which began on January 3, 2015. Restructuring or winding down Fannie Mae and Freddie Mac had been stated goals of both houses of Congress, and also the Obama administration, during the 113th U.S. Congress.
On June 25, 2013, Senators Bob Corker (R-TN) and Mark Warner (D-VA) sponsored the Housing Finance Reform and Taxpayer Protection Act of 2013 (the “Corker-Warner Bill”) into the U.S. Senate. While the Corker-Warner Bill appeared to have lost momentum after the introduction of a competing bill in 2014, the Corker-Warner Bill was re-introduced in the U.S. Senate in September 2015 by its original sponsors, joined by Senators Elizabeth Warren (D-MA) and David Vitter (R-LA). As originally drafted, the Corker-Warner Bill has three key provisions:
| • | the establishment of the Federal Mortgage Insurance Corporation (the “FMIC”); |
| • | the creation of a Mortgage Insurance Fund (the “Fund”); and |
| • | the wind-down of Fannie Mae and Freddie Mac. |
The FMIC would be a government guarantor modeled after the Federal Deposit Insurance Corporation (the “FDIC”) in that it would collect insurance premiums and maintain a deposit fund on all outstanding obligations. Every mortgage-backed security issued through the FMIC would have a private investor bearing the first risk of loss and holding at least $0.10 in equity capital for every dollar of risk. This private capital buffer is intended to protect taxpayers from the risk of default on the mortgages underlying securities issued by the FMIC. Thus, the ultimate purpose of the FMIC would be to require credit investors to bear the initial risk of default on MBS.
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The Federal Housing Finance Authority (the “FHFA”) would be abolished after the establishment of the FMIC, and all current responsibilities of the FHFA, as well as its resources, would be transferred to the FMIC. In particular, the Corker-Warner Bill specifies that the FMIC would maintain a database of uniform loan-level information on eligible mortgages, develop standard uniform securitization agreements and oversee the common securitization platform currently being developed by the FHFA. In the event losses due to default on underlying mortgages exceed the first position losses of private credit investors in securities issued by the FMIC, the FMIC would cover such losses out of the Fund (described below). The Corker-Warner Bill specifies that the FMIC would endeavor to attain a reserve balance of 1.25% of the aggregate outstanding principal balance of covered securities within five years of the establishment of the FMIC and 2.50% of such amount within ten years of the establishment of the FMIC. The Fund would be paid with insurance premiums, akin to user fees, paid by private investors with various reporting requirements. The Corker-Warner Bill would revoke the charters of Fannie Mae and Freddie Mac upon the establishment of the FMIC. Fannie Mae and Freddie Mac would wind down as expeditiously as possible while maximizing returns to taxpayers as their assets are sold off.
In March 2015, housing and mortgage financial reform legislation, H.R. 1491, was proposed by congressmen John Delaney (D-MD), John Carney (D-DE) and James A. Himes (D-CT), each of whom is a member of the House Financial Services Committee. The bill is called The Partnership to Strengthen Homeownership Act, and is similar to one introduced by the same congressmen in the last Congress (H.R. 5055), which never made it out of committee. Under this proposed legislation, all government guaranteed single-family and multi-family MBS would be supported by a minimum of 5% private sector capital, which would stand in a first loss position. The remaining 95% of the risk would be shared between Ginnie Mae and a private reinsurer on a pari passu basis. Fees paid to Ginnie Mae for providing these securities would be allocated to affordable housing programs. Under the bill, Freddie Mac and Fannie Mae would be wound down over a five-year period, and their multifamily businesses would be spun out as separate entities. Ginnie Mae would be required to create and implement a workable multifamily guarantee that utilizes private sector pricing consistent with the single family model. The GSEs’ current multifamily businesses would continue to function within the new multifamily housing market as purely private organizations with an explicit government guarantee provided by Ginnie Mae and a private sector reinsurer.
We expect debate and discussion on residential housing and mortgage reform to continue over the next few years; however, we cannot be certain if or when H.R. 1491, the Corker-Warner Bill or any other housing finance reform bill will emerge from committee or be approved by Congress, and if so, what the effects may be. Historically, significant legislation has been difficult to pass in a presidential election year, and we cannot predict what effect the 2016 election cycle will have on the progress of housing finance reform legislation.
In addition to housing finance reform legislation, in May 2014, FHFA Director Mel Watt presented the 2014 Strategic Plan for the Conservatorship of Fannie Mae and Freddie Mac, and the 2014 Conservatorship Scorecard for Fannie Mae and Freddie Mac focusing on how FHFA will manage the conservatorships of Fannie Mae and Freddie Mac under its present statutory mandates. The Strategic Plan tends to favor policies that promote housing affordability, expand credit availability for new and refinanced mortgages, and increase the role of private capital in the mortgage market.
In August 2014, in the first step of what is expected to be a multi-year effort, the FHFA requested industry input on the development of a common mortgage-backed security under the auspices of both Fannie Mae and Freddie Mac. Under the current proposal, the common mortgage-backed security would leverage their existing security structures and would encompass many of the pooling features of the current Fannie Mae mortgage-backed security and more of the disclosure framework of the current Freddie Mac participation certificate.
In October 2014, FHFA Director Watt announced a number of general policy initiatives by the FHFA, including restoring a program that allows Fannie Mae and Freddie Mac to guarantee loans with down payments as low as 3%. Director Watt also said that the FHFA was taking steps to bring certainty to the circumstances under which Fannie Mae and Freddie Mac will require originators to repurchase defaulted mortgages that were later discovered to have underwriting defects. In November 2014, the FHFA also increased the 2014 Conservatorship Scorecard targets for Fannie Mae and Freddie Mac to complete credit risk transfers involving at least $90 billion in unpaid principal balance of single-family mortgages, up from $30 billion in 2013, and has encouraged Fannie Mae and Freddie Mac to test multiple types of credit risk transfer structures, including securities-based transactions and insurance transactions. Under the terms of their agreements with the U.S. Treasury Department, Fannie Mae and Freddie Mac, under the direction of the FHFA, also continue to reduce the size of their retained mortgage portfolios.
Furthermore, in October 2014, the FHFA, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Securities And Exchange Commission, the Federal Reserve System and the Department of Housing and Urban Development adopted a final rule implementing the credit risk retention requirements of Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, for asset-backed securities. As required by the Dodd-Frank Act, the final credit risk retention rule generally require “securitizers” to retain not less than 5% of the credit risk of the mortgage loans securitized. The credit risk retention requirements applicable to RMBS became effective as of December 31, 2015.
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Our strategies
Our investment strategy
We invest in a diversified pool of mortgage assets that generate attractive risk-adjusted returns to our investors over the long-term through a combination of dividends and capital appreciation. Our target assets include Agency RMBS, Non-Agency RMBS, ABS, CMBS, MSRs, residential and commercial loans and other real estate-related assets. Following our IPO, the risk-reward profile of investment opportunities supported the deployment of a majority of our capital into Agency RMBS. We believe that yields and net interest spreads on Agency RMBS that are currently available for investment are generally lower than what we have historically realized in our portfolio. Our goal for much of 2015, and looking forward to 2016, centers around deploying an increasing portion of our capital into attractive credit investments, including residential and commercial real estate loans.
As of December 31, 2015, the fair value of our investment portfolio on a non-GAAP basis, inclusive of TBAs, consisted of 44.2% Agency RMBS, 45.1% residential investments, 8.8% commercial investments and 1.9% ABS. This compares with 2014, when the fair value of our investment portfolio on a non-GAAP basis, inclusive of TBAs, consisted of 55.4% Agency RMBS, 37.4% residential investments, 5.4% commercial investments and 1.8% ABS.
Our financing and hedging strategy
We generate income principally from the yields earned on our investments and, to the extent that leverage is deployed, on the difference between the yields earned on our investments and our cost of borrowing and any hedging activities. Subject to maintaining our qualification as a REIT for U.S. federal income tax purposes and our Investment Company Act exemption, to the extent leverage is deployed, we may use a number of sources to finance our investments.
We use leverage to increase potential returns to our stockholders and to fund the acquisition of our assets. We define “Non-GAAP Leverage” as the sum of repurchase agreements, inclusive of repurchase agreements accounted for as linked transactions and those held through affiliated entities, advances from the Federal Home Loan Bank of Cincinnati (“FHLBC Advances”), the payable on unsettled buys less the financing on unsettled sells, and the consolidated tranche issued by the consolidated VIE which is classified as “Securitized debt” on our consolidated balance sheet. Leverage excludes repurchase agreements and net receivables/payables on unsettled trades pertaining to U.S. Treasury securities due to the highly liquid and temporary nature of these investments. We define “at risk” leverage as non-GAAP leverage inclusive of our net TBA position (at cost). These calculations divide leverage by our GAAP stockholders equity. As of December 31, 2015 our non-GAAP “at-risk”, non-GAAP and GAAP debt-to-equity leverage ratios were 3.53 to 1, 3.42 to 1, and 3.39 to 1, respectively, which reflect our current mix of Agency RMBS and credit portfolio. As of December 31, 2014 our non-GAAP “at risk”, non-GAAP and GAAP debt-to-equity leverage ratios were 4.17 to 1, 3.85 to 1, and 3.66 to 1. For a tabular representation of the above, refer to the “Financing activities” section of Item 7.
We currently finance our investments primarily through short-term borrowings structured as repurchase agreements and through FHLBC Advances. As of December 31, 2015 and December 31, 2014, we either directly or through our equity method investments in affiliates, had entered into master repurchase agreements, (“MRAs”), or loan agreements with 38 and 35 counterparties, respectively, under which we had borrowed an aggregate $2.5 billion and $2.8 billion, respectively, on a non-GAAP basis from 21 and 24 counterparties, respectively. As of December 31, 2015, the borrowings under our financing arrangements had maturities between January 4, 2016 and September 17, 2019, and as of December 31, 2014, the borrowings under repurchase agreements had maturities between January 2, 2015 and September 17, 2019.
In July 2015, our captive insurance subsidiary, MITT Insurance, was granted membership in the FHLBC and commenced obtaining advances from the FHLBC. Membership in the FHLBC permits MITT Insurance to access a variety of products and services offered by the FHLBC, including low-cost financing to finance our Agency RMBS, and obligates MITT Insurance to purchase FHLBC membership stock and activity stock, the latter being a percentage of the advances it obtains from the FHLBC. As with our repurchase agreement borrowings, if the value of any assets pledged to the FHLBC as collateral for advances decreases, the FHLBC could require posting of additional collateral to the amount of advances outstanding. As a result of the Final Rule, MITT Insurance must wind down its membership with the FHLBC by February 19, 2016. The Final Rule also prevented MITT Insurance from taking any new advances or extending and existing advances from the FHLBC.
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Subject to maintaining our qualification as a REIT and our Investment Company Act exemption, to the extent leverage is deployed, we utilize derivative financial instruments (or hedging instruments), including interest rate swap agreements, TBAs, interest rate swaptions, credit derivatives and non-derivative instruments including Agency interest-only securities and long or short positions in U.S. Treasury securities in an effort to hedge the interest rate risk associated with the financing of our portfolio. Specifically, we may seek to hedge our exposure to potential interest rate mismatches between the interest we earn on our investments and our borrowing costs caused by fluctuations in short-term interest rates. In utilizing leverage and interest rate hedges, our objectives are to improve risk-adjusted returns and, where possible, to lock in, on a long-term basis, a spread between the yield on our assets and the cost of our financing. As of December 31, 2015, we had entered into $1.0 billion notional of interest rate swaps that have variable maturities between October 30, 2017 and June 5, 2025, and $226.0 million notional of long positions in U.S. Treasury securities that have variable maturities between September 15, 2018 and September 30, 2022. As of December 31, 2014 we had entered into $1.4 billion notional of interest rate swaps that have variable maturities between May 27, 2017 and March 5, 2024. We had no positions in U.S. Treasury securities on December 31, 2014.
Risk management strategy
Our overall portfolio strategy is designed to generate attractive returns through various phases of the economic cycle. We believe that our broad approach within the real estate market, which considers all major categories of real estate assets, allows us to invest in a variety of attractive investment opportunities and help insulate our portfolio from some of the risks that arise from investing in a single collateral type.
The components of our risk management strategy are:
| • | Disciplined adherence to risk-adjusted return. Our Manager deploys capital only when it believes that risk-adjusted returns are attractive. In this analysis, our Manager considers the initial net interest spread of the investment, the cost of hedging and our ability to optimize returns over time through rebalancing activities. Our Manager’s management team has extensive experience implementing this approach. | |
| • | Focus on multiple sectors. Our Manager looks for attractive investment opportunities in all major sectors of the U.S. mortgage market. Our management team evaluates investment opportunities in residential mortgage loans and securities (prime conforming, jumbo, Alt-A, and subprime) and across a wide spectrum of commercial property types. We believe this approach enables our Manager to identify attractive investments when it believes certain portions of the market are attractively priced or when investment opportunities in one or more sectors are scarce. By pursuing a broad investment strategy within the mortgage market, we believe our mortgage portfolio is less exposed to dislocations in specific sectors of the market. We believe a diversified mortgage portfolio outperforms the traditional single strategy portfolios in the REIT market, with returns more resistant to changes in the interest rate and consumer credit environment. | |
| • | Concurrent evaluation of interest rate and credit risk. Our Manager seeks to balance our portfolio with both credit risk-intensive assets and interest rate risk-intensive assets. Both of these primary risk types are evaluated against a common risk-adjusted return framework. | |
| • | Active hedging and rebalancing of portfolio. Our Manager periodically evaluates our portfolio against preestablished risk tolerances and will take corrective action through asset sales, asset acquisitions, and dynamic hedging activities to bring the portfolio back within these risk tolerances. We believe this approach generates more attractive long-term returns than an approach that either attempts to hedge away a majority of the interest rate and/or credit risk in the portfolio at the time of acquisition, on the one end of the risk spectrum, or a highly speculative approach that does not attempt to hedge any of the interest rate or credit risk in the portfolio on the other end of the risk spectrum. | |
| • | Opportunistic approach to increased risk. Our Manager’s investment strategy is to preserve our ability to extend risk taking capacity during periods of changing market fundamentals. |
Our investments
Our target asset classes
As of December 31, 2015, the fair value of our investment portfolio on a non-GAAP basis, inclusive of TBAs comprised 44.2% of Agency RMBS, 42.9% of Non-Agency RMBS, 1.9% of ABS, 6.4% of CMBS, 2.2% residential mortgage loans, 2.4% commercial loans and 0.0% excess mortgage servicing rights. We have the discretion to invest in these and other target assets (as described below).
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Our target asset classes and the principal investments in which we invest are as follows:
|
Asset Class |
Principal Investments | |
| Agency RMBS | • RMBS for which a U.S. government agency such as the Government National Mortgage Association, or Ginnie Mae, or a federally-chartered corporation such as the Federal National Mortgage Association, or Fannie Mae, or the Federal Home Loan Mortgage Corporation, or Freddie Mac, guarantees payments of principal and interest on the securities they issue. | |
| Non-Agency RMBS | • Fixed- and floating-rate residential Non-Agency RMBS, including investment grade and non-investment grade classes. The mortgage loan collateral for residential Non-Agency RMBS consists of residential mortgage loans that do not generally conform to underwriting guidelines issued by U.S. government agencies or U.S. government-sponsored entities. | |
| Other real estate-related assets and financial assets |
• Fixed- and floating-rate CMBS, including investment grade and non-investment grade classes. CMBS are secured by, or evidence ownership interest in, a single commercial mortgage loan or a pool of commercial mortgage loans.
• Residential mortgage loans secured by residential real property, including prime, Alt-A, and subprime mortgage loans.
• Commercial mortgage loans secured by commercial real property, including mezzanine loans and preferred equity.
• First or second lien loans, subordinate interests in first mortgages, bridge loans to be used in the acquisition, construction or redevelopment of a property and mezzanine financing secured by interests in commercial real estate.
• Other real estate structured finance products, MSRs, other real estate-related loans and securities and other financial assets.
• Investment grade and non-investment grade debt and equity tranches of securitizations backed by various asset classes including, but not limited to, small balance commercial mortgages, aircraft, automobiles, credit cards, equipment, manufactured housing, franchises, recreational vehicles and student loans. Investments in ABS generally are not qualifying income for purposes of the 75% asset test applicable to REITs and generally do not generate qualifying income for purposes of the 75% income test applicable to REITs. As a result we may be limited in our ability to invest in such assets.
• Interests in certain types of real estate. |
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Our board of directors has adopted a set of investment guidelines that outline our target assets and other criteria which are used by our Manager to evaluate specific investment opportunities as well as our overall portfolio composition. Our Manager makes day-to-day determinations as to the timing and percentage of our assets that will be invested in each of the approved asset classes. Our decisions depend upon prevailing market conditions and may change over time in response to opportunities available in different interest rate, economic and credit environments. As a result, we cannot predict the percentage of our assets that will be invested in any one of our approved asset classes at any given time. We may change our strategy and policies without a vote of our stockholders. We believe that the diversification of our portfolio of assets and the flexibility of our strategy combined with our Manager’s and its affiliates’ experience will enable us to achieve attractive risk-adjusted returns under a variety of market conditions and economic cycles.
Investment policies
Investment guidelines
We comply with investment policies and procedures and investment guidelines that are approved by our board of directors and implemented by our Manager. Our Chief Investment Officer reports on our investment portfolio at each regularly scheduled meeting of our board of directors. Our independent directors do not review or approve individual investment, leverage or hedging decisions made by our Manager.
Our board of directors has adopted the following guidelines, among others, for our investments and borrowings:
| • | no investment shall be made that would cause us to fail to qualify as a REIT for federal income tax purposes; |
| • | no investment shall be made that would cause us to be regulated as an investment company under the Investment Company Act; and |
| • | our investments will be in our target assets. |
These investment guidelines may be changed by our board of directors without the approval of our stockholders.
Distribution policy
The following tables detail our common stock dividends during the years ended December 31, 2015, 2014 and 2013:
| 2015 | ||||||||||||||
| Declaration Date | Record Date | Payment Date | Dividend Per Share | |||||||||||
| 3/12/2015 | 3/23/2015 | 4/30/2015 | $ | 0.60 | ||||||||||
| 6/11/2015 | 6/22/2015 | 7/31/2015 | 0.60 | |||||||||||
| 9/10/2015 | 9/21/2015 | 10/30/2015 | 0.60 | |||||||||||
| 12/10/2015 | 12/21/2015 | 1/29/2016 | 0.475 | |||||||||||
| 2014 | ||||||||||||||
| Declaration Date | Record Date | Payment Date | Dividend Per Share | |||||||||||
| 3/5/2014 | 3/18/2014 | 4/28/2014 | $ | 0.60 | ||||||||||
| 6/9/2014 | 6/19/2014 | 7/28/2014 | 0.60 | |||||||||||
| 9/11/2014 | 9/22/2014 | 10/27/2014 | 0.60 | |||||||||||
| 12/4/2014 | 12/18/2014 | 1/27/2015 | 0.60 | |||||||||||
| 2013 | ||||||||||||||
| Declaration Date | Record Date | Payment Date | Dividend Per Share | |||||||||||
| 3/5/2013 | 3/18/2013 | 4/26/2013 | $ | 0.80 | ||||||||||
| 6/6/2013 | 6/18/2013 | 7/26/2013 | 0.80 | |||||||||||
| 9/9/2013 | 9/19/2013 | 10/28/2013 | 0.60 | |||||||||||
| 12/5/2013 | 12/18/2013 | 1/27/2014 | 0.60 | |||||||||||
We intend to continue to make regular quarterly distributions to holders of our common stock. We generally need to distribute at least 90% of our ordinary taxable income each year (subject to certain adjustments) to our stockholders in order to qualify as a REIT under the Internal Revenue Code of 1986, as amended, or the Code. Our ability to make distributions to our stockholders depends, in part, upon the performance of our investment portfolio. Distributions to our stockholders are generally taxable to our stockholders as ordinary income, although a portion of our distributions may be designated by us as capital gain or qualified dividend income or may constitute a return of capital. For the years ended December 31, 2015 and December 31, 2014, we elected to satisfy the REIT distribution requirements in part with a dividend paid in 2016 and 2015, respectively. In conjunction with this, we accrued an excise tax of $1.7 million and $1.7 million in 2015 and 2014, respectively, which is included in the “Taxes payable” line item on the consolidated balance sheet in Item 8.
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The following tables detail our preferred stock dividends during the years ended December 31, 2015, 2014 and 2013:
| 2015 | ||||||||||||||||
| Dividend | Declaration Date | Record Date | Payment Date | Dividend Per Share | ||||||||||||
| 8.25% Series A | 2/12/2015 | 2/27/2015 | 3/17/2015 | $ | 0.51563 | |||||||||||
| 8.25% Series A | 5/14/2015 | 5/29/2015 | 6/17/2015 | 0.51563 | ||||||||||||
| 8.25% Series A | 8/14/2015 | 8/31/2015 | 9/17/2015 | 0.51563 | ||||||||||||
| 8.25% Series A | 11/13/2015 | 11/30/2015 | 12/17/2015 | 0.51563 | ||||||||||||
| Dividend | Declaration Date | Record Date | Payment Date | Dividend Per Share | ||||||||||||
| 8.00% Series B | 2/12/2015 | 2/27/2015 | 3/17/2015 | $ | 0.50 | |||||||||||
| 8.00% Series B | 5/14/2015 | 5/29/2015 | 6/17/2015 | 0.50 | ||||||||||||
| 8.00% Series B | 8/14/2015 | 8/31/2015 | 9/17/2015 | 0.50 | ||||||||||||
| 8.00% Series B | 11/13/2015 | 11/30/2015 | 12/17/2015 | 0.50 | ||||||||||||
| 2014 | ||||||||||||||||
| Dividend | Declaration Date | Record Date | Payment Date | Dividend Per Share | ||||||||||||
| 8.25% Series A | 2/14/2014 | 2/28/2014 | 3/17/2014 | $ | 0.51563 | |||||||||||
| 8.25% Series A | 5/15/2014 | 5/30/2014 | 6/17/2014 | 0.51563 | ||||||||||||
| 8.25% Series A | 8/14/2014 | 8/29/2014 | 9/17/2014 | 0.51563 | ||||||||||||
| 8.25% Series A | 11/12/2014 | 11/28/2014 | 12/17/2014 | 0.51563 | ||||||||||||
| Dividend | Declaration Date | Record Date | Payment Date | Dividend Per Share | ||||||||||||
| 8.00% Series B | 2/14/2014 | 2/28/2014 | 3/17/2014 | $ | 0.50 | |||||||||||
| 8.00% Series B | 5/15/2014 | 5/30/2014 | 6/17/2014 | 0.50 | ||||||||||||
| 8.00% Series B | 8/14/2014 | 8/29/2014 | 9/17/2014 | 0.50 | ||||||||||||
| 8.00% Series B | 11/12/2014 | 11/28/2014 | 12/17/2014 | 0.50 | ||||||||||||
| 2013 | ||||||||||||||||
| Dividend | Declaration Date | Record Date | Payment Date | Dividend Per Share | ||||||||||||
| 8.25% Series A | 2/14/2013 | 2/28/2013 | 3/18/2013 | $ | 0.51563 | |||||||||||
| 8.25% Series A | 5/14/2013 | 5/31/2013 | 6/17/2013 | 0.51563 | ||||||||||||
| 8.25% Series A | 8/15/2013 | 8/30/2013 | 9/17/2013 | 0.51563 | ||||||||||||
| 8.25% Series A | 11/14/2013 | 11/29/2013 | 12/17/2013 | 0.51563 | ||||||||||||
| Dividend | Declaration Date | Record Date | Payment Date | Dividend Per Share | ||||||||||||
| 8.00% Series B | 2/14/2013 | 2/28/2013 | 3/18/2013 | $ | 0.50 | |||||||||||
| 8.00% Series B | 5/14/2013 | 5/31/2013 | 6/17/2013 | 0.50 | ||||||||||||
| 8.00% Series B | 8/15/2013 | 8/30/2013 | 9/17/2013 | 0.50 | ||||||||||||
| 8.00% Series B | 11/14/2013 | 11/29/2013 | 12/17/2013 | 0.50 | ||||||||||||
Our competitive advantages
We believe that our competitive advantages include the following:
Investment team with extensive RMBS experience
The experience of Angelo, Gordon investment professionals provides competitive advantages to us. Angelo, Gordon has over 140 investment professionals across its lines of investment disciplines. Of those, over 80 are involved in one of Angelo, Gordon’s real estate investment disciplines—RMBS, CMBS, commercial real estate, private equity real estate, real estate debt and net lease real estate. The insights, experience, and contacts of these professionals are available to us as a resource. Our Manager’s dedicated RMBS investment team is led by Jonathan Lieberman and has over 20 investment professionals, including portfolio managers, traders, analysts, and statisticians. The senior investment professionals have broad experience in managing residential mortgage-related assets through a variety of market cycles and credit and interest rate environments. The RMBS team has oversight from Michael Gordon, David Roberts and Jonathan Lieberman who have an average of over 35 years of investment experience. Angelo, Gordon is an established leader in the alternative investment field and its overall investment philosophy is credit and value-centric in that its investment process is based on a highly analytical framework and, with respect to RMBS, takes into account factors such as loan-level cash flows, historical and current borrower performance and collateral valuation.
Breadth of Angelo, Gordon’s experience
Although our core investment strategy is focused on RMBS, Angelo, Gordon’s expertise in related investment disciplines such as residential and consumer debt, commercial real estate debt, commercial real estate, net lease real estate, distressed credit, leveraged loans and private equity provides our Manager with both (i) valuable investment insights to our RMBS investment selection and strategy and (ii) flexibility to opportunistically invest in target assets other than RMBS as market conditions warrant. As market conditions change and new opportunities are created that are consistent with our strategy and are structurally appropriate for us, we believe Angelo, Gordon’s extensive experience can assist our Manager in moving quickly to take advantage of those opportunities on our behalf.
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Access to our Manager’s relationships
Angelo, Gordon has created a broad network of deal sources, including relationships with major issuers of residential debt securities and the broker-dealers that trade these securities, augmented by ongoing dialogue with a substantial number of smaller, regional firms that tend to find investment opportunities that are often priced and sold on an off-market basis. Our Manager’s investment team has extensive industry contacts and client relationships which have generated proprietary deal flow.
Disciplined investment approach and granular credit analysis
We seek to maximize our risk-adjusted returns through our Manager’s disciplined investment approach, which relies on rigorous quantitative and qualitative analysis. Our investment thesis is predicated upon in-depth loan-level analysis and our proprietary analytics, which allow us to underwrite loans individually based on updated borrower credit information and property attributes. Our focus on fundamental granular analysis remains the cornerstone of our investment philosophy, and we believe that through this approach we can identify attractive investment opportunities.
Access to Angelo, Gordon’s well developed infrastructure and asset management systems
Angelo, Gordon has invested and continues to invest in the technology, analytics and systems that we believe are required to effectively and comprehensively evaluate potential investments. Our Manager’s investment team and Angelo, Gordon’s technology group has developed proprietary databases, portfolio systems and quantitative models to enhance valuation analytics (pipeline modeling, roll rates and severity of loss, amongst others). Our Manager’s investment team has developed proprietary prepayment, default, delinquency roll rate and loss severity models to analyze current mark-to-market home values on a loan-by-loan basis using borrower monthly performance statistics, credit characteristics and home price appreciation (or depreciation) by metropolitan statistical area for most of the residential market.
Access to Angelo, Gordon’s accounting, tax and internal risk control management systems
Our Manager utilizes Angelo, Gordon’s well developed accounting, tax and internal control departments, comprising over 50 certified public accountants. Additionally, our Manager has access to Angelo, Gordon’s technology, client service, disaster recovery and operational infrastructure to support our operations. We believe that Angelo, Gordon has a strong reputation for risk management and compliance.
Operating and regulatory structure
REIT qualification
We have elected to be treated as a REIT under Sections 856 through 859 of the Code. Our qualification as a REIT depends upon our ability to meet on a continuing basis, through actual investment and operating results, various complex requirements under the Code relating to, among other things, the sources of our gross income, the composition and values of our assets, our distribution levels and the diversity of ownership of our shares. We believe that we are organized in conformity with the requirements for qualification and taxation as a REIT under the Code, and that our manner of operation enables us to meet the requirements for qualification and taxation as a REIT.
As a REIT, we generally are not subject to U.S. federal income tax on our REIT taxable income that we distribute currently to our stockholders. If we fail to qualify as a REIT in any taxable year and do not qualify for certain statutory relief provisions, we will be subject to U.S. federal income tax at regular corporate rates and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year during which we lost our REIT qualification. Accordingly, our failure to qualify as a REIT could have a material adverse impact on our results of operations and our ability to pay distributions, if any, to our stockholders. Even if we qualify for taxation as a REIT, we may be subject to some U.S. federal, state and local taxes on our income or property. In addition, any income earned by a domestic taxable REIT subsidiary, or TRS, will be subject to corporate income taxation.
Investment Company Act exemption
We conduct our operations so that we are not considered an investment company under Section 3(a)(1)(C) of the Investment Company Act. Under Section 3(a)(1)(C) of the Investment Company Act, a company is deemed to be an investment company if it is engaged, or proposes to engage, in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire “investment securities” having a value exceeding 40% of the value of its total assets (exclusive of U.S. government securities and cash items) on an unconsolidated basis, (“the 40% test”). “Investment securities” do not include, among other things, U.S. government securities, and securities issued by majority-owned subsidiaries that (i) are not investment companies and (ii) are not relying on the exceptions from the definition of investment company provided by Section 3(c)(1) or 3(c)(7) of the Investment Company Act.
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The operations of many of our wholly-owned or majority-owned subsidiaries’ are generally conducted so that they are exempted from investment company status in reliance upon Section 3(c)(5)(C) of the Investment Company Act. Because entities relying on Section 3(c)(5)(C) are not investment companies, our interests in those subsidiaries do not constitute “investment securities” for purposes of Section 3(a)(1)(C). To the extent that our direct subsidiaries qualify only for either Section 3(c)(1) or 3(c)(7) exemptions from the Investment Company Act, we limit our holdings in those kinds of entities so that, together with other investment securities, we satisfy the 40% test. Although we continuously monitor our and our subsidiaries’ portfolios on an ongoing basis to ensure compliance with that test, there can be no assurance that we will be able to maintain the exemptions from registration for us and each of our subsidiaries.
The method we use to classify our subsidiaries’ assets for purposes of Section 3(c)(5)(C) of the Investment Company Act is based in large measure upon no-action positions taken by the SEC staff. These no-action positions were issued in accordance with factual situations that may be substantially different from the factual situations we may face, and a number of these no-action positions were issued decades ago. No assurance can be given that the SEC or its staff will concur with our classification of our or our subsidiaries’ assets or that the SEC or its staff will not, in the future, issue further guidance that may require us to reclassify those assets for purposes of qualifying for an exclusion from registration under the Investment Company Act. In August 2011 the SEC solicited public comment on a wide range of issues relating to Section 3(c)(5)(C), including the nature of the assets that qualify for purposes of the exemption and leverage used by mortgage related vehicles. There can be no assurance that the laws and regulations governing the Investment Company Act status of companies primarily owning real estate related assets, including the SEC or its staff providing more specific or different guidance regarding these exemptions, will not change in a manner that adversely affects our operations. To the extent that the SEC or its staff provides more specific guidance regarding Section 3(c)(5)(C) or any of the other matters bearing upon the definition of investment company and the exceptions to that definition, we may be required to adjust our investment strategy accordingly. Additional guidance from the SEC or its staff could provide additional flexibility to us, or it could further inhibit our ability to pursue the investment strategy we have chosen.
Conducting our operations so as not to be considered an investment company under the Investment Company Act limits our ability to make certain investments. For example, these restrictions limit our and our subsidiaries’ ability to invest directly in mortgage-related securities that represent less than the entire ownership in a pool of mortgage loans, debt and equity tranches of securitizations, certain real estate companies or assets not related to real estate.
Restrictions on ownership and transfer of shares
Our charter, subject to certain exceptions, prohibits any person from directly or indirectly owning (i) more than 9.8% in value or in number of shares, whichever is more restrictive, of our outstanding common stock, or (ii) more than 9.8% in value or in number of shares, whichever is more restrictive, of our outstanding capital stock. We refer to those limitations in this report collectively as the share ownership limits. Our charter also prohibits any person from directly or indirectly owning shares of any class of our stock if such ownership would result in our being “closely held” under Section 856(h) of the Code or otherwise cause us to fail to qualify as a REIT.
Our charter generally provides that any capital stock owned or transferred in violation of the foregoing restrictions will be deemed to be transferred to a charitable trust for the benefit of a charitable beneficiary, and the purported owner or transferee will acquire no rights in such shares. If the foregoing is ineffective for any reason to prevent a violation of these restrictions, then the transfer of such shares will be void ab initio.
Competition
Our net income depends, in large part, on our ability to acquire assets at favorable spreads over our borrowing and hedging costs. In acquiring our investments, we compete with other REITs, specialty finance companies, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, financial institutions, governmental bodies, and other entities. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Market conditions.” In addition, there are numerous REITs and specialty finance companies with similar asset acquisition objectives. These other REITs and specialty finance companies increase competition for the available supply of mortgage assets suitable for purchase. Many of our competitors are significantly larger than we are, have access to greater capital and other resources and may have other advantages over us. In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships than we can. Current market conditions may attract more competitors, which may increase the competition for sources of financing. An increase in the competition for sources of financing could adversely affect the availability and cost of financing.
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We have access to our Manager’s professionals and their industry expertise, which we believe provides us with a competitive advantage. These professionals help us assess investment risks and determine appropriate pricing for certain potential investments. These relationships enable us to compete more effectively for attractive investment opportunities. Despite certain competitive advantages, we may not be able to achieve our business goals or expectations due to the competitive risks that we face.
Staffing
We are managed by our Manager pursuant to a management agreement. Our Manager, pursuant to a delegation agreement dated as of June 29, 2011, has delegated to Angelo, Gordon the overall responsibility with respect to our Manager’s day-to-day duties and obligations arising under our management agreement. In addition, all of our officers are employees of Angelo, Gordon or its affiliates. We have no employees. Angelo, Gordon has over 370 employees.
Available Information
Our principal executive offices are located at 245 Park Avenue, 26th Floor, New York, New York 10167. Our telephone number is (212) 692-2000. Our website can be found at www.agmit.com. We make available free of charge on, or through the SEC filings section of our website, access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as are filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as well as our proxy statements with respect to our annual meetings of stockholders, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Our Exchange Act reports filed with, or furnished to, the SEC are also available at the SEC’s website at www.sec.gov. The content of any website referred to in this Form 10-K is not incorporated by reference into this Form 10-K unless expressly noted. You also may inspect and copy these reports, proxy statements and other information, as well as the annual report and related exhibits and schedules, at the Public Reference Room of the SEC at 100 F Street, NE, Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
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If any of the following risks occur, our business, financial condition or results of operations could be materially and adversely affected. In that case, the trading price of our common stock could decline, and stockholders may lose some or all of their investment.
Risks related to our investments
The residential mortgage loans that we acquire, the mortgages underlying the RMBS that we acquire, the commercial mortgage loans we acquire, the commercial mortgage loans underlying the CMBS that we acquire and the assets underlying the ABS that we acquire are all subject to defaults, foreclosure timeline extension, fraud, price depreciation and unfavorable modification of loan principal amount, interest rate and premium, any of which could result in losses to us.
In the event of any default under a mortgage loan held directly by us or through a Non-Agency securitization structure we invest in, we bear a risk of loss of principal to the extent of any deficiency between the value of the collateral and the principal and accrued interest of the mortgage loan, which could have a material adverse effect on our cash flow from operations. In the event of the bankruptcy of a mortgage loan borrower, the mortgage loan to such borrower will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the mortgage loan will be subject to the avoidance powers of the bankruptcy trustee or debtor in possession to the extent the lien is unenforceable under state law. Foreclosure of a mortgage loan can be an expensive and lengthy process which could have a substantial negative effect on our anticipated return on the foreclosed mortgage loan.
Our investments in residential mortgage loans and Non-Agency RMBS are subject to the risks of defaults, foreclosure timeline extension, fraud and home price depreciation and unfavorable modification of loan principal amount, interest rate and amortization of principal, accompanying the underlying residential mortgage loans. The ability of a borrower to repay a mortgage loan secured by a residential property is dependent upon the income or assets of the borrower. A number of factors may impair borrowers’ abilities to repay their loans, including:
| • | adverse changes in national and local economic and market conditions; |
| • | the availability of affordable refinancing options; and |
| • | uninsured or under-insured property losses caused by earthquakes, floods and other natural disasters. |
In the event of defaults on the residential mortgage loans and residential mortgage loans that underlie our investments in RMBS and the exhaustion of any underlying or any additional credit support, we may not realize our anticipated return on our investments and we may incur a loss on these investments.
CMBS are secured by a single commercial mortgage loan or a pool of commercial mortgage loans. CMBS that we invest in are subject to all of the risks of the respective underlying commercial mortgage loans. Commercial mortgage loans are secured by multifamily or commercial property and are subject to risks of delinquency and foreclosure, and risks of loss that are greater than similar risks associated with loans made on the security of single-family residential property. The ability of a borrower to repay a loan secured by an income-producing property typically is dependent primarily upon the successful business operation of such property rather than upon the existence of independent income or assets of the borrower. If the net operating income of the property is reduced, the borrower’s ability to repay the loan may be impaired and duration may be extended. Net operating income of an income-producing property can be affected by a number of factors that include:
| • | overall macroeconomic conditions in the area in which the properties underlying the mortgages are located; | |
| • | tenant mix and the success of tenant businesses; |
| • | property location, condition and management decisions; |
| • | competition from comparable types of properties; and |
| • | changes in laws that increase operating expenses or limit rents that may be charged. |
ABS are securities backed by various asset classes including, but not limited to, small balance commercial mortgages, aircraft, automobiles, credit cards, equipment, manufactured housing, franchises, recreational vehicles and student loans. ABS remain subject to the credit exposure of the underlying receivables. In the event of increased rates of delinquency with respect to any receivables underlying our ABS, we may not realize our anticipated return on these investments.
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The failure of servicers to effectively service the mortgage loans underlying the RMBS in our portfolio or any mortgage loans we own may materially and adversely affect us.
Most residential mortgage loans and securitizations of residential mortgage loans require a servicer to manage collections on each of the underlying loans. Both default frequency and default severity of loans may depend upon the quality of the servicer. If servicers are not vigilant in encouraging borrowers to make their monthly payments, the borrowers may be far less likely to make these payments, which could result in a higher frequency of default. If servicers take longer to liquidate non-performing assets, losses may tend to be higher than originally anticipated. Higher losses may also be caused by less competent dispositions of real estate owned (“REO”) properties. The failure of servicers to effectively service the mortgage loans underlying the RMBS in our portfolio or any mortgage loans we own could negatively impact the value of our investments and our performance. Servicer quality is of prime importance in the default performance of residential mortgage loans and RMBS. Many servicers have gone out of business in recent years, requiring a transfer of servicing to another servicer. This transfer takes time, and loans may become delinquent because of confusion or lack of attention. When servicing is transferred, servicing fees may increase, which may have an adverse effect on the RMBS held by us. In the case of pools of securitized loans, servicers may be required to advance interest on delinquent loans to the extent the servicer deems those advances recoverable. In the event the servicer does not advance interest on delinquent loans, interest may not be able to be paid even on more senior securities. Servicers may also advance more interest than is in fact recoverable once a defaulted loan is disposed, and the loss to the trust may be greater than the outstanding principal balance of that loan (greater than 100% loss severity).
The expanding body of federal, state and local regulations and the investigations of servicers may increase their cost of compliance and the risks of noncompliance, and may adversely affect their ability to perform their servicing obligations.
We have engaged, and we depend upon, third-party mortgage servicers to service the pools of residential mortgage loans that we acquire. We also depend upon the mortgage servicers that have been hired by issuers to service the mortgages underlying the RMBS that we acquire. The mortgage servicing business is subject to extensive regulation by federal, state and local governmental authorities and is subject to various laws and judicial and administrative decisions imposing requirements and restrictions and increased compliance costs on a substantial portion of their operations. The volume of new or modified laws and regulations has increased in recent years. Some jurisdictions and municipalities have enacted laws that restrict loan servicing activities, including delaying or preventing foreclosures or forcing the modification of certain mortgages.
Federal legislation has also been proposed which, among other things, could hinder the ability of a servicer to foreclose promptly on defaulted residential loans, and which could result in servicers being held responsible for violations in the residential loan origination process. Certain mortgage lenders and third-party servicers have voluntarily, or as part of settlements with law enforcement authorities, established loan-modification programs relating to loans they hold or service. These federal, state and local legislative or regulatory actions that result in modification of our outstanding mortgages, or interests in mortgages acquired by us, may adversely affect the value of, and the returns on, such residential loans. Mortgage servicers may be incentivized by the Federal government to pursue such loan modifications, as well as forbearance plans and other actions intended to prevent foreclosure, even if such loan modifications and other actions are not in the best interests of the beneficial owners of the mortgages. As a consequence of the foregoing matters, our business, financial condition, results of operations and ability to pay dividends, if any, to our stockholders may be adversely affected.
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We may not control the special servicing of the mortgage loans included in the securities in which we invest and, in such cases, the special servicer may take actions that could adversely affect our interests.
With respect to the securities in which we invest, overall control over the special servicing of the related underlying mortgage loans is held by a “directing certificateholder” or a “controlling class representative,” which is appointed by the holders of the most subordinate class of security in such series. Depending on the class of MBS we have acquired or may acquire, we may not have the right to appoint the directing certificateholder. In connection with the servicing of the specially serviced mortgage loans, the related special servicer may, at the direction of the directing certificateholder, take actions with respect to the specially serviced mortgage loans that could adversely affect our interests.
Our Manager’s due diligence of potential investments may not reveal all of the liabilities associated with such investments and may not reveal other weaknesses in such investments, which could lead to investment losses.
Our Manager values our target assets based on loss-adjusted yields, taking into account estimated future losses on the mortgage loans included in the securitization’s pool of loans, and the estimated impact of these losses on expected future cash flows. Our Manager’s loss estimates may not prove accurate, as actual results may vary from estimates. In the event that our Manager underestimates the pool level losses relative to the price we pay for a particular investment, we may experience losses with respect to such investment.
Before making an investment, our Manager assesses the strengths and weaknesses of the originators, borrowers, and the underlying property values, as well as other factors and characteristics that are material to the performance of the investment. In making the assessment and otherwise conducting customary due diligence, our Manager relies on resources available to it and, in some cases, an investigation by third parties. There can be no assurance that our Manager’s due diligence process will uncover all relevant facts or that any investment will be successful.
Mezzanine loan assets involve greater risks of loss than senior loans secured by income-producing properties.
We hold mezzanine loans which take the form of subordinated loans secured by second mortgages on the underlying property or loans secured by a pledge of the ownership interests of either the entity owning the property or a pledge of the ownership interests of the entity that owns the interest in the entity owning the property. These types of assets involve a higher degree of risk than long-term senior mortgage lending secured by income-producing real property, because the loan may become unsecured as a result of foreclosure by the senior lender. In the event of a bankruptcy of the entity providing the pledge of its ownership interests as security, we may not have full recourse to the assets of such entity, or the assets of the entity may not be sufficient to satisfy our mezzanine loan. If a borrower defaults on our mezzanine loan or debt senior to our loan, or in the event of a borrower bankruptcy, our mezzanine loan will be satisfied only after the senior debt. As a result, we may not recover some or any of our initial expenditure. In addition, mezzanine loans may have higher loan-to-value ratios than conventional mortgage loans, resulting in less equity in the property and increasing the risk of loss of principal. Significant losses related to our mezzanine loans would result in operating losses for us and may limit our ability to make distributions to our stockholders.
Because we acquire mainly fixed-rate securities, an increase in interest rates may adversely affect our book value.
Rising interest rates generally reduce the demand for mortgage loans due to the higher cost of borrowing. A reduction in the volume of mortgage loans originated may affect the volume of our target assets available to us, which could adversely affect our ability to acquire assets that satisfy our investment objectives. Rising interest rates may also cause our target assets that were issued prior to an interest rate increase to provide yields that are below prevailing market interest rates. If rising interest rates cause us to be unable to acquire a sufficient volume of our target assets with a yield that is above our borrowing cost, our ability to satisfy our investment objectives and to generate income and pay dividends may be materially and adversely affected. Additionally, in periods of rising interest rates, our Agency RMBS may experience reduced returns if the owners of the underlying mortgages pay off their mortgages more slowly than anticipated. This could cause the prices of our Agency RMBS to fall more than we anticipated and for our hedge portfolio to underperform relative to the decline in the value of our Agency RMBS which could negatively affect our book value.
The relationship between short-term and longer-term interest rates is often referred to as the “yield curve.” Ordinarily, short-term interest rates are lower than longer-term interest rates. If short-term interest rates rise disproportionately relative to longer-term interest rates (a flattening of the yield curve), our borrowing costs may increase more rapidly than the interest income earned on our assets. Because we expect our investments, on average, generally will bear interest based on longer-term rates than our borrowings, a flattening of the yield curve would tend to decrease our net income, book value and the market value of our net assets. Additionally, to the extent cash flows from investments that return scheduled and unscheduled principal are reinvested, the spread between the yields on the new investments and available borrowing rates may decline, which would likely decrease our net income.
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Although interest rates from the beginning to end of 2015 did not change significantly, prices of Agency RMBS declined due to marginally higher rates in the treasury benchmark 5-year to 7-year part of the curve as well as reduced payups for specified collateral over TBA. This drop in price was not offset in whole by our swap rate hedges largely due to a dislocation in the historical relationship between USD LIBOR swap rates and benchmark treasury rates. From December 31, 2014 to December 31, 2015, the yield on 5-year Treasury Securities (“U.S. Treasuries”) increased 11 basis points (“bps”) to 1.76% and the yield on 10-year U.S. Treasuries increased 10 bps to 2.27%. From December 31, 2014 to December 31, 2015, 5-year USD LIBOR swap rates decreased 3 bps to 1.74% and 7-year USD LIBOR swap rates decreased 9 bps to 1.95%. In a remarkable development by historical standards swap spreads (defined as the yield of USD LIBOR swaps minus the yield on equivalent maturity U.S. Treasury securities) from four years and out turned negative during the third and fourth quarters of 2015 and have generally remained so since. This caused many interest rate hedging instruments such as interest rate swaps, which we use to hedge our Agency RMBS, to underperform relative to Agency RMBS. As a result, our Agency RMBS portfolio did not increase in market value by an amount sufficient to offset the decrease in value of our interest rate swaps, which negatively affected our book value. We believe many factors contributed to this swap spread inversion, including the ongoing intensification of the regulatory environment on bank and dealer balance sheets, higher corporate bond issuances and associated hedging activity, and ongoing liquidations of U.S. Treasuries by foreign central banks and large sovereign wealth funds. This breakdown in the traditional swap spread relationship has made hedging our portfolio with USD LIBOR swaps much less effective and has contributed to ongoing uncertainty about our hedge ratio and the associated directions on our Agency assets.
Rapid changes in the values of our residential mortgage loans and other real estate-related assets may make it more difficult for us to maintain our qualification as a REIT or exemption from registration under the Investment Company Act.
If the market value or income potential of our residential mortgage loans and other real estate-related assets declines as a result of increased interest rates, prepayment rates or other factors, we may need to increase certain real estate investments and income and/or liquidate our non-qualifying assets in order to maintain our REIT qualification or exemption from registration under the Investment Company Act. If the decline in real estate asset values and/or income occurs quickly, this may be especially difficult to accomplish. This difficulty may be exacerbated by the illiquid nature of certain investments. We may have to make investment decisions that we otherwise would not make absent our REIT and Investment Company Act considerations.
Changes in prepayment rates could negatively affect the value of our investment portfolio, which could result in reduced earnings or losses and negatively affect the cash available for distribution to our stockholders.
The value of our investment portfolio may be affected by prepayment rates on mortgage loans. Many loans do not contain any restrictions on borrowers’ abilities to prepay their residential mortgage loans and therefore the expected weighted average life of Agency RMBS and MSRs are generally much shorter than would be implied by their stated contractual maturities. Interest only Agency RMBS only entitle the holder to interest payments made on the underlying mortgage loans. Therefore, the yield to maturity of interest only Agency RMBS is extremely sensitive to the rate of principal payments (particularly prepayments) on the underlying pool of mortgages.
Prepayment rates on loans are influenced by changes in market interest rates and a variety of economic, geographic and other factors beyond our control. Consequently, we cannot predict with certainty such prepayment rates, and no strategy can completely insulate us from prepayment or other such risks. Homeowners tend to prepay mortgage loans faster when interest rates decline. Consequently, owners of the loans have to reinvest the money received from the prepayments at the lower prevailing interest rates. Conversely, homeowners tend not to prepay mortgage loans when interest rates increase. Consequently, owners of the loans are unable to reinvest money that would have otherwise been received from prepayments at the higher prevailing interest rates. This volatility in prepayment rates may affect our ability to maintain targeted amounts of leverage on our portfolio and may result in reduced earnings or losses for us and negatively affect the cash available for distribution to our stockholders.
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Many of our investments may be illiquid and we may not be able to vary our portfolio in response to changes in economic and other conditions.
We expect generally that certain of the securities we purchase will be in connection with privately-negotiated transactions that will not be registered under the relevant securities laws, resulting in a prohibition against their transfer, sale, pledge or other disposition except in a transaction that is exempt from the registration requirements of, or is otherwise in accordance with, those laws. Generally, we will not be able to sell these securities publicly without the expense and time required to register the securities under the Securities Act of 1933, as amended, or the Securities Act, if the obligors agree to do so, or will be able to sell the securities only under Rule 144 or other rules under the Securities Act which permit only limited sales under specified conditions. Moreover, turbulent market conditions could significantly and negatively impact the liquidity of our assets. The illiquidity of such investments may make it difficult for us to sell if the need or desire arises. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value maintained for it in our records.
We may be adversely affected by risks affecting borrowers or the asset or property types in which our investments may be concentrated at any given time, as well as from unfavorable changes in the related geographic regions.
Our assets are not subject to any geographic, diversification or concentration limitations except that we concentrate in residential mortgage-related investments. Accordingly, our investment portfolio may be concentrated by geography, asset, property type and/or borrower, increasing the risk of loss to us if the particular concentration in our portfolio is subject to greater risks or undergoing adverse developments. In addition, adverse conditions in the areas where the properties securing or otherwise underlying our investments are located (including business layoffs or downsizing, industry slowdowns, changing demographics and other factors) and local real estate conditions (such as oversupply or reduced demand) may have an adverse effect on the value of our investments. A material decline in the demand for real estate in these areas may materially and adversely affect us. Lack of diversification can increase the correlation of non-performance and foreclosure risks among our investments.
Our investments are generally recorded at fair value, and quoted prices or observable inputs may not be available to determine such value, resulting in the use of significant unobservable inputs to determine value.
The values of some of our investments may not be readily determinable. We measure the fair value of these investments quarterly, in accordance with guidance set forth in Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC 820-10, “Fair Value Measurements and Disclosures.” The fair value at which our assets are recorded may not be an indication of their realizable value. Ultimate realization of the value of an asset depends to a great extent on economic and other conditions that are beyond the control of our Manager, our Company or our board of directors. Further, fair value is only an estimate based on good faith judgment of the price at which an investment can be sold since market prices of investments can only be determined by negotiation between a willing buyer and seller. If we were to liquidate a particular asset, the realized value may be more than or less than the amount at which such asset is valued.
To a large extent, our Manager’s determination of the fair value of our investments depends on inputs provided by third-party dealers and pricing services. Valuations of certain securities in which we invest are often difficult to obtain or are unreliable. In general, dealers and pricing services heavily disclaim their valuations. Dealers may claim to furnish valuations only as an accommodation and without special compensation, and so they may disclaim any and all liability for any direct, incidental, or consequential damages arising out of any inaccuracy or incompleteness in valuations, including any act of negligence or breach of any warranty. Depending on the complexity and illiquidity of a security, valuations of the same security can vary substantially from one dealer or pricing service to another. Therefore, our results of operations for a given period could be adversely affected if our determinations regarding the fair market value of these investments are materially higher than the values that we ultimately realize upon their disposal.
Our Manager utilizes analytical models and data in connection with the valuation of our investments, and any incorrect, misleading or incomplete information used in connection therewith will subject us to potential risks.
Given the complexity of certain of our investments and strategies, our Manager must rely heavily on analytical models (both proprietary models developed by our Manager and those supplied by third parties) and information and data supplied by third parties, or Models and Data. Models and Data are used to value investments or potential investments and also in connection with hedging our investments. When Models and Data prove to be incorrect, misleading or incomplete, any decisions made in reliance thereon expose us to potential risks. For example, by relying on Models and Data, especially valuation models, our Manager may be induced to buy certain investments at prices that are too high, to sell certain other investments at prices that are too low or to miss favorable opportunities altogether. Similarly, any hedging based on faulty Models and Data may prove to be unsuccessful. Furthermore, any valuations of our investments that are based on valuation models may prove to be incorrect.
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Some of the risks of relying on analytical models and third-party data are particular to analyzing tranches from securitizations, such as mortgage-backed securities. These risks include, but are not limited to, the following: (i) collateral cash flows and/or liability structures may be incorrectly modeled in all or only certain scenarios, or may be modeled based on simplifying assumptions that lead to errors; (ii) information about collateral may be incorrect, incomplete, or misleading; (iii) collateral or bond historical performance (such as historical prepayments, defaults, cash flows, etc.) may be incorrectly reported or subject to interpretation (e.g., different issuers may report delinquency statistics based on different definitions of what constitutes a delinquent loan); or (iv) collateral or bond information may be outdated, in which case the models may contain incorrect assumptions as to what has occurred since the date information was last updated.
Some of the analytical models used by our Manager, such as mortgage prepayment models, mortgage default models, and models providing risk sensitivities and duration output, are predictive in nature. The use of predictive models has inherent risks. For example, such models may incorrectly forecast future behavior, leading to potential losses on a cash flow and/or a mark-to-market basis. Incorrect sensitivities and duration output may lead to an unsound hedging strategy. In addition, the predictive models used by our Manager may differ substantially from those models used by other market participants, with the result that valuations based on these predictive models may be substantially higher or lower for certain investments than actual market prices. Furthermore, since predictive models are usually constructed based on historical data supplied by third parties, the success of relying on such models may depend heavily on the accuracy and reliability of the supplied historical data and the ability of these historical models to accurately reflect future periods.
All valuation models rely on correct market data inputs. If incorrect market data is entered into even a well-founded valuation model, the resulting valuations will be incorrect. However, even if the input of market data is correct, “model prices” often differ substantially from market prices, especially for securities with complex characteristics, such as derivative securities.
Our investments in residential and commercial loans are difficult to value and are dependent upon the ability to finance, refinance and securitize such investments. The inability to do so could materially and adversely affect our liquidity and earnings and limit the cash available for distribution to our stockholders.
Our investments include investments in RPLs and NPLs. RPLs are loans on which a borrower was previously delinquent but has resumed repaying. Our ability to sell RPLs for a profit depends on the borrower continuing to make payments. An RPL could become a NPL, which could reduce our earnings. Investments in NPLs and sub-performing loans may involve workout negotiations, restructuring and the possibility of foreclosure. These processes may be lengthy and expensive. If loans become real estate owned, or REO, servicing companies will have to manage these properties and may not be able to sell them. See the “Our ability to sell REO on terms acceptable to us or at all may be limited” risk factor.
We may seek to refinance an NPL or RPL to realize greater value from such loan. However, there may be impediments to executing a refinancing strategy for NPLs and RPLs. For example, many mortgage lenders have adjusted their loan programs and underwriting standards to be more conservative, which has reduced the availability of mortgage credit to prospective borrowers. This has resulted in reduced availability of financing alternatives for borrowers seeking to refinance their mortgage loans. The decline in housing prices may also result in higher loan-to-value ratios and leave borrowers with insufficient equity in their homes to permit them to refinance. To the extent prevailing mortgage interest rates rise from their current low levels, these risks would be exacerbated. The effect of the above would likely serve to make refinancing of NPLs and RPLs potentially more difficult and less profitable for us.
Our ability to sell REO on terms acceptable to us or at all may be limited.
REO assets are illiquid relative to other assets we may own. Furthermore, the real estate market is affected by many factors that are beyond our control, such as general economic conditions, availability of financing, interest rates and supply and demand. We cannot predict whether we will be able to sell any REO assets for the price or on the terms set by us or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of an REO asset. In certain circumstances, we may be required to expend cash to correct defects or to make improvements before a property can be sold, and we cannot assure that we will have cash available to correct defects or make improvements. As a result, our ownership of REOs could materially and adversely affect our liquidity, earnings and cash available for distribution to our stockholders.
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Risks related to financing and hedging
We may incur significant debt in the future, which will subject us to increased risk of loss and may reduce cash available for distributions to our stockholders.
Subject to market conditions and availability, we may further increase our debt in the future. We use leverage to finance our assets through borrowings from repurchase agreements and other secured and unsecured forms of borrowing. Although we are not required to maintain any particular leverage ratio, the amount of leverage we deploy for particular assets depends upon our Manager’s assessment of the credit and other risks of those assets. Our board of directors may establish and change our leverage policy at any time without stockholder approval. In addition, we may leverage individual assets at substantially higher levels. Incurring debt could subject us to many risks that, if realized, would materially and adversely affect us, including the risk that:
| • | our cash flow from operations may be insufficient to make required payments of principal of and interest on the debt or we may fail to comply with any of the other covenants contained, which will likely result in (i) an acceleration of such debt (and any other debt containing a cross-default or cross-acceleration provision) that we may be unable to repay from internal funds or to refinance on favorable terms, or at all, (ii) our inability to borrow unused amounts under our financing agreements, even if we are current in payments on borrowings under those agreements and/or (iii) the loss of some or all of our assets to foreclosure or sale; |
| • | our debt increases our vulnerability to adverse economic and industry conditions with no assurance that investment yields will increase with higher financing costs; |
| • | we may be required to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for operations, investments, stockholder distributions or other purposes; and |
| • | we may not be able to refinance debt that matures prior to the investment it was used to finance on favorable terms, or at all. |
Interest rate fluctuations could significantly decrease our results of operations, cash flows and the market value of our investments.
Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Interest rate fluctuations present a variety of risks to our operations. Our primary interest rate exposure relates to the yield on our investments and the financing cost of our debt. Changes in interest rates will affect our net interest income, which is the difference between the interest income we earn on our interest-earning investments and the interest expense we incur in financing these investments. Interest rate fluctuations resulting in our interest expense exceeding interest income will result in operating losses for us. Changes in the level of interest rates also may affect our ability to invest in investments, the value of our investments and our ability to realize gains from the disposition of assets. Changes in interest rates may also affect borrower default rates and may impact the ability of borrowers to refinance or modify loans and/or to sell real estate assets owned. Such change could negatively impact the value of our investments.
Most of our financing costs are determined by reference to floating rates, such as a LIBOR or a Treasury index, plus a margin, the amount of which will depend on a number of factors, including, without limitation, (i) for collateralized debt, the value and liquidity of the collateral, and for non-collateralized debt, our credit, (ii) the level and movement of interest rates and (iii) general market conditions and liquidity. In a period of rising interest rates, our interest expense on floating-rate debt would increase, while any additional interest income we earn on our floating-rate investments may not compensate for such increase in interest expense. Additionally, the interest income we earn on our fixed-rate investments would not change, the duration and weighted average life of our fixed-rate investments would increase and the market value of our fixed-rate investments would decrease. Similarly, in a period of declining interest rates, our interest income on floating-rate investments would decrease, while any decrease in the interest we are charged on our floating-rate debt may not compensate for such decrease in interest income. Additionally, interest we are charged on our fixed-rate debt would not change. Any such scenario could materially and adversely affect us.
Our operating results depend, in large part, on differences between the income earned on our investments, net of credit losses, and our financing and hedging costs. We anticipate that, in most cases, for any period during which our investments are not financed with borrowings of equal duration, the income earned on such investments will respond more slowly to interest rate fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, may immediately and significantly decrease our results of operations and cash flows and the market value of our investments.
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We depend, and may in the future depend, on repurchase agreement or FHLBC Advance financing to acquire target assets, and our inability to access this funding could have a material adverse effect on our results of operations, financial condition and business.
We use repurchase agreement and FHLBC Advance financing (“financing arrangements”) as a strategy to increase the return on our assets. However, we may not be able to achieve our desired leverage ratio for a number of reasons, including if the following events occur:
| • | our lenders do not make financing arrangements available to us at acceptable rates; |
| • | certain of our lenders exit the repurchase market; |
| • | our membership in the FHLB of Cincinnati is terminated; (see following risk factor for more details) |
| • | our lenders require that we pledge additional collateral to cover our borrowings, which we may be unable to do; or |
| • | we determine that the leverage would expose us to excessive risk. |
Our ability to fund our purchases of target assets may be impacted by our ability to secure financing arrangements on acceptable terms. We can provide no assurance that lenders will be willing or able to provide us with sufficient financing. In addition, because financing arrangements represent commitments of capital, lenders may respond to market conditions by making it more difficult for us to secure continued financing. During certain periods of the credit cycle, lenders may curtail their willingness to provide financing.
If major lenders stop financing our target assets, the value of our target assets could be negatively impacted, thus reducing net stockholders’ equity, or book value. Furthermore, if many of our lenders or potential lenders are unwilling or unable to provide us with financing arrangements, we could be forced to sell our target assets at an inopportune time when prices are depressed.
In addition, if the regulatory capital requirements imposed on our lenders change, our lenders may be required to significantly increase the cost of the financing that they provide to us. Our lenders also may revise their eligibility requirements for the types of assets they are willing to finance or the terms of such financings, based on, among other factors, the regulatory environment and their management of perceived risk, particularly with respect to assignee liability.
Moreover, the amount of financing we receive, or may in the future receive, under our financing arrangements is directly related to the lenders’ valuations of the target assets that secure the outstanding borrowings. If the valuation of our target assets decreases, we may be unable to access or maintain financing for our target assets, which could have a material adverse effect on our results of operations, financial condition, business and liquidity.
As a result of the membership of our captive insurance company in the FHLB of Cincinnati being terminated, we may be unable to obtain sufficient financing on favorable terms or at all to repay or replace our outstanding advances from the FHLB of Cincinnati upon any required liquidation, which could adversely affect our liquidity and/or cause us to sell our assets under adverse market conditions and possibly incur substantial losses.
On January 12, 2016, the FHFA issued RIN 2590-AA39, Members of Federal Home Loan Banks (the “Final Rule”). The Final Rule, expressly excludes captive insurance companies, such as MITT Insurance, from being eligible for membership in the FHLB. Under the Final Rule, MITT Insurance must wind down its membership with the FHLBC by February 19, 2017. The Final Rule also requires that the FHLB cannot make any new advances or extend any existing advances to MITT Insurance. In addition, upon the termination of membership, the FHLB must liquidate all outstanding advances to MITT Insurance, settle all other business transactions, and repurchase or redeem all FHLB stock held by MITT Insurance in accordance with the Final Rule.
The adopting release for the Final Rule expressly invited Congress to address the treatment of captive insurance companies excluded from FHLB membership by the Final Rule (“Excluded Captives”) with respect to membership in the FHLB. In October 2015, Reps. Blaine Luetkemeyer (R-Mo.), Denny Heck (D-Wash.), Patrick McHenry (R-N.C.) and John Carney (D-Del.) introduced H.R. 3808, a bill that would have preemptively prevented the FHFA from adopting the Final Rule. There can be no way of predicting if any subsequent legislation addressing the status of Excluded Captives with respect to the FHLB will be proposed in either house of Congress, the likelihood of passage of any such legislation, and the ultimate effects, if any, on the availability of short-term, low-cost funding provided by the FHLBs to Excluded Captives subsequent to the enactment of any such legislation.
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The Final Rule will require us to promptly repay our FHLBC Advances. There can be no assurance that we will be able to obtain sufficient financing on favorable terms or at all to repay or replace our outstanding FHLBC Advances upon any such unwinding, which could adversely affect our liquidity and/or force us to sell our assets under adverse market conditions and incur substantial losses. Certain of our competitors with captive insurance company members of a Federal Home Loan Bank are also required to replace their advances, which would create greater demand for replacement financing for said assets and which may increase financing costs at a time when funding collateral is becoming more expensive under regulatory rules. Additionally, we are now at a competitive disadvantage vis-à-vis our competitors with captive insurance company members of a Federal Home Loan Bank which became members prior to the publication of the Proposed Rule and therefore have and will continue to have access to lower cost long-term funding with which to acquire their target assets.
Forced sales of assets by one or more of our largest competitors could destabilize the financial markets that provide our financing.
When we fund our purchases of target assets, we aim to secure sufficient financing on terms that are acceptable to us. The terms of the financings we receive are influenced by the demand for similar funding by our competitors, including other REITs, specialty finance companies and other financial entities. Many of our competitors are significantly larger than us, have greater financial resources and significantly larger balance sheets than we do. Any sizable interest rate shocks or disruptions in secondary mortgage markets resulting in the failure of one or more of our largest competitors could pose a significant risk to the U.S. economy, and would be expected to have a material adverse effect on our ability to access or maintain short-term financing for our target assets.
In October 2013 the International Monetary Fund issued its Global Financial Stability Report which states that a major interest rate shock could lead to forced asset sales by mortgage REITs. Such forced asset sales could adversely affect the market value and funding costs of our assets. The report suggested that, if warranted, government authorities could consider designating the largest mortgage REITs as systemically important non-bank financial entities. To date, the U.S. Financial Stability Oversight Council, the board of regulators established after the 2008 financial crisis, has not taken action to label any of the largest mortgage REITs as systemically important.
Our current lenders require, and future lenders may require, us to enter into restrictive covenants relating to our operations.
As of December 31, 2015 and December 31, 2014, we, either directly or through our equity method investments in affiliates, have entered into MRAs or loan agreements, with 38 and 35 counterparties, respectively, under which we had borrowed an aggregate $2.5 billion and $2.8 billion, respectively, from 21 and 24 counterparties, respectively, on a non-GAAP basis. As of December 31, 2015, the borrowings under these financing arrangements had maturities between January 4, 2016 and September 17, 2019, and as of December 31, 2014, the borrowings under repurchase agreements had maturities between January 2, 2015 and September 17, 2019. These agreements generally include customary representations, warranties and covenants, but may also contain more restrictive supplemental terms and conditions. Although specific to each master repurchase or loan agreement, typical supplemental terms include requirements of minimum equity, leverage ratios, performance triggers or other financial ratios. If we fail to meet or satisfy any covenants, supplemental terms or representations and warranties, we would be in default under these agreements and our lenders could elect to declare all amounts outstanding under the agreements to be immediately due and payable, enforce their respective interests against collateral pledged under such agreements and restrict our ability to make additional borrowings. Certain financing agreements may contain cross-default provisions, so that if a default occurs under any one agreement, the lenders under our other agreements could also declare a default. Further, under our repurchase agreements, we may be required to pledge additional assets to our lenders in the event the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral, which may take the form of additional securities, loans or cash.
Future lenders may impose similar restrictions on us that would affect our ability to incur additional debt, make certain investments or acquisitions, reduce liquidity below certain levels, make distributions to our stockholders, redeem debt or equity securities and impact our flexibility to determine our operating policies and investment strategies. For example, our loan documents may contain negative covenants that limit, among other things, our ability to repurchase our common stock, distribute more than a certain amount of our net income or funds from operations to our stockholders, employ leverage beyond certain amounts, sell assets, engage in mergers or consolidations, grant liens and enter into transactions with affiliates. If we fail to meet or satisfy any of these covenants, we would be in default under these agreements, and our lenders could elect to declare outstanding amounts due and payable, terminate their commitments, require the posting of additional collateral and enforce their interests against existing collateral. We may also be subject to cross-default and acceleration rights and, with respect to collateralized debt, the posting of additional collateral and foreclosure rights upon default. Further, this could also make it difficult for us to satisfy the qualification requirements necessary to maintain our status as a REIT for U.S. federal income tax purposes.
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Counterparties may require us to maintain a certain amount of cash uninvested or to set aside non-levered assets sufficient to maintain a specified liquidity position which would allow us to satisfy our collateral obligations. As a result, we may not be able to leverage our assets as fully as we would choose, which could reduce our return on equity. If we are unable to meet these collateral obligations, our financial condition could deteriorate materially.
Warehouse facilities and other forms of short-term financings may not always be available to finance our acquisition of residential and commercial loans.
Our ability to fund our acquisitions of residential and commercial loans depends on our securing warehouse, repurchase, and other forms of short-term financing on acceptable terms. We generally intend to repay the short-term financing of a pool of loans under one of these facilities at or prior to the expiration of that financing with the proceeds of a securitization or other sale of the loans, through the proceeds of other short-term borrowings, or with other equity or longer-term debt financing. In addition, while a loan is financed under a warehouse facility, to the extent the market value of the loan declines (which market value is generally determined by the counterparty under the facility), we are required to either immediately reacquire the loan or meet a margin requirement to pledge additional collateral, such as cash or additional loans, in an amount at least equal to the decline in value.
We cannot assure you that we will be successful in establishing sufficient sources of warehouse, repurchase facilities and other short-term debt when needed. Our inability to access warehouse and repurchase facilities, credit facilities, or other forms of debt financing on acceptable terms may inhibit our ability to acquire residential and commercial loans, which could have a material adverse effect on our financial results, financial condition, and business.
If a counterparty to our repurchase transaction or FHLBC Advance defaults on its obligation to resell or return the underlying security back to us at the end of the transaction term, or if the value of the underlying security has declined as of the end of that term, or if we default on our obligations under the repurchase agreement or FHLBC Advance, we will lose money on such financing arrangement.
When we engage in financing arrangements, we generally sell securities to lenders (i.e., repurchase agreement counterparties) or deliver securities to the FHLBC and receive cash from the lenders. The lenders are obligated to resell or return the same securities back to us at the end of the term of the transaction. Because the cash we receive from lenders when we initially sell or deliver the securities to the lender is less than the value of those securities (this difference is the haircut), if the lender defaults on its obligation to resell or return the same securities back to us we may incur a loss on the transaction equal to the amount of the haircut (assuming there was no change in the value of the securities). On December 31, 2015, we had greater than 5% stockholders’ equity at risk on a non-GAAP basis with each of 4 repurchase agreement counterparties: Wells Fargo Bank, N.A., JP Morgan Securities, LLC, Credit Suisse Securities, LLC, and RBC (Barbados) Trading Corporation.
We will also lose money on financing arrangements if the value of the underlying securities has declined as of the end of the transaction term, as we will have to repurchase or reclaim the securities for their initial value but will receive securities worth less than that amount. Further, if we default on one of our obligations under a financing arrangement, the lender will be able to terminate the transaction and cease entering into any other financing arrangements with us. If a default occurs under any of our financing arrangements and the lenders terminate one or more of our financing arrangements, we may need to enter into replacement financing arrangements with different lenders. There can be no assurance that we will be successful in entering into such replacement financing arrangements on the same terms as the financing arrangements that were terminated or at all. Any losses we incur on our financing arrangements could adversely affect our earnings and thus our cash available for distribution to our stockholders.
Our rights under our repurchase agreements may be subject to the effects of the bankruptcy laws in the event of the bankruptcy or insolvency of us or our lenders under the financing arrangements, which may allow our lenders to repudiate our financing arrangements.
In the event of our insolvency or bankruptcy, certain repurchase agreements may qualify for special treatment under the U.S. Bankruptcy Code, the effect of which, among other things, would be to allow the lender under the applicable repurchase agreements to avoid the automatic stay provisions of the U.S. Bankruptcy Code and to foreclose on the pledged collateral without delay, exacerbating our legal title and the right to proceeds. In the event of the insolvency or bankruptcy of a lender during the term of a repurchase agreement, the lender may be permitted, under applicable insolvency laws, to repudiate the contract, and our claim against the lender for damages may be treated simply as that of an unsecured creditor. In addition, if the lender is a broker or dealer subject to the Securities Investor Protection Act of 1970, or an insured depository institution subject to the Federal Deposit Insurance Act, our ability to exercise our rights to recover our securities under a repurchase agreements or to be compensated for any damages resulting from the lender’s insolvency may be further limited by those statutes. These claims would be subject to significant delay and, if and when received, may be substantially less than the damages we actually incur.
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Pursuant to the terms of borrowings under our financing arrangements, we are subject to margin calls that could result in defaults or force us to sell assets under adverse market conditions or through foreclosure.
We enter into financing arrangements to finance the acquisition of our target assets. Pursuant to the terms of borrowings under our financing arrangements, a decline in the value of the collateral may result in our lenders initiating margin calls. A margin call means that the lender requires us to pledge additional collateral to re-establish the ratio of the value of the collateral to the amount of the borrowing. The specific collateral value to borrowing ratio that would trigger a margin call is not set in the master repurchase agreements or loan agreements and is not determined until we engage in a repurchase transaction or borrowing arrangement under these agreements. Our fixed-rate collateral generally may be more susceptible to margin calls as periods of increased interest rates tend to affect more negatively the market value of fixed-rate securities. In addition, some collateral may be more illiquid than other instruments in which we invest, which could cause them to be more susceptible to margin calls in a volatile market environment. Moreover, collateral that prepays more quickly increases the frequency and magnitude of potential margin calls as there is a significant time lag between when the prepayment is reported (which reduces the market value of the security) and when the principal payment is actually received. If we are unable to satisfy margin calls, our lenders may foreclose on our collateral. The threat of or occurrence of a margin call could force us to sell, either directly or through a foreclosure, our collateral under adverse market conditions. Because of the leverage we expect to have, we may incur substantial losses upon the threat or occurrence of a margin call.
Hedging against interest rate exposure may materially and adversely affect our results of operations and cash flows.
Subject to maintaining our qualification as a REIT and our exemption under the Investment Company Act, we pursue hedging strategies to reduce our exposure to adverse changes in interest rates. Our hedging activity will vary in scope based on the level of interest rates, the type of investments held, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:
| • | interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates; |
| • | available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought; |
| • | the duration of the hedge may not match the duration of the related liability or asset; |
| • | the amount of income that a REIT may earn from hedging transactions to offset interest rate losses is limited by U.S. federal tax provisions governing REITs; |
| • | the credit quality of the hedging counterparty owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and |
| • | the hedging counterparty owing the money in the hedging transaction may default on its obligation to pay. |
In addition, we may fail to recalculate, re-adjust and execute hedges in an efficient manner which may negatively affect our earnings and book value.
Our hedging activities, which are intended to limit losses, may materially and adversely affect our results of operations and cash flows. The cost of using hedging instruments increases as the period covered by the instrument lengthens during periods of rising and volatile interest rates. We may increase our hedging activity and thus increase our hedging costs during periods when interest rates are volatile or rising and hedging costs have increased. Therefore, while we may enter into such transactions seeking to reduce interest rate risks, unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions. In addition, the degree of correlation between price movements of the instruments used in hedging strategies and price movements in the portfolio positions or liabilities being hedged may vary materially. Moreover, it may be impossible to establish a perfect correlation between such hedging instruments and the portfolio positions or liabilities being hedged. Any such imperfect correlation may prevent us from achieving the intended hedge and expose us to increased risk of loss.
We may enter into hedging transactions that could expose us to contingent liabilities in the future.
Subject to maintaining our qualification as a REIT, part of our investment strategy involves entering into hedging transactions that could require us to fund cash payments in certain circumstances (such as the early termination of the hedging instrument caused by an event of default or other early termination event, or the decision by a counterparty to request margin securities it is contractually owed under the terms of the hedging instrument). The amount due would be equal to the unrealized loss of the open hedging positions with the respective counterparty and could also include other fees and charges. These economic losses will be reflected in our results of operations, and our ability to fund these obligations will depend on the liquidity of our assets and access to capital at the time, and the need to fund these obligations could adversely impact our financial condition.
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Hedging instruments may not be traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities and involve risks and costs that could result in material losses.
Hedging instruments involve risk since they may not be traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities. Consequently, there may be few or no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions. Furthermore, the enforceability of agreements underlying derivative transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in a default. Default by a party with whom we enter into a hedging transaction may result in the loss of unrealized profits and force us to replace the affected hedging instruments, at the then current market price. Although generally we seek to reserve the right to terminate our hedging positions, it may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. No assurance can be given that a liquid secondary market will exist for derivative instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in significant losses.
Clearing facilities or exchanges upon which some of our hedging instruments are traded may increase margin requirements on our hedging instruments in the event of uncertainty or adverse developments in financial markets.
In response to events having or expected to have adverse economic consequences or which create market uncertainty, clearing facilities or exchanges upon which some of our hedging instruments, such as interest rate swaps, are traded may require us to post additional collateral against our hedging instruments. In the event that future adverse economic developments or market uncertainty result in increased margin requirements for our hedging instruments, it could materially adversely affect our liquidity position, business, financial condition and results of operations.
It may be uneconomical to “roll” our TBA dollar roll transactions or we may be unable to meet margin calls on our TBA contracts, which could negatively affect our financial condition and results of operations.
We utilize TBA dollar roll transactions as a means of investing in and financing Agency RMBS. TBA contracts enable us to purchase or sell, for future delivery, Agency RMBS with certain principal and interest terms and certain types of collateral, but the particular Agency RMBS to be delivered are not identified until shortly before the TBA settlement date. Prior to settlement of the TBA contract we may choose to move the settlement of the securities out to a later date by entering into an offsetting position (referred to as a “pair off”), net settling the paired off positions for cash, and simultaneously purchasing a similar TBA contract for a later settlement date, collectively referred to as a “dollar roll.” The Agency RMBS purchased for a forward settlement date under the TBA contract are typically priced at a discount to Agency RMBS for settlement in the current month. This difference (or discount) is referred to as the “price drop.” The price drop is the economic equivalent of net interest carry income on the underlying Agency RMBS over the roll period (interest income less implied financing cost) and is commonly referred to as “dollar roll income.” Consequently, dollar roll transactions and such forward purchases of Agency RMBS represent a form of off-balance sheet financing and increase our "at risk" leverage.
Under certain market conditions, TBA dollar roll transactions may result in negative carry income whereby the Agency RMBS purchased for a forward settlement date under the TBA contract are priced at a premium to Agency RMBS for settlement in the current month. Under such conditions, it may be uneconomical to roll our TBA positions prior to the settlement date, and we could have to take physical delivery of the underlying securities and settle our obligations for cash. We may not have sufficient funds or alternative financing sources available to settle such obligations. In addition, pursuant to the margin provisions established by the Mortgage-Backed Securities Division (“MBSD”) of the Fixed Income Clearing Corporation we are subject to margin calls on our TBA contracts. Further, our prime brokerage agreements may require us to post additional margin above the levels established by the MBSD. Negative carry income on TBA dollar roll transactions or failure to procure adequate financing to settle our obligations or meet margin calls under our TBA contracts could result in defaults or force us to sell assets under adverse market conditions or through foreclosure and adversely affect our financial condition and results of operations.
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Risks related to U.S. government programs
The Federal Reserve’s recent increase of the federal funds rate could impact the market for and the value of the Agency RMBS in which we invest as well as our net asset value, net interest margin, net income and book value.
On December 16, 2015, the Federal Reserve announced its decision to raise the target range of the federal funds rate by 25 basis points, from 0% to 0.25%, to 0.25% to 0.50%. The FOMC stated that the process of normalizing interest rates is likely to proceed gradually and future policy actions depend on how the economy evolves relative to the FOMC’s objectives of maximum employment and 2% inflation. A large portion of our portfolio is comprised of Agency RMBS and as a result, our net asset value, net interest margin, net income and book value could be negatively affected by additional increases in the federal funds rate.
Adoption of the Basel III standards could negatively affect our access to future financings.
In response to various financial crises and the volatility of financial markets, the Basel Committee on Banking Supervision, (the “Basel Committee”) an international body comprised of senior representatives of bank supervisory authorities and central banks from 27 countries, including the United States, adopted the Basel III standards several years ago. The final package of Basel III reforms was approved by the G20 leaders in November 2010. U.S. regulators have elected to implement substantially all of the Basel III standards, which plan to be fully phased in by January 1, 2019. One of these new standards involves implementing a supplemental leverage ratio (“SLR”) and a liquidity coverage ratio (“LCR”).
The SLR applies to U.S. bank holding companies with $700 billion or more in consolidated assets, or over $10 trillion in assets under custody, and their bank subsidiaries. The SLR requires that a covered institution maintain a regulatory leverage buffer of 2% above the minimum leverage ratio that is otherwise required (3%), for a total of 5%, and covered bank subsidiaries must maintain a 6% leverage ratio to be considered well-capitalized. The LCR applies to all banking organizations with $250 billion or more in total consolidated assets, or $10 billion or more in foreign exposure on the organization’s balance sheet, and a less stringent LCR applies to a banking organization with $50 billion or more in consolidated assets that does not meet the other tests. The LCR creates a minimum liquidity standard that requires a banking organization to hold high quality, liquid assets that would meet net cash outflows during a 30-day stress period. The SLR will be effective on January 1, 2018 and the LCR will be effective on January 1, 2017. Implementation of these ratios may increase the financing costs of highly liquid assets, which may negatively impact our net interest margin and book value.
The Basel III standards will require certain banks to (i) hold more capital, predominantly in the form of common equity, than under the current capital framework, (ii) maintain specific leverage and liquidity ratios, (iii) decrease their reliance on short term, unstable financing and obtain and rely on funding sources that are stable and longer term in nature, (iv) calculate capital requirements using standardized models rather than the banks’ own internal models, (v) limit internal transfers between trading books and banking books, limiting the amount of capital that banks have available for deployment, and (vi) provide additional reporting regarding risk monitoring, among others. The adoption of these standards could impact the leverage and funding profiles of large financial institutions and their affiliates, including many broker-dealers and other subsidiaries that are affiliated with large banking organizations and from which we obtain financing, and may constrain our ability to obtain attractive future financings and increase the cost of such financings if they are obtained. If the adoption of these standards causes the availability of financing to decline, we may have fewer financing options in the future which could lead to lower profitability and could adversely affect our financial condition, net interest margin and book value.
The federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between these agencies and the U.S. government, may adversely affect our business.
The payments we receive on the Agency RMBS in which we invest depend upon a steady stream of payments on the mortgages underlying the securities and are guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac. Ginnie Mae is part of a U.S. Government agency and its guarantees are backed by the full faith and credit of the United States. Fannie Mae and Freddie Mac are U.S. Government-sponsored entities, or GSEs, but their guarantees are not backed by the full faith and credit of the United States.
In 2008 Congress and the U.S. Treasury undertook a series of actions to stabilize financial markets, generally, and Fannie Mae and Freddie Mac, in particular. The Housing and Economic Recovery Act of 2008 was signed into law on July 30, 2008, and established the Federal Housing Finance Agency, or the FHFA, with enhanced regulatory authority over, among other things, the business activities of Fannie Mae and Freddie Mac and the size of their portfolio holdings. On September 7, 2008, in response to the deterioration in the financial condition of Fannie Mae and Freddie Mac, the FHFA placed Fannie Mae and Freddie Mac into conservatorship, which is a statutory process pursuant to which the FHFA operates Fannie Mae and Freddie Mac as conservator in an effort to stabilize the entities. The appointment of the FHFA as conservator of both Fannie Mae and Freddie Mac allows the FHFA to control the actions of the two GSEs without forcing them to liquidate, which would be the case under receivership. In addition, the U.S. Treasury took steps to capitalize and provide financing to Fannie Mae and Freddie Mac and agreed to purchase direct obligations and Agency RMBS issued or guaranteed by them.
Shortly after Fannie Mae and Freddie Mac were placed in federal conservatorship, the Secretary of the U.S. Treasury, in announcing the actions, noted that the guarantee structure of Fannie Mae and Freddie Mac required examination and that changes in the structures of the entities were necessary to reduce risk to the financial system. The future roles of Fannie Mae and Freddie Mac could be significantly reduced and the nature of their guarantees could be eliminated or considerably limited relative to historical measurements. Any changes to the nature of the guarantees provided by Fannie Mae and Freddie Mac could redefine what constitutes Agency RMBS and could have broad adverse market implications as well as negatively impact our liquidity, financing rates, net income, and book value.
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The problems faced by Fannie Mae and Freddie Mac that resulted in their being placed into federal conservatorship have stirred debate among some federal policy makers regarding the continued role of the U.S. Government in providing liquidity for the residential mortgage market. The gradual recovery of the housing market in 2014 made Fannie Mae and Freddie Mac profitable again and increased the uncertainty about their futures. If federal policy makers decide that the U.S. Government’s role in providing liquidity for the residential mortgage market should be reduced or eliminated, each of Fannie Mae and Freddie Mac could be dissolved and the U.S. Government could decide to stop providing liquidity support of any kind to the mortgage market. If Fannie Mae or Freddie Mac were eliminated, or their structures were to change radically, we would not be able to acquire Agency RMBS from these companies, which would drastically reduce the amount and type of Agency RMBS available for investment.
Our income could be negatively affected in a number of ways depending on the manner in which related events unfold. For example, the continued backing of Fannie Mae and Freddie Mac by the U.S. Treasury and, any additional credit support it may provide in the future to the GSEs could have the effect of lowering the interest rate we receive from Agency RMBS, thereby tightening the spread between the interest we earn on our Agency RMBS portfolio and our cost of financing that portfolio. A reduction in the supply of Agency RMBS could also increase the prices of Agency RMBS we seek to acquire thereby reducing the spread between the interest we earn on our portfolio of targeted assets and our cost of financing that portfolio.
Any new laws affecting these GSEs may exacerbate market uncertainty and have the effect of reducing the actual or perceived credit quality of securities issued or guaranteed by Fannie Mae or Freddie Mac. It is also possible that such laws could adversely impact the market for such securities and the spreads at which they trade. All of the foregoing could materially adversely affect the pricing, supply, liquidity and value of our target assets and otherwise materially adversely affect our business, operations and financial condition.
We are subject to the risk that agencies of and entities sponsored by the U.S. government may not be able to fully satisfy their guarantees of Agency RMBS or that these guarantee obligations may be repudiated, which may adversely affect the value of our investment portfolio and our ability to sell or finance these securities.
The interest and principal payments we receive on the Agency RMBS in which we invest are guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. Unlike the Ginnie Mae certificates in which we may invest, the principal and interest on securities issued by Fannie Mae and Freddie Mac are not guaranteed by the U.S. government. All the Agency RMBS in which we invest depend on a steady stream of payments on the mortgages underlying the securities.
As conservator of Fannie Mae and Freddie Mac, the FHFA may disaffirm or repudiate (subject to certain limitations for qualified financial contracts) contracts that Freddie Mac or Fannie Mae entered into prior to the FHFA’s appointment as conservator if it determines, in its sole discretion, that performance of the contract is burdensome and that disaffirmation or repudiation of the contract promotes the orderly administration of its affairs. The Housing and Economic Recovery Act of 2008, or HERA, requires the FHFA to exercise its right to disaffirm or repudiate most contracts within a reasonable period of time after its appointment as conservator. Fannie Mae and Freddie Mac have disclosed that the FHFA has disaffirmed certain consulting and other contracts that these entities entered into prior to the FHFA’s appointment as conservator. Freddie Mac and Fannie Mae have also disclosed that the FHFA has advised that it does not intend to repudiate any guarantee obligation relating to Fannie Mae and Freddie Mac’s mortgage-related securities, because the FHFA views repudiation as incompatible with the goals of the conservatorship. In addition, the HERA provides that mortgage loans and mortgage-related assets that have been transferred to a Freddie Mac or Fannie Mae securitization trust must be held for the beneficial owners of the related mortgage-related securities, and cannot be used to satisfy the general creditors of Freddie Mac or Fannie Mae.
If the guarantee obligations of Freddie Mac or Fannie Mae were repudiated by the FHFA, payments of principal and/or interest to holders of Agency RMBS issued by Freddie Mac or Fannie Mae would be reduced in the event of any borrowers’ late payments or failure to pay or a servicer’s failure to remit borrower payments to the trust. In that case, trust administration and servicing fees could be paid from mortgage payments prior to distributions to holders of Agency RMBS. Any actual direct compensatory damages owed due to the repudiation of Freddie Mac or Fannie Mae’s guarantee obligations may not be sufficient to offset any shortfalls experienced by holders of Agency RMBS. The FHFA also has the right to transfer or sell any asset or liability of Freddie Mac or Fannie Mae, including its guarantee obligation, without any approval, assignment or consent. If the FHFA were to transfer Freddie Mac or Fannie Mae’s guarantee obligations to another party, holders of Agency RMBS would have to rely on that party for satisfaction of the guarantee obligation and would be exposed to the credit risk of that party. If the new party does not guarantee these Agency RMBS, we are subject to credit loss on the Agency RMBS which could negatively affect liquidity, net income and book value.
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Mortgage loan modification and refinancing programs may adversely affect the value of, and our returns on, mortgage-backed securities and residential mortgage loans.
The U.S. government, through the Federal Reserve, the FHA, the FHFA and the FDIC, has implemented a number of federal programs designed to assist homeowners, including the Home Affordable Modification Program, or HAMP, which provides homeowners with assistance in avoiding residential mortgage loan foreclosures, and the Home Affordable Refinance Program, or HARP, which allows borrowers who are current on their mortgage payments to refinance and reduce their monthly mortgage payments at loan-to-value ratios up to 125% without new mortgage insurance. Similar modification programs are also offered by several large non-GSE financial institutions.
HAMP, HARP and other loss mitigation programs may involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans (through forbearance and/or forgiveness) and/or the rate of interest payable on the loans, or to extend the payment terms of the loans. Non-Agency RMBS and residential mortgage loan yields and cash flows could particularly be negatively impacted by a significant number of loan modifications with respect to a given security or residential mortgage loan pool, including, but not limited to, those related to principal forgiveness and coupon reduction. These loan modification, loss mitigation and refinance programs may adversely affect the value of, and the returns on, mortgage-backed securities and residential mortgage loans that we own or may purchase.
We cannot predict the impact, if any, on our earnings or cash available for distribution to our stockholders of the FHFA's proposed revisions to Fannie Mae's and Freddie Mac's existing infrastructures in order to align the standards and practices of the two entities.
On May 13, 2014, the FHFA released its updated 2014 Strategic Plan for the Conservatorships of Fannie Mae and Freddie Mac, which set forth three goals for the next phase of the Fannie Mae and Freddie Mac conservatorships. These three goals are to (i) maintain foreclosure prevention activities and credit availability for new and refinanced mortgages, which should refine and improve servicing initiatives for distressed borrowers (ii) reduce taxpayer risk by expanding the credit risk transfer transactions which would increase the participation of private capital in assuming credit risk associated with the secondary mortgage market, and (iii) build a new single-family securitization infrastructure for use by the GSEs and adaptable for use by other participants in the secondary market in the future. This would be done by replacing the current, outdated infrastructures of Fannie Mae and Freddie Mac with a common, more efficient securitization infrastructure that aligns the standards and practices of the two entities, beginning with core functions performed by both entities such as issuance, master servicing, bond administration, collateral management and data integration, also known as the Common Securitization Platform (“CSP”).
Furthermore, in October 2014, FHFA director Watt announced a number of general policy initiatives by the FHFA , including restoring a program that allows Fannie Mae and Freddie Mac to guarantee loans with down payments as low as 3%. Director Watt also said that the FHFA was taking steps to bring certainty to the circumstances under which Fannie Mae and Freddie Mac will require originators to repurchase defaulted mortgages that were later discovered to have underlying defects. We cannot predict the prospects for the enactment, timing or final content of housing reform legislation.
The FHFA recognizes that there are a number of economic factors that could influence the agency’s success in achieving its goals, such as the fragility in domestic and global economies, uncertainty over the future of housing finance reform initiatives affecting the financial condition, performance, and future prospects of the GSEs. The FHFA plans to announce in 2016 the date on which Freddie Mac will begin using the CSP. In addition, as part of the 2016 Conservatorship Scorecards for Freddie Mac, Fannie Mae, Common Securitization Solutions (the joint venture owned by Fannie Mae and Freddie Mac that is developing the CSP), the FHFA may provide information on the timing of Fannie Mae and Freddie Mac’s use of the CSP to issue Single Securities (a single mortgage backed security issued by either Fannie Mae or Freddie Mac whose goal would be to improve overall liquidity of Fannie Mae and Freddie Mac securities). The FHFA also plans to continue discussions with stakeholders about the implementation of the CSP and about future plans for the evolution of the CSP. If such proposals are fully implemented, it is also unclear how closely what is implemented will resemble the proposals in the FHFA’s current strategic plan or what the effects of the implementation will be in terms of our stockholders’ equity, earnings or cash available for distribution to our stockholders.
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Risks related to our business
Increases in interest rates could adversely affect the value of our investments and cause our interest expense to increase, which could result in reduced earnings or losses and negatively affect our profitability as well as the cash available for distribution to our stockholders.
Our investment portfolio contains a significant allocation to RMBS, as well as other assets such as ABS, CMBS and mortgage loans. In a normal yield curve environment, an investment in such assets will generally decline in value if long-term interest rates increase. Declines in market value may ultimately reduce earnings or result in losses to us, which may negatively affect cash available for distribution to our stockholders.
Ordinarily, short-term interest rates are lower than longer-term interest rates. If short-term interest rates rise disproportionately relative to longer-term interest rates (a flattening of the yield curve), our borrowing costs may increase more rapidly than the interest income earned on our assets. Because we expect our investments, on average, generally will bear interest based on longer-term rates than our borrowings, a flattening of the yield curve would tend to decrease our net income, book value and the market value of our net assets. It is also possible that short-term interest rates may exceed longer-term interest rates (a yield curve inversion), in which event our borrowing costs may exceed our interest income and we could incur operating losses.
A significant risk associated with our target assets is the risk that both long-term and short-term interest rates will increase significantly. If long-term rates increase significantly, the market value of these investments will decline, and the duration and weighted average life of the investments will increase. We could realize losses if these investments were sold. At the same time, an increase in short-term interest rates will increase the amount of interest owed on the repurchase agreements and FHLBC Advances we enter into to finance the purchase of our investments.
In addition, in a period of rising interest rates, our operating results will depend in large part on the difference between the income from our assets and financing costs. We anticipate that, in most cases, the income from such assets will respond more slowly to interest rate fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net income. Increases in these rates will tend to decrease our net income and the market value of our assets.
We may experience periods of illiquidity for our assets, which could adversely impact the value of our assets, our ability to finance our business or operate profitably.
Possible market developments, including continued adverse developments in financial and capital markets, could reduce the liquidity in the markets of the assets that we own. A lack of liquidity may result from the absence of a willing buyer or an established market for these assets, legal or contractual restrictions on resale or disruptions in the secondary markets. Such decreased liquidity can cause us to sell our assets at a price lower than we would normally sell them or cause us to hold our assets longer than we would normally hold them. In addition, such illiquidity could cause our lenders to require us to pledge additional assets as collateral. If we are unable to obtain sufficient short-term financing or our assets are insufficient to meet the collateral requirements, then we may be compelled to liquidate particular assets at an inopportune time. We bear the risk of being unable to dispose of our interest-earning assets at advantageous times or in a timely manner, and if such assets experience periods of illiquidity, our profitability may be adversely affected and we could incur substantial losses.
Investment in new business strategies and acquisitions could disrupt the Company’s ongoing business and present risks not originally contemplated.
The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, greater than expected liabilities and expenses, inadequate return of capital and unidentified issues not discovered in the Company’s due diligence. These new ventures are inherently risky and may not be successful.
We may change our investment and operational policies without stockholder consent, which may adversely affect the market value of our common stock and our ability to make distributions to our stockholders.
Our board of directors determines our operational policies and may amend or revise such policies, including our policies with respect to our REIT qualification, acquisitions, dispositions, operations, indebtedness and distributions, or approve transactions that deviate from these policies, without a vote of, or notice to, our stockholders. Operational policy changes could adversely affect the market value of our common stock and our ability to make distributions to our stockholders.
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We may also change our investment strategies and policies and target asset classes at any time without the consent of our stockholders, which could result in our making investments that are different in type from, and possibly riskier than, our current assets or the investments contemplated in this report. A change in our investment strategies and policies and target asset classes may increase our exposure to interest rate risk, default risk and real estate market fluctuations, which could adversely affect the market value of our common stock and our ability to make distributions to our stockholders.
We are highly dependent on information systems and systems failures, breaches or cyber-attacks could significantly disrupt our business, which could have a material adverse effect on our results of operations and cash flows.
Our business is highly dependent on the communications and information systems of our Manager. Any failure interruption or unauthorized access of these systems could cause delays or other problems in our securities trading activities, which could have a material adverse effect on our results of operations and cash flows and negatively affect the market price of our common stock and ability to make distributions to our stockholders.
System breaches in particular are evolving and include, but are not limited to, malicious software, attempts to gain unauthorized access to data, and other electronic security breaches that could result in disruptions of our Manager’s communications and information systems, unauthorized release of confidential or proprietary information and damage or corruption of data. These events could lead to higher operating costs from remedial actions, loss of business and potential liability.
Risks associated with our management and relationship with our Manager and its affiliates
We are dependent upon our Manager, its affiliates and their key personnel and may not find a suitable replacement if the management agreement with our Manager is terminated or such key personnel are no longer available to us, which would materially and adversely affect us.
In accordance with our management agreement, we are externally managed and advised by our Manager, and all of our officers are employees of Angelo, Gordon or its affiliates. We have no separate facilities and we have no employees. Pursuant to our management agreement, our Manager is obligated to supply us with our senior management team, and the members of that team may have conflicts in allocating their time and services between us and other entities or accounts managed by our Manager, now or in the future, including other Angelo, Gordon funds. Substantially all of our investment, financing and risk management decisions are made by our Manager and not by us, and our Manager also has significant discretion as to the implementation of our operating policies and strategies. Furthermore, our Manager has the sole discretion to hire and fire employees, and our board of directors and stockholders have no authority over the individual employees of our Manager, although our board of directors does have authority over our officers who are supplied by our Manager. Accordingly, we are completely reliant upon, and our success depends exclusively on, our Manager’s personnel, services, resources, facilities, relationships and contacts. No assurance can be given that our Manager will act in our best interests with respect to the allocation of personnel, services and resources to our business. In addition, the management agreement does not require our Manager to dedicate specific personnel to us or to require personnel servicing our business to allocate a specific amount of time to us. The failure of any of our Manager’s key personnel to service our business with the requisite time and dedication, or the departure of such personnel from our Manager, or the failure of our Manager to attract and retain key personnel, would materially and adversely affect our ability to execute our business plan. Further, when there are turbulent conditions in the real estate industry, distress in the credit markets or other times when we will need focused support and assistance from our Manager, the attention of our Manager’s personnel and executive officers and the resources of Angelo, Gordon will also be required by the other funds and accounts managed by our Manager and its affiliates, placing our Manager’s resources in high demand. In such situations, we may not receive the level of support and assistance that we may receive if we were internally managed or if our Manager did not act as a manager for other entities. If the management agreement is terminated and a suitable replacement for our Manager is not secured in a timely manner or at all, we would likely be unable to execute our business plan, which would materially and adversely affect us.
The management agreement was not negotiated on an arm’s length basis and the terms, including the fees payable to our Manager, may not be as favorable to us as if the agreement was negotiated with unaffiliated third parties.
All of our officers and our non-independent directors are employees of Angelo, Gordon or its affiliates. The management agreement was negotiated between related parties, and we did not have the benefit of arm’s length negotiations of the type normally conducted with an unaffiliated third party and the terms, including the fees payable to our Manager, may not be as favorable to us. We may choose not to enforce, or to enforce less vigorously, our rights under the management agreement because of our desire to maintain our ongoing relationship with our Manager.
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We expect that our Manager will source all of our investments, and existing or future entities or accounts managed by our Manager may compete with us for, or may participate in, some of those investments, which could result in conflicts of interest.
Although we are subject to Angelo, Gordon’s allocation policy, which specifically addresses some of the conflicts relating to our investment opportunities, there is no assurance that this policy will be adequate to address all of the conflicts that may arise, or address such conflicts in a manner that results in the allocation of a particular investment opportunity to us or is otherwise favorable to us. Our Manager may be precluded from transacting in particular investments in certain situations, including, but not limited to, situations where Angelo, Gordon or its affiliates may have a prior contractual commitment with other accounts or clients or as to which Angelo, Gordon or any of its affiliates possess material, non-public information. Consistent with Angelo, Gordon’s fiduciary duty to all of its clients, it may give priority in the allocation of investment opportunities to certain clients to the extent necessary to apply regulatory requirements, client guidelines and/or contractual obligations. Angelo, Gordon or our Manager may determine that an investment opportunity is appropriate for a particular account, but not for another. In addition, Angelo, Gordon or its employees may invest in opportunities declined by our Manager for us. The investment allocation policy may be amended by Angelo, Gordon at any time without our consent. As the investment programs of the various entities and accounts managed by Angelo, Gordon change and develop over time, additional issues and considerations may affect Angelo, Gordon’s allocation policy and its expectations with respect to the allocation of investment opportunities.
Our Manager and Angelo, Gordon and their respective employees also may have ongoing relationships with the obligors of investments or the clients’ counterparties and they or their clients may own equity or other securities or obligations issued by such parties. In addition, Angelo, Gordon, either for its own accounts or for the accounts of other clients, may hold securities or obligations that are senior to, or have interests different from or adverse to, the securities or obligations that are acquired for us. Employees may also invest in other entities managed by other managers which are eligible to purchase target assets. Angelo, Gordon or our Manager and their respective employees may make investment decisions for us that may be different from those undertaken for their personal accounts or on behalf of other clients (including the timing and nature of the action taken). Angelo, Gordon and its affiliates may at certain times simultaneously seek to purchase or sell the same or similar investments for clients or for themselves. Likewise, our Manager may on our behalf purchase or sell an investment in which another Angelo, Gordon client or affiliate is already invested or has co-invested. Such transactions may differentiate across Angelo, Gordon clients or affiliates.
We may enter into transactions to purchase or sell investments with entities or accounts managed by our Manager.
Our Manager may make, or may be required to make, investment decisions on our behalf where our trading counterparty is an entity affiliated with or an account managed by our Manager. Although we are subject to Angelo, Gordon’s cross trade policy, which specifically addresses the requirements of these types of trades, there is no assurance that this policy will ensure the most favorable outcome for us or will ensure that this policy will be adequate to address all of the conflicts that may arise. There is no assurance that the terms of such transactions would be as favorable to us as transacting in the open market with unaffiliated third parties. Furthermore, the cross trade policy may be amended by Angelo, Gordon at any time without our consent. As the investment programs of the various entities and accounts managed by our Manager change over time, additional issues and considerations may affect the cross trade policy and our Manager’s expectations with respect to such transactions.
Our board of directors has approved very broad investment policies for our Manager and does not review or approve each investment decision made by our Manager.
Our Manager is authorized to follow very broad investment policies and, therefore, has great latitude in determining the types of assets that are proper investments for us, the allocations among asset classes and individual investment decisions. In the future, our Manager may make investments with lower rates of return than those anticipated under current market conditions and/or may make investments with greater risks to achieve those anticipated returns. Our board of directors periodically reviews our investment policies and our investment portfolio but does not review or approve each proposed investment by our Manager. In addition, in conducting periodic reviews, our board of directors relies primarily on information provided to it by our Manager. Furthermore, our Manager may use complex strategies and transactions that may be costly, difficult or impossible to unwind by the time they are reviewed by our board of directors.
The management fee may not provide sufficient incentive to our Manager to maximize risk-adjusted returns on our investment portfolio because it is based on our Stockholders’ Equity, adjusted for certain non-cash and other items, and not on our performance.
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Our Manager is entitled to receive a management fee that is based on our Stockholders’ Equity, adjusted for certain non-cash and other items as further discussed in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, at the end of each quarter. Accordingly, the possibility exists that significant management fees could be payable to our Manager for a given quarter despite the fact that we could experience a net loss during that quarter. Our Manager’s entitlement to such significant non-performance-based compensation may not provide sufficient incentive to our Manager to devote its time and effort to source and maximize risk-adjusted returns on our investment portfolio, which could, in turn, adversely affect our ability to make distributions to our stockholders and the market price of our common stock. The compensation payable to our Manager will increase as a result of any future issuances of our equity securities, even if the issuances are dilutive to existing stockholders.
Termination of our management agreement would be costly and, in certain cases, not permitted.
It is difficult and costly to terminate the management agreement we have entered into with our Manager without cause. Our independent directors review our Manager’s performance and the management fees annually. The management agreement renews automatically each year for an additional one-year period, subject to certain termination rights. As of December 31, 2015 no termination events had been experienced. The management agreement provides that it may be terminated annually by us without cause upon the affirmative vote of at least two-thirds of our independent directors or by a vote of the holders of at least two-thirds of our outstanding common stock, in each case based upon (i) our Manager’s unsatisfactory performance that is materially detrimental to us or (ii) our determination that the management fees payable to our Manager are not fair, subject to our Manager’s right to prevent termination based on unfair fees by accepting a reduction of management fees agreed to by at least two-thirds of our independent directors. Our Manager must be provided 180-days’ prior notice of any such termination. We may not terminate or elect not to renew the management agreement, even in the event of our Manager’s poor performance, without having to pay substantial termination fees. Upon any such termination without cause, the management agreement provides that we will pay our Manager a termination fee equal to three times the average annual management fee earned by our Manager during the 24-month period prior to termination, calculated as of the end of the most recently completed fiscal quarter. While under certain circumstances the obligation to make such a payment might not be enforceable, this provision may increase the cost to us of terminating the management agreement and adversely affect our ability to terminate the management agreement without cause.
Our Manager may terminate the management agreement if we become required to register as an investment company under the Investment Company Act with termination deemed to occur immediately before such event, in which case we would not be required to pay a termination fee to our Manager. Furthermore, our Manager may decline to renew the management agreement by providing us with 180 days’ written notice, in which case we would not be required to pay a termination fee to our Manager. Our Manager may also terminate the management agreement upon at least 60 days’ prior written notice if we default in the performance of any material term of the management agreement and the default continues for a period of 30 days after written notice to us, whereupon we would be required to pay to our Manager the termination fee described above. If the management agreement is terminated and no suitable replacement is found to manage us, we may not be able to execute our business plan.
Depository institutions that finance our investments may require that AG REIT Management, LLC remain as our Manager under the management agreement and that certain key personnel of our Manager continue to service our business. If AG REIT Management, LLC ceases to be our Manager or one or more of our Manager’s key personnel are no longer servicing our business, it may constitute an event of default and the depository institution providing the arrangement may have acceleration rights with respect to outstanding borrowings and termination rights with respect to our ability to finance our future investments with that institution. If we are unable to obtain financing for our accelerated borrowings and for our future investments under such circumstances, we may be required to curtail our asset acquisitions and/or dispose of assets at an inopportune time.
We have engaged Red Creek Asset Management LLC (“Asset Manager”) for certain of our residential mortgage loans and Securitized Whole Loans, who is an affiliate of our Manager. The terms of the asset management agreement with the Asset Manager may not be as favorable to us as if the agreement was negotiated with unaffiliated third parties.
In connection with our investments in residential loans and Securitized Whole Loans, we engage asset managers to provide advisory, consultation, asset management and other services to formulate and implement strategic plans to manage, collect and dispose of loans in a manner that is reasonably expected to maximize the amount of proceeds from each loan. Beginning in November 2015, we engaged the Asset Manager, a related party of the Manager and direct subsidiary of Angelo, Gordon, as the asset manager for certain of our residential loans and Securitized Whole Loans. We will pay separate arm’s-length asset management fees as assessed and confirmed by a third party valuation firm for (i) non-performing loans and (ii) reperforming loans, in each case, to the Asset Manager. The asset management agreement was negotiated between related parties and we did not have the benefit of arm’s-length negotiations as we normally would with unaffiliated third parties. As such, the terms may not be as favorable to us as they otherwise might have been.
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Risks related to our organization and structure
Loss of our exemption from regulation under the Investment Company Act would negatively affect the value of shares of our common stock and our ability to distribute cash to our stockholders.
We conduct our operations so that we maintain an exemption from the Investment Company Act. Under Section 3(a)(1)(A) of the Investment Company Act, a company is an investment company if it is, or holds itself out as being, engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities. Under Section 3(a)(1)(C) of the Investment Company Act, a company is deemed to be an investment company if it is engaged, or proposes to engage, in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire “investment securities” having a value exceeding 40% of the value of its total assets (exclusive of U.S. government securities and cash items) on an unconsolidated basis, or the 40% test. “Investment securities” do not include, among other things, U.S. government securities, and securities issued by majority-owned subsidiaries that (i) are not investment companies and (ii) are not relying on the exceptions from the definition of investment company provided by Section 3(c)(1) or 3(c)(7) of the Investment Company Act (the so called “private investment company” exemptions).
We are not engaged, except to a minor extent, in actively investing, reinvesting or trading in securities. Rather, we are primarily engaged in the business of owning or holding the securities of our wholly-owned or majority-owned subsidiaries that are in real estate-related businesses. Therefore, we believe that we are not an investment company as defined in Section 3(a)(1)(A).
We also believe we are not considered an investment company under Section 3(a)(1)(C) of the Investment Company Act. The operations of many of our wholly-owned or majority-owned subsidiaries’ are generally conducted so that they are exempted from investment company status in reliance upon Section 3(c)(5)(C) of the Investment Company Act. Because entities relying on Section 3(c)(5)(C) are not investment companies, our interests in those subsidiaries do not constitute “investment securities” for purposes of Section 3(a)(1)(C). To the extent that our direct subsidiaries qualify only for either Section 3(c)(1) or 3(c)(7) exemptions from the Investment Company Act, we limit our holdings in those kinds of entities so that, together with other investment securities, we satisfy the 40% test. Although we continuously monitor our and our subsidiaries’ portfolios on an ongoing basis to determine compliance with that test, there can be no assurance that we will be able to maintain the exemptions from registration for us and each of our subsidiaries.
As discussed, we generally conduct our wholly-owned or majority-owned subsidiaries’ operations so that they are exempted from investment company status in reliance upon Section 3(c)(5)(C) of the Investment Company Act. Section 3(c)(5)(C) exempts from the definition of “investment company” entities primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. The staff of the Securities and Exchange Commission, or the SEC, generally requires an entity relying on Section 3(c)(5)(C) to invest at least 55% of its portfolio in “qualifying assets” and at least another 25% in additional qualifying assets or in “real estate-related” assets (with no more than 20% comprised of miscellaneous assets).
The method we use to classify our and our subsidiaries’ assets for purposes of the Investment Company Act is based in large measure upon no-action positions taken by the SEC staff. These no-action positions were issued in accordance with factual situations that may be substantially different from the factual situations we may face, and a number of these no-action positions were issued decades ago. No assurance can be given that the SEC or its staff will concur with our classification of our or our subsidiaries’ assets or that the SEC or its staff will not, in the future, issue further guidance that may require us to reclassify those assets for purposes of qualifying for an exclusion from regulation under the Investment Company Act. In August 2011, the SEC solicited public comment on a wide range of issues relating to Section 3(c)(5)(C), including the nature of the assets that qualify for purposes of the exemption and leverage used by mortgage related vehicles. There can be no assurance that the laws and regulations governing the 1940 Act status of companies primarily owning real estate related assets, including the SEC or its staff providing more specific or different guidance regarding these exemptions, will not change in a manner that adversely affects our operations. To the extent that the SEC or its staff provides more specific guidance regarding Section 3(c)(5)(C) or any of the other matters bearing upon the definition of investment company and the exceptions to that definition, we may be required to adjust our investment strategy accordingly. Additional guidance from the SEC or its staff could provide additional flexibility to us, or it could further inhibit our ability to pursue the investment strategy we have chosen.
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Qualification for exemption from the definition of investment company under the Investment Company Act limits our ability to make certain investments. For example, these restrictions limit our and our subsidiaries’ ability to invest directly in mortgage-related securities that represent less than the entire ownership in a pool of mortgage loans, debt and equity tranches of securitizations, certain real estate companies or assets not related to real estate. If we fail to qualify for these exemptions, or the SEC determines that companies that invest in RMBS are no longer able to rely on these exemptions, we could be required to restructure our activities in a manner that, or at a time when, we would not otherwise choose to do so, or we may be required to register as an investment company under the Investment Company Act, either of which could negatively affect the value of shares of our common stock and our ability to make distributions to our stockholders.
If we were required to register with CFTC as a Commodity Pool Operator, it could materially adversely affect our business, financial condition and results of operations.
Under the Dodd-Frank Act, the U.S. Commodity Futures Trading Commission, or the CFTC, was given jurisdiction over the regulation of swaps. Under new rules implemented by the CFTC, companies that utilize swaps as part of their business model, including many mortgage REITs, are deemed to fall within the statutory definition of Commodity Pool Operator, or CPO, and, absent relief from the CFTC’s Division of Swap Dealer and Intermediary Oversight, are required to register with the CFTC as a CPO. As a result of numerous requests for no-action relief from CPO registration, in December 2012 the CFTC issued no-action relief entitled “No-Action Relief from the Commodity Pool Operator Registration Requirement for Commodity Pool Operators of Certain Pooled Investment Vehicles Organized as Mortgage Real Estate Investment Trusts,” which permits a CPO to receive relief from registration requirements by filing a claim stating that the CPO meets the criteria specified in the no-action letter. We submitted a claim for relief within the required time period and believe we meet the criteria for such relief. There can be no assurance, however, that the CFTC will not modify or withdraw the no-action letter in the future or that we will be able to continue to satisfy the criteria specified in the no-action letter in order to qualify for relief from CPO registration. If we were required to register as a CPO in the future or change our business model to ensure that we can continue to satisfy the requirements of the no-action relief, it could materially and adversely affect our ability to operate our business, our financial condition and our results of operations.
Certain provisions of Maryland law could inhibit a change in our control.
Certain provisions of the Maryland General Corporation Law, or the MGCL, may have the effect of inhibiting a third party from making a proposal to acquire us or of impeding a change in our control under circumstances that otherwise could provide the holders of our common stock with the opportunity to realize a premium over the then prevailing market price of such shares. We are subject to the “business combination” provisions of the MGCL that, subject to limitations, prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our then outstanding voting shares or an affiliate or associate of ours who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10% or more of the voting power of our then outstanding voting shares) or an affiliate thereof for five years after the most recent date on which the stockholder becomes an interested stockholder and, thereafter, imposes special stockholder voting requirements to approve these combinations unless the consideration being received by common stockholders satisfies certain conditions. These provisions of the MGCL do not apply, however, to business combinations that are approved or exempted by the board of directors prior to the time that the interested stockholder becomes an interested stockholder. Pursuant to the statute, our board of directors has by resolution exempted business combinations between us and any other person, provided that the business combination is first approved by our board of directors. This resolution, however, may be altered or repealed in whole or in part at any time. If this resolution is repealed, or our board of directors does not otherwise approve a business combination, this statute may discourage others from trying to acquire control of us and increase the difficulty of consummating any offer.
The “control share” provisions of the MGCL provide that “control shares” of a Maryland corporation (defined as shares which, when aggregated with all other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in the election of directors) acquired in a “control share acquisition” (defined as the acquisition of “control shares,” subject to certain exceptions) have no voting rights except to the extent approved by our stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding votes entitled to be cast by the acquirer of control shares, our officers and our directors who are also our employees. Our bylaws contain a provision exempting from the control share acquisition statute any and all acquisitions by any person of our shares. There can be no assurance that this provision will not be amended or eliminated at any time in the future.
The “unsolicited takeover” provisions of the MGCL permit our board of directors, without stockholder approval and regardless of what is currently provided in our charter or bylaws, to implement certain provisions since we have a class of equity securities registered under the Exchange Act and at least three directors who are not officers or employees of the corporation and are not affiliated with any acquiring person. These provisions may have the effect of inhibiting a third party from making an acquisition proposal for us or of delaying, deferring or preventing a change in our control under circumstances that otherwise could provide the holders of our common stock with the opportunity to realize a premium over the then current market price.
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Our authorized but unissued common and preferred shares may prevent a change in our control.
Our charter authorizes us to issue additional authorized but unissued common stock and preferred shares. In addition, our board of directors may, without stockholder approval, increase the aggregate number of our authorized shares or the number of shares of any class or series that we have authority to issue and classify or reclassify any unissued common stock or preferred shares and may set the preferences, rights and other terms of the classified or reclassified shares. As a result, among other things, our board may establish a class or series of common stock or preferred shares that could delay or prevent a transaction or a change in our control that might involve a premium price for our common stock or otherwise be in the best interests of our stockholders.
Our rights and the rights of our stockholders to take action against our directors and officers are limited, which could limit your recourse in the event of actions taken not in your best interest.
Our charter limits the liability of our present and former directors and officers to us and our stockholders for money damages to the maximum extent permitted under Maryland law. Under current Maryland law, our present and former directors and officers will not have any liability to us or our stockholders for money damages other than liability resulting from:
| • | actual receipt of an improper benefit or profit in money, property or services; or |
| • | active and deliberate dishonesty by the director or officer that was established by a final judgment as being material to the cause of action. |
Our charter authorizes us to indemnify our present and former directors and officers for actions taken by them in those capacities to the maximum extent permitted by Maryland law. Our bylaws require us to indemnify each present and former director or officer, to the maximum extent permitted by Maryland law, in the defense of any proceeding to which he or she is made, or threatened to be made, a party by reason of his or her service to us. In addition, we may be obligated to pay or reimburse the expenses incurred by our present and former directors and officers without requiring a preliminary determination of their ultimate entitlement to indemnification. As a result, we and our stockholders may have more limited rights against our present and former directors and officers than might otherwise exist absent the current provisions in our charter and bylaws or that might exist with other companies, which could limit your recourse in the event of actions not in your best interest.
Our charter contains provisions that make removal of our directors difficult, which could make it difficult for our stockholders to effect changes to our management.
Our charter and bylaws provide that, subject to the rights of any series of preferred shares, a director may be removed only for “cause” (as defined in our charter), and then only by the affirmative vote of at least two-thirds of the votes entitled to be cast generally in the election of directors. Vacancies generally may be filled only by a majority of the remaining directors in office, even if less than a quorum, for the full term of the director who vacated. These requirements make it more difficult to change our management by removing and replacing directors and may prevent a change in our control that is in the best interests of our stockholders.
Risks related to taxation
Our failure to qualify as a REIT would result in higher taxes and reduced cash available for distribution to our stockholders.
We operate in a manner that is intended to cause us to qualify as a REIT for U.S. federal income tax purposes. However, the U.S. federal income tax laws governing REITs are complex, and interpretations of the U.S. federal income tax laws governing qualification as a REIT are limited. Qualifying as a REIT requires us to meet various tests regarding the nature of our assets and our income, the ownership of our outstanding stock, and the amount of our distributions on an ongoing basis.
Our ability to satisfy the asset tests depends upon the characterization and fair market values of our assets, some of which are not susceptible to a precise determination, and for which we will not obtain independent appraisals. Our compliance with the REIT income and quarterly asset requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis. Although we intend to operate so that we will qualify as a REIT, given the highly complex nature of the rules governing REITs, the ongoing importance of factual determinations, and the possibility of future changes in our circumstances, no assurance can be given that we will so qualify for any particular year.
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If we fail to qualify as a REIT in any calendar year, we would be required to pay U.S. federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates, and dividends paid to our stockholders would not be deductible by us in computing our taxable income. Further, if we fail to qualify as a REIT, we might need to borrow money or sell assets in order to pay any resulting tax. Our payment of income tax would decrease the amount of our income available for distribution to our stockholders. Furthermore, if we fail to maintain our qualification as a REIT, we no longer would be required to distribute substantially all of our REIT taxable income to our stockholders. Unless our failure to qualify as a REIT was subject to relief under U.S. federal tax laws, we could not re-elect to qualify as a REIT for four taxable years following the year in which we failed to qualify.
Complying with the REIT requirements can be difficult and may cause us to forego otherwise attractive opportunities.
To qualify as a REIT for U.S. federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of our shares. We may be required to make distributions to our stockholders at disadvantageous times or when we do not have funds readily available for distribution, and may be unable to pursue otherwise attractive investments in order to satisfy the source-of-income or asset-diversification requirements for qualifying as a REIT. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.
The REIT distribution requirements could adversely affect our ability to execute our business strategies.
We generally must distribute annually at least 90% of our net taxable income, excluding any net capital gain, in order for corporate income tax not to apply to earnings that we distribute. To the extent that we satisfy this distribution requirement, but distribute less than 100% of our taxable income, we will be subject to U.S. federal corporate, and may be subject to state and local income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our stockholders in a calendar year is less than a minimum amount specified under U.S. federal income tax laws. We intend to make distributions to our stockholders to comply with the requirements of the Code and to avoid paying corporate income tax. However, differences in timing between the recognition of taxable income and the actual receipt of cash could require us to sell assets or borrow funds on a short-term or long-term basis to meet the distribution requirements of the Code.
We may find it difficult or impossible to meet distribution requirements in certain circumstances. Due to the nature of the assets in which we will invest, we may be required to recognize taxable income from those assets in advance of our receipt of cash flow on or proceeds from disposition of such assets. For example, we may be required to accrue interest and discount income on mortgage loans, mortgage-backed securities, and other types of debt securities or interests in debt securities before we receive any payments of interest or principal on such assets. We also acquire distressed debt investments that may be subsequently modified by agreement with the borrower. If the amendments to the outstanding debt are “significant modifications” under the applicable Treasury regulations, the modified debt may be considered to have been reissued to us at a gain in a debt-for-debt exchange with the borrower, with gain recognized by us to the extent that the principal amount of the modified debt exceeds our cost of purchasing it prior to modification. Finally, we may be required under the terms of indebtedness that we incur to use cash received from interest payments to make principal payments on that indebtedness, with the effect of recognizing income but not having a corresponding amount of cash available for distribution to our stockholders.
As a result, to the extent such income is not recognized within a domestic TRS, the requirement to distribute a substantial portion of our net taxable income could cause us to: (i) sell assets in adverse market conditions, (ii) borrow on unfavorable terms, (iii) distribute amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment of debt or (iv) make a taxable distribution of our shares as part of a distribution in which stockholders may elect to receive shares or (subject to a limit measured as a percentage of the total distribution) cash, in order to comply with REIT requirements. Moreover, if our only feasible alternative were to make a taxable distribution of our shares to comply with the REIT distribution requirements for any taxable year and the value of our shares was not sufficient at such time to make a distribution to our stockholders in an amount at least equal to the minimum amount required to comply with such REIT distribution requirements, we would generally fail to qualify as a REIT for such taxable year and would be precluded from being taxed as a REIT for the four taxable years following the year during which we ceased to qualify as a REIT.
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Even if we qualify as a REIT, we may face tax liabilities that reduce our cash flow.
Even if we qualify for taxation as a REIT, we may be subject to certain U.S. federal, state and local taxes on our income and assets, including taxes on any undistributed income, tax on income from certain activities conducted as a result of a foreclosure, and state or local income, property and transfer taxes, such as mortgage recording taxes. In addition, in order to meet the REIT qualification requirements, or to avert the imposition of a 100% tax that applies to certain gains derived by a REIT from dealer property or inventory, we may hold certain assets through, and derive a significant portion of our taxable income and gains in, TRSs. Such subsidiaries are subject to corporate level income tax at regular rates. Any of these taxes would decrease cash available for distribution to our stockholders.
Liquidation of assets may jeopardize our REIT qualification.
To qualify as a REIT, we must comply with requirements regarding our assets and our sources of income. If we are compelled to liquidate our investments to repay obligations to our lenders, we may be unable to comply with these requirements, ultimately jeopardizing our qualification as a REIT, or we may be subject to a 100% tax on any resultant gain if we sell assets that are treated as dealer property or inventory.
The failure of assets subject to repurchase agreements to be treated as owned by us for U.S. federal income tax purposes could adversely affect our ability to qualify as a REIT.
We have entered and may in the future enter into repurchase agreements that are structured as sale and repurchase agreements pursuant to which we nominally sell certain of our assets to a counterparty and simultaneously enter into an agreement to repurchase these assets at a later date in exchange for a purchase price. Economically, these agreements are financings which are secured by the assets sold pursuant thereto. We believe that we are treated for REIT asset and income test purposes as the owner of the assets that are the subject of any such sale and repurchase agreement notwithstanding that such agreements may transfer record ownership of the assets to the counterparty during the term of the agreement. It is possible, however, that the IRS could assert that we did not own the assets during the term of the sale and repurchase agreement, in which case we could fail to qualify as a REIT.
Complying with the REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Code may limit our ability to hedge our assets and operations. Under current law, any income that we generate from transactions intended to hedge our interest rate, inflation and/or currency risks will be excluded from gross income for purposes of the REIT 75% and 95% gross income tests if (i) the instrument hedges risk of interest rate or currency fluctuations on indebtedness incurred or to be incurred to carry or acquire real estate assets, (ii) the instrument hedges risk of currency fluctuations with respect to any item of income or gain that would be qualifying income under the REIT 75% or 95% gross income tests, or (iii) the instrument was entered into to “offset” certain instruments described in clauses (i) or (ii) of this sentence and certain other requirements are satisfied and such instrument is properly identified under applicable Treasury Regulations. Income from hedging transactions that do not meet these requirements will generally constitute nonqualifying income for purposes of both the REIT 75% and 95% gross income tests. As a result of these rules, we may have to limit our use of hedging techniques that might otherwise be advantageous to us and could result in greater risks associated with interest rate fluctuations or other changes than we would otherwise be able to mitigate.
Our ability to invest in and dispose of TBA securities could be limited by our REIT status, and we could lose our REIT status as a result of these investments.
We may utilize TBA dollar roll transactions as a means of investing and financing Agency RMBS. The law is unclear regarding whether TBAs will be qualifying assets for the 75% asset test and whether income and gains from dispositions of TBAs will be qualifying income for the 75% gross income test.
Until such time as we seek and receive a favorable private letter ruling from the IRS or we are advised by counsel that TBAs should be treated as qualifying assets for purposes of the 75% asset test, we will limit our net investment in TBAs and any non-qualifying assets to no more than 25% of our assets at the end of any calendar quarter and will limit our investments in TBAs with a single counterparty to no more than 5% of our total assets at the end of any calendar quarter. Further, until such time as we seek and receive a favorable private letter ruling from the IRS or we are advised by counsel that income and gains from the disposition of TBAs should be treated as qualifying income for purposes of the 75% gross income test, we will limit our gains from dispositions of TBAs and any non-qualifying income to no more than 25% of our gross income for each calendar year. Accordingly, our ability to utilize TBA dollar roll transactions as a means of investing and financing Agency RMBS could be limited.
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Moreover, even if we are advised by counsel that TBAs should be treated as qualifying assets or that income and gains from dispositions of TBAs should be treated as qualifying income, it is possible that the IRS could successfully take the position that such assets are not qualifying assets and such income is not qualifying income. In that event, we could be subject to a penalty tax or we could fail to qualify as a REIT if (i) the value of our TBAs, together with our non-qualifying assets for the 75% asset test, exceeded 25% of our gross assets at the end of any calendar quarter or if the value of our investments in TBAs with a single counterparty exceeded 5% of our total assets at the end of any calendar quarter or (ii) our income and gains from the disposition of TBAs, together with our non-qualifying income for the 75% gross income test, exceeded 25% of our gross income for any taxable year.
The tax on prohibited transactions will limit our ability to engage in transactions, including certain methods of securitizing mortgage loans that would be treated as sales for U.S. federal income tax purposes.
A REIT’s net income from prohibited transactions is subject to a 100% tax with no offset for losses. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property, but including mortgage loans, held primarily for sale to customers in the ordinary course of business. We might be subject to this tax if we dispose of or securitize loans in a manner that was treated as a sale of the loans, if we frequently buy and sell securities or open and close TBA contracts in a manner that is treated as dealer activity with respect to such securities or contracts for U.S. federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose to engage in certain sales of loans through a TRS and not at the REIT level, and may limit the structures we utilize for our securitization transactions, even though the sales or structures might otherwise be beneficial to us.
The share ownership limits applicable to us that are imposed by the Code for REITs and our charter may restrict our business combination opportunities.
In order for us to maintain our qualification as a REIT under the Code, not more than 50% in value of our outstanding shares may be owned, directly or indirectly, by five or fewer individuals (as defined in the Code to include certain entities) at any time during the last half of each taxable year after our first taxable year. Our charter, with certain exceptions, authorizes our board of directors to take the actions that are necessary or appropriate to preserve our qualification as a REIT. Under our charter, no person may own, directly or indirectly, (i) more than 9.8% in value or in number of shares, whichever is more restrictive, of our outstanding common stock, or (ii) more than 9.8% in value or in number of shares, whichever is more restrictive, of our outstanding capital stock. However, our board of directors may, in its sole discretion, grant an exemption to the share ownership limits (prospectively or retrospectively), subject to certain conditions and the receipt by our board of certain representations and undertakings. In addition, our board of directors may change the share ownership limits as described under “Business—Restrictions on ownership and transfer of our shares.” The share ownership limit is based upon direct or indirect ownership by “persons,” which is defined to include entities and certain groups of stockholders. Our share ownership limits might delay or prevent a transaction or a change in our control that might involve a premium price for our common stock or otherwise be in the best interests of our stockholders.
The constructive ownership rules contained in our charter are complex and may cause the outstanding shares owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity. As a result, the acquisition of less than these percentages of the outstanding shares by an individual or entity could cause that individual or entity to own constructively in excess of these percentages of the outstanding shares and thus violate the share ownership limits. Any attempt to own or transfer our common stock or preferred shares (if and when issued) in excess of the share ownership limits without the consent of our board of directors or in a manner that would cause us to be “closely held” under Section 856(h) of the Code (without regard to whether the shares are held during the last half of a taxable year) will result in the shares being deemed to be transferred to a director for a charitable trust or, if the transfer to the charitable trust is not automatically effective to prevent a violation of the share ownership limits or the restrictions on ownership and transfer of our shares, any such transfer of our shares will be void ab initio. Further, any transfer of our shares that would result in our shares being held by fewer than 100 persons will be void ab initio.
We may lose our REIT status if the IRS successfully challenges our characterization of our income from our foreign TRS.
We have elected to treat one foreign entity as a TRS and we may elect to treat other foreign entities as TRSs in the future. We will likely be required to include in our income, even without the receipt of actual distributions, earnings from our investment in any foreign TRS. Income inclusions from equity investments in foreign corporations are technically neither actual dividends nor any of the other enumerated categories of qualifying income for the 95% gross income test. However, the IRS has issued private letter rulings to other REITs holding that income inclusions from equity investments in foreign corporations would be treated as qualifying income for purposes of the 95% gross income test. Private letter rulings may be relied upon only by the taxpayers to whom they are issued and the IRS may revoke a private letter ruling. Based on those private letter rulings and advice of counsel, we intend to treat such income inclusions as qualifying income for purposes of the 95% gross income test. Nevertheless, no assurance can be provided that the IRS would not successfully challenge our treatment of such income as qualifying income. In the event that such income was determined not to qualify for the 95% gross income test, we could be subject to a penalty tax with respect to such income to the extent it exceeds 5% of our gross income or we could fail to continue to qualify as a REIT.
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If our foreign TRS is subject to U.S. federal income tax at the entity level, it would greatly reduce the amounts that entity would have available to distribute to us and pay its creditors.
There is a specific exemption from federal income tax for non-U.S. corporations that restrict their activities in the United States to trading stock and securities (or any activity closely related thereto) for their own account whether such trading (or such other activity) is conducted by the corporation or its employees through a resident broker, commission agent, custodian or other agent. We intend that our foreign TRS and certain other foreign entities we may form or acquire in the future will rely on that exemption or otherwise operate in a manner so that they will not be subject to U.S. federal income tax on their net income at the entity level. If the IRS succeeded in challenging that tax treatment, it would greatly reduce the amount that those entities would have available to distribute to us and to pay to their creditors.
New legislation or administrative or judicial action, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to qualify as a REIT.
The present U.S. federal income tax treatment of REITs may be modified, possibly with retroactive effect, by legislative, judicial or administrative action at any time, which could affect the U.S. federal income tax treatment of an investment in our common stock. The U.S. federal tax rules that affect REITs are under review constantly by persons involved in the legislative process, the IRS and the U.S. Treasury Department, which results in statutory changes as well as frequent revisions to Treasury regulations and interpretations. Revisions in U.S. federal tax laws and interpretations thereof could cause us to change our investments and commitments, which could also affect the tax considerations of an investment in our stock.
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Item 1B. Unresolved Staff Comments
None.
As of December 31, 2015, we did not own any real estate or other physical property materially important to our operations. Our principal executive offices are located at 245 Park Avenue, 26th Floor, New York, New York 10167. Our telephone number is (212)-692-2000.
We are at times subject to various legal proceedings arising in the ordinary course of business. As of the date of this report, we are not party to any litigation or legal proceedings, or to our knowledge, any threatened litigation or legal proceedings, which we believe, individually or in the aggregate, would have a material adverse effect on our results of operations or financial condition.
Item 4. Mine safety disclosures
Not applicable.
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Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market and dividend information
Our common stock is traded on the NYSE under the symbol “MITT.” As of February 17, 2016, there were 28,288,534 shares of common stock outstanding and approximately 47 registered holders of our common stock. The 47 holders of record include Cede & Co., which holds shares as nominee for The Depository Trust Company, which itself holds shares on behalf of the beneficial owners of the Company’s common stock. Such information was obtained through the Company’s registrar and transfer agent, based on the results of a broker search.
The following tables set forth, for the periods indicated, the high and low sale price of our common stock as reported on the NYSE and the dividends declared per share of our common stock.
| Sales Prices | ||||||||
| 2015 | High | Low | ||||||
| First Quarter | $ | 19.25 | $ | 18.21 | ||||
| Second Quarter | 19.52 | 17.24 | ||||||
| Third Quarter | 18.45 | 15.07 | ||||||
| Fourth Quarter | 16.17 | 12.58 | ||||||
| 2014 | High | Low | ||||||
| First Quarter | $ | 18.56 | $ | 15.70 | ||||
| Second Quarter | 19.51 | 17.47 | ||||||
| Third Quarter | 20.00 | 17.80 | ||||||
| Fourth Quarter | 19.94 | 17.84 | ||||||
| 2015 | ||||||||
| Declaration Date | Record Date | Payment Date | Dividend Per Share | |||||
| 3/12/2015 | 3/23/2015 | 4/30/2015 | $ | 0.60 | ||||
| 6/11/2015 | 6/22/2015 | 7/31/2015 | 0.60 | |||||
| 9/10/2015 | 9/21/2015 | 10/30/2015 | 0.60 | |||||
| 12/10/2015 | 12/21/2015 | 1/29/2016 | 0.475 | |||||
| 2014 | ||||||||
| Declaration Date | Record Date | Payment Date | Dividend Per Share | |||||
| 3/5/2014 | 3/18/2014 | 4/28/2014 | $ | 0.60 | ||||
| 6/9/2014 | 6/19/2014 | 7/28/2014 | 0.60 | |||||
| 9/11/2014 | 9/22/2014 | 10/27/2014 | 0.60 | |||||
| 12/4/2014 | 12/18/2014 | 1/27/2015 | 0.60 | |||||
We intend to pay quarterly dividends and to distribute to our stockholders all of our annual taxable income in a timely manner. This will enable us to maintain our qualification as a REIT under the Code. We have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected for the reasons described under the caption “Risk Factors.” All distributions will be made at the discretion of our board of directors and will depend on our earnings, our financial condition, maintenance of our REIT status, Maryland law and such other factors as our board of directors may deem relevant from time to time.
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Equity incentive plan information
We have adopted equity incentive plans to provide incentive compensation to attract and retain qualified directors, officers, advisors, consultants and other personnel, including our Manager and affiliates and personnel of our Manager and its affiliates. The total number of shares that may be made subject to awards under our Manager Equity Incentive Plan and our Equity Incentive Plan is 277,500 shares. Awards under our equity incentive plans are forfeitable until they become vested.
The following table presents certain information about our equity incentive plans as of December 31, 2015:
| Number of Securities Remaining | ||||||||||||
| Number of Securities to | Weighted Average | Available for Future Issuance | ||||||||||
| be Issued Upon Exercise | Exercise Price of | Under Equity Compensation Plans | ||||||||||
| of Outstanding Options, | Outstanding Options, | (Excluding Securities Reflected in | ||||||||||
| Plan Category | Warrants and Rights | Warrants, and Rights | the First Column of this Table) | |||||||||
| Equity compensation plans approved by stockholders | - | $ | - | 142,226 | ||||||||
| Equity compensation plans not approved by stockholders | - | - | - | |||||||||
| Total | - | $ | - | 142,226 | ||||||||
Performance graph
The following graph provides a comparison of the cumulative total return on our common stock from June 30, 2011 to the NYSE closing price per share on December 31, 2015 with the cumulative total return on the Standard & Poor’s 500 Composite Stock Price Index (the “S&P 500”) and an index of selected issuers of FTSE NAREIT Mortgage REITs. Total return values were calculated assuming $100 invested with the reinvestment of all dividends. Please note that historical prices are not necessarily indicative of future price performance.
Source: Bloomberg.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
In November 2015, our board of directors authorized a stock repurchase program (“Repurchase Program”), to repurchase up to $25.0 million of our outstanding common stock. The Repurchase Program does not have an expiration date. As part of the Repurchase Program, shares may be purchased in open market transactions, including through block purchases, through privately negotiated transactions, or pursuant to any trading plan that may be adopted in accordance with Rule 10b5-1 of the Exchange Act. Open market repurchases will be made in accordance with Exchange Act Rule 10b-18, which sets certain restrictions on the method, timing, price and volume of open market stock repurchases. Subject to applicable securities laws, the timing, manner, price and amount of any repurchases of common stock under the Repurchase Program may be determined by us in our discretion, using available cash resources. Shares of common stock repurchased by us under the Repurchase Program, if any, will be cancelled and, until reissued by us, will be deemed to be authorized but unissued shares of our common stock. The Repurchase Program may be suspended or discontinued by us at any time and without prior notice. The authorization does not obligate us to acquire any particular amount of common stock. We are incorporated in the State of Maryland and under the laws of that state, shares of our stock that are acquired by us constitute authorized but unissued shares. The cost of the acquisition of shares of our stock in excess of the aggregate par value of the shares first reduces additional paid-in capital, to the extent available, with any residual cost applied against retained earnings. As of December 31, 2015, we repurchased 126,715 shares of common stock at a total cost of approximately $1.7 million and at an average cost per share of $13.19. As of December 31, 2015, approximately $23.3 million of common stock remained authorized for future share repurchases under the Repurchase Program.
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The following table presents a summary of our common stock repurchases under the Repurchase Program for the year ended December 31, 2015.
| Maximum Number (or | ||||||||||||||||
| Total Number of Shares | approximate dollar value) of | |||||||||||||||
| Total Number of | Weighted Avesrage | Purchased as Part of Publicly | Shares that May Yet be Purchased | |||||||||||||
| Month Purchased (1) | Shares Repurchased | Price per Share Paid (2) | Announced Program | Under the Program (3) | ||||||||||||
| December 2015 | 126,715 | $ | 13.19 | 126,715 | $ | 23,328,521 | ||||||||||
| Total | 126,715 | $ | 13.19 | 126,715 | $ | 23,328,521 | ||||||||||
(1) Based on trade date. The Program was announced on November 4, 2015. The Program does not have an expiration date.
(2) Includes brokerage commissions and clearing fees
(3) The maxmium dollar amount auhorized was $25.0 million.
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ITEM 6. SELECTED FINANCIAL DATA.
The selected financial data set forth below has been derived from the Company’s audited consolidated financial statements.
The information presented below is only a summary and does not provide all of the information contained in our historical financial statements, including the related notes. You should read the information below in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our historical financial statements, including the related notes, included elsewhere in this report.
| December 31, 2015 | December 31, 2014 | December 31, 2013 | December 31, 2012 | December 31, 2011 | ||||||||||||||||
| Balance Sheet Data: | ||||||||||||||||||||
| Real estate securities, at fair value: | ||||||||||||||||||||
| Agency | $ | 1,201,441,652 | $ | 1,808,314,746 | $ | 2,423,002,768 | $ | 3,785,867,151 | $ | 1,263,214,099 | ||||||||||
| Non-Agency | 1,229,811,018 | 1,140,077,928 | 844,217,568 | 568,858,645 | 58,787,051 | |||||||||||||||
| ABS | 54,761,837 | 66,693,243 | 71,344,784 | 33,937,097 | 4,526,620 | |||||||||||||||
| CMBS | 148,948,690 | 100,520,652 | 93,251,470 | 148,365,887 | 13,537,851 | |||||||||||||||
| Residential mortgage loans, at fair value | 57,080,227 | 85,089,859 | - | - | - | |||||||||||||||
| Commercial loans, at fair value | 72,800,000 | 72,800,000 | - | 2,500,000 | - | |||||||||||||||
| U.S. Treasury securities, at fair value | 223,434,922 | - | - | - | - | |||||||||||||||
| Investments in affiliates | 43,040,191 | 20,345,131 | 16,411,314 | - | - | |||||||||||||||
| Excess mortgage servicing rights, at fair value | 425,311 | 628,367 | - | - | - | |||||||||||||||
| Cash and cash equivalents | 46,253,291 | 64,363,514 | 86,190,011 | 149,594,782 | 35,851,249 | |||||||||||||||
| Receivable on unsettled trades | - | - | - | 96,310,999 | - | |||||||||||||||
| Derivative assets, at fair value | 1,755,467 | 11,382,622 | 55,060,075 | - | 1,428,595 | |||||||||||||||
| Total assets | 3,164,076,232 | 3,458,405,131 | 3,684,706,374 | 4,855,268,512 | 1,394,205,951 | |||||||||||||||
| Repurchase agreements | 2,034,963,460 | 2,644,955,948 | 2,891,634,416 | 3,911,419,818 | 1,150,149,407 | |||||||||||||||
| FHLBC Advances | 396,894,000 | - | - | - | - | |||||||||||||||
| Securitized debt | 30,046,861 | 39,777,914 | - | - | - | |||||||||||||||
| Payable on unsettled trades | 1,198,587 | - | - | 84,658,035 | 18,759,200 | |||||||||||||||
| Derivative liabilities, at fair value | 6,863,770 | 8,608,209 | 2,206,289 | 36,375,947 | 9,569,643 | |||||||||||||||
| Dividend payable | 13,496,139 | 17,031,609 | 17,020,893 | 18,540,667 | 7,011,171 | |||||||||||||||
| Stockholders’ equity | 666,944,713 | 732,675,143 | 704,430,734 | 794,621,781 | 206,283,920 | |||||||||||||||
| Period from | ||||||||||||||||||||
| Year Ended | Year Ended | Year Ended | Year Ended | March 7, 2011 to | ||||||||||||||||
| December 31, 2015 | December 31, 2014 | December 31, 2013 | December 31, 2012 | December 31, 2011 | ||||||||||||||||
| Statement of Operations Data: | ||||||||||||||||||||
| Net Interest Income | ||||||||||||||||||||
| Interest income | $ | 141,273,414 | $ | 141,573,188 | $ | 151,000,673 | $ | 96,376,692 | $ | 18,748,669 | ||||||||||
| Interest expense | 31,230,369 | 26,497,398 | 25,553,273 | 15,010,444 | 1,696,344 | |||||||||||||||
| 110,043,045 | 115,075,790 | 125,447,400 | 81,366,248 | 17,052,325 | ||||||||||||||||
| Other Income | ||||||||||||||||||||
| Net realized gain/(loss) | (17,148,069 | ) | 3,637,954 | (115,594,848 | ) | 24,568,561 | 3,701,392 | |||||||||||||
| Income/(loss) from linked transactions, net | - | 12,503,516 | 5,610,609 | 24,983,333 | (808,564 | ) | ||||||||||||||
| Realized loss on periodic interest settlements of derivative instruments, net | (13,204,884 | ) | (22,261,187 | ) | (27,912,227 | ) | (9,962,125 | ) | (2,162,290 | ) | ||||||||||
| Unrealized gain/(loss) on real estate securities and loans, net | (32,491,857 | ) | 72,480,056 | (84,195,306 | ) | 52,071,455 | 11,040,692 | |||||||||||||
| Unrealized gain/(loss) on derivative and other instruments, net | (12,180,501 | ) | (51,255,430 | ) | 89,112,320 | (24,086,526 | ) | (6,491,430 | ) | |||||||||||
| (75,025,311 | ) | 15,104,909 | (132,979,452 | ) | 67,574,698 | 5,279,800 | ||||||||||||||
| Expenses | ||||||||||||||||||||
| Management fee to affiliate | 9,971,287 | 10,089,239 | 10,688,725 | 6,413,443 | 1,512,898 | |||||||||||||||
| Other operating expenses | 12,356,644 | 11,874,427 | 10,844,988 | 5,443,059 | 1,566,642 | |||||||||||||||
| Servicing fees | 604,996 | 511,519 | - | - | - | |||||||||||||||
| Equity based compensation to affiliate | 164,487 | 291,131 | 251,447 | 400,200 | 176,165 | |||||||||||||||
| Excise tax | 1,500,000 | 1,783,539 | 1,483,630 | 1,748,327 | 105,724 | |||||||||||||||
| 24,597,414 | 24,549,855 | 23,268,790 | 14,005,029 | 3,361,429 | ||||||||||||||||
| Income/(loss) before income tax benefit/(expense) and equity in earnings/(loss) from affiliates | 10,420,320 | 105,630,844 | (30,800,842 | ) | 134,935,917 | 18,970,696 | ||||||||||||||
| Income tax benefit/(expense) | - | 79,914 | (3,041,616 | ) | - | - | ||||||||||||||
| Equity in earnings/(loss) from affiliates | 3,398,217 | 3,684,810 | 2,263,822 | - | - | |||||||||||||||
| Net Income/(Loss) | 13,818,537 | 109,395,568 | (31,578,636 | ) | 134,935,917 | 18,970,696 | ||||||||||||||
| Dividends on preferred stock | 13,469,416 | 13,469,416 | 13,469,416 | 4,137,010 | - | |||||||||||||||
| Net Income/(Loss) Available to Common Stockholders | $ | 349,121 | $ | 95,926,152 | $ | (45,048,052 | ) | $ | 130,798,907 | $ | 18,970,696 | |||||||||
| Share Data: | ||||||||||||||||||||
| Earnings/(Loss) Per Share of Common Stock | ||||||||||||||||||||
| Basic | $ | 0.01 | $ | 3.38 | $ | (1.61 | ) | $ | 7.20 | $ | 3.20 | |||||||||
| Diluted | $ | 0.01 | $ | 3.37 | $ | (1.61 | ) | $ | 7.18 | $ | 3.20 | |||||||||
| Dividends Declared Per Share of Common Stock | $ | 2.275 | $ | 2.40 | $ | 2.80 | $ | 2.97 | $ | 1.10 | ||||||||||
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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our consolidated financial statements and the accompanying notes to our consolidated financial statements, which are included in this report.
Overview
We are a Maryland corporation focused on investing in, acquiring and managing a diversified portfolio of residential mortgage assets, other real estate-related securities and financial assets, which we refer to as our target assets. We conduct our operations to qualify and be taxed as a real estate investment trust, or REIT, for U.S. federal income tax purposes. Accordingly, we generally will not be subject to U.S. federal income taxes on our taxable income that we distribute currently to our stockholders as long as we maintain our intended qualification as a REIT. We also operate our business in a manner that permits us to maintain our exemption from registration under the Investment Company Act of 1940, as amended, or the Investment Company Act.
The majority of our portfolio is comprised of mortgage-backed securities, specifically residential mortgage-backed securities, or RMBS. Certain of the assets in our RMBS portfolio have an explicit guarantee of principal and interest by a U.S. government agency such as the Government National Mortgage Association, or Ginnie Mae, or a government-sponsored entity such as the Federal National Mortgage Association, or Fannie Mae, or the Federal Home Loan Mortgage Corporation, or Freddie Mac (collectively, “GSEs”). We refer to these securities as Agency RMBS. Our Agency RMBS investments include mortgage pass-through securities, securities entitling the holder only to the interest payments made on the mortgages underlying certain MBS (“interest-only strips”), collateralized mortgage obligations (“CMOs”), and certain Agency RMBS for which the underlying collateral is not identified until shortly (generally two days) before the purchase or sale settlement date (“TBAs”).
Our portfolio also includes a significant portion of RMBS that are not issued or guaranteed by Ginnie Mae or a GSE, which we refer to as Non-Agency RMBS. Our Non-Agency RMBS investments may include investment grade and non-investment grade fixed- and floating-rate securities. We categorize our Non-Agency RMBS by credit score at origination into Prime, Alt-A and Subprime. Our RMBS Interest Only securities (Non-Agency RMBS backed by interest-only strips), CRTs (defined below), RPL/NPL MBS, (described below), and Securitized Whole Loans, (described below) represent our Non-Agency RMBS not categorized by credit score at origination.
Credit Risk Transfer securities (“CRTs”) are unguaranteed and unsecured mezzanine, junior mezzanine and first loss securities issued by Fannie Mae and Freddie Mac to decrease their exposure to mortgage default risk. The securities reference a pool of recently acquired single family mortgages from a specified time period. The risk of loss on the reference pool of mortgages is transferred to investors who may experience losses when credit events such as defaults, liquidations or delinquencies occur. The notes pay an uncapped floating rate spread over one-month LIBOR.
RPL/NPL MBS are mortgage-backed securities collateralized by re-performing mortgage loans (“RPL”) or non-performing mortgage loans (“NPL”). The RPL/NPL MBS that we own represent the senior and mezzanine tranches such securitizations. These RPL/NPL MBS are structured with significant credit enhancement (typically approximately 50% to the senior tranche and 40% to the mezzanine tranche) to mitigate our exposure to credit risk on these securities. “Credit enhancement” refers to the amount of subordination available to absorb all credit losses prior to losses being allocated to more senior tranches. Subordinate tranches typically receive no cash flow (interest or principal) until the senior and mezzanine tranches are paid off. In addition, the RPL/NPL MBS that we own typically contain an “interest rate step-up” feature, whereby the interest rate or “coupon” on the senior tranche increases by typically 300 basis points or typically 400 basis points in the case of mezzanine tranches (a “step up”) that begin to take effect if the security that we hold has not been redeemed or repurchased by the issuer within 36 months of issuance. We expect that the combination of the priority cash flow of the senior tranche and the 36-month step-up will result in these securities exhibiting short average lives and, accordingly, reduced interest rate sensitivity.
Securitized Whole Loans are residential mortgage loans (generally RPLs or NPLs) in securitized form that we purchase from a related party or parties. The securitizations typically take the form of various classes of notes and a trust certificate. Securitized Whole Loans do not include RPLs or NPLs that we hold through interests in certain consolidated trusts.
We have also invested in other target assets, including asset backed securities, or ABS, and commercial mortgage-backed securities, or CMBS. Our CMBS portfolio includes CMBS interest only securities (CMBS backed by interest-only strips) and Freddie Mac K-Series CMBS (described below).
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Freddie Mac K-Series CMBS (“K-Series CMBS”) include CMBS, CMBS interest only and CMBS principal only securities which are regularly-issued structured pass-through securities backed by multifamily mortgage loans. K-Series CMBS feature a wide range of investor options which include guaranteed senior and interest only bonds as well as unguaranteed mezzanine, subordinate and interest only bonds which are issued by Freddie Mac. Our K-Series CMBS portfolio includes unguaranteed senior, mezzanine, subordinate and interest only bonds. In Item 7, we have categorized Freddie Mac K-Series CMBS interest only bonds as part of our “CMBS Interest Only” assets.
We have also invested in residential and commercial mortgage loans, including RPLs and NPLs, as well as excess mortgage servicing rights (“MSRs”). We have the discretion to invest in other target assets such as other real estate structured finance products, other real estate-related loans and securities and interests in certain types of real estate. Non-Agency RMBS, ABS, CMBS, MSRs and residential and commercial mortgage loans are referred to as our “credit portfolio”, or credit investments, and residential and commercial mortgage loans are collectively referred to as loans. We use the term “credit securities” to refer to our credit portfolio excluding loans and MSRs. Additionally, we use the term “real estate securities” or “securities” to refer to our Agency RMBS portfolio and our credit securities.
On December 9, 2015, we, alongside private funds under the management of Angelo, Gordon, formed a mortgage banking platform called Arc Home LLC (“Arc Home”) to originate conforming, FHA, Jumbo and non-qualifying residential mortgage loans (“non-QM”). In January 2016, Arc Home entered into a definitive agreement to acquire a Fannie Mae, Freddie Mac, Federal Housing Administration (“FHA”), Veteran’s Administration (“VA”), and Ginnie Mae seller/servicer of mortgages with licenses to conduct business in 47 states. Arc Home is currently working to secure approval for the acquisition from the GSEs, FHA, VA, Ginnie Mae and various state licensing authorities, which is required prior to closing the transaction.
We conduct our operations to qualify and be taxed as a REIT for U.S. federal income tax purposes. Accordingly, we generally will not be subject to federal income tax on our taxable income that we distribute currently to our stockholders as long as weSS maintain our intended qualification as a REIT. We operate our business in a manner that permits us to maintain our exemption from registration under the Investment Company Act.
Factors impacting our operating results
Our operating results can be affected by a number of factors and primarily depend on, among other things, the level of our net interest income, the market value of our assets and the supply of, and demand for, our target assets in the marketplace. Our net interest income, which reflects the amortization of purchase premiums and accretion of purchase discounts, varies primarily as a result of changes in market interest rates and prepayment speeds, as measured by the Constant Prepayment Rate, (“CPR”), on our RMBS. Interest rates vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty. Our operating results can also be impacted by unanticipated credit events, such as defaults, liquidations, or delinquencies, experienced by borrowers whose mortgage loans are included in our RMBS.
Market conditions
Credit markets experienced a difficult fourth quarter, and it was a disappointing second half of the year for RMBS and ABS assets. Credit concerns, underperformance and lack of liquidity in other credit markets overwhelmed the mortgage and asset backed sectors. MBS and ABS credit spreads widened slightly during the quarter as fears of a global contagion from China’s economic slowdown accelerated, the price of oil continued to slide and a lack of liquidity spread across most capital markets. Primary issuance was anemic and many issuers were forced to postpone new deals until market demand improved. Agency MBS had a difficult fourth quarter versus swap hedges. Continuing the trend that began in the third quarter of 2015, interest rate swaps used for interest rate hedging by most mortgage and ABS investors outperformed both MBS and credit securities. As a result, the spread on MBS and ABS assets, relative to our interest rate swap hedges, widened during the quarter, driving a decline in book value. The driving forces behind swap spread outperformance of both benchmark treasuries and spread products continued to be corporate bond issuance, global cross border capital movements and related selling of US dollar denominated reserve assets to holders that are more likely to require bank balance sheet funding. Non-mortgage consumer credit experienced some divergence in performance between credit card delinquencies, which remained at historical lows, and defaults on auto, equipment and student loans, which increased modestly. Consumer mortgage credit continued its pattern of stable to modest improvement in borrower performance. Home prices also continued to modestly rise and inventory levels remain light to tight in many major markets. Consumer appetite for housing continued to remain stable with expanding mortgage credit availability taking hold in the markets.
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Investment activities
For the period from our IPO to December 31, 2011, the risk-reward profile of investment opportunities supported the deployment of a majority of our capital in Agency RMBS. Labor, housing and economic fundamentals, together with U.S. monetary policy designed to keep interest rates low, supported our Agency RMBS investments in this period. Overweighting of these investments was also favored by the relative ease of funding and superior liquidity. We also acquired a limited amount of Non-Agency RMBS, ABS and CMBS assets for our investment portfolio during this period.
In 2012, we accomplished our goal to begin increasing our exposure to credit investments and leveraging the broader Angelo, Gordon platform. Throughout the first quarter of 2013, we remained positioned in Agency RMBS assets that we believed would perform well in an ongoing elevated prepayment environment. During the second quarter of 2013 however, we concurrently elected to increase our hedging activity, perceiving the potential for an increase in interest rate volatility and benchmark interest rates. Throughout 2014, we reduced our hedging activity, rotated into shorter duration Agency RMBS and continued rotating assets away from Agency RMBS into credit investments. In 2015, we continued to base our investment decisions on a variety of factors, including liquidity, duration, interest rate expectations and hedging. Our investment decisions supported the continued allocation into credit assets throughout 2015 and the mix of assets in our portfolio may accordingly shift over time. As of December 31, 2015, we had a portfolio that consisted of 44.2% of Agency RMBS inclusive of TBAs and 55.8% of credit investments inclusive of investments held within affiliated entities.
We currently finance our investments in real estate securities and loans primarily through short-term borrowings structured as repurchase agreements as well as loans from the FHLBC. The FHLBC provides us with short-term secured loans, called advances. We use Agency RMBS as collateral for our advances. Subject to maintaining our qualification as a REIT and our Investment Company Act exemption, to the extent leverage is deployed, we utilize derivative financial instruments (or hedging instruments), including interest rate swaps, swaption agreements, synthetic IO Indexes, and certain non-derivative financial instruments such as Agency Interest-Only securities and U.S. Treasury securities, in an effort to hedge the interest rate risk associated with the financing of our portfolio. Specifically, we may seek to hedge our exposure to potential interest rate mismatches between the interest we earn on our investments and our borrowing costs caused by fluctuations in short-term interest rates. In utilizing leverage and interest rate hedges, our objectives are to improve risk-adjusted returns and, where possible, to lock in, on a long-term basis, a spread between the yield on our assets and the cost of our financing and hedging.
In July 2015, our captive insurance subsidiary, MITT Insurance, was granted membership in the FHLBC and commenced obtaining advances from the FHLBC. Membership in the FHLBC obligates MITT Insurance to hold FHLBC membership stock and activity stock, the latter being a percentage of the advances it obtained from the FHLBC. As with our repurchase agreement borrowings, if the value of any assets pledged to the FHLBC as collateral for advances decreases, the FHLBC could require posting of additional collateral to the amount of advances outstanding.
In January 2016, the FHFA issued the Final Ruling, which expressly excludes our captive insurance subsidiary from being eligible for membership in the FHLBC and prevents the FHLBC from making any new advances or extending any existing advances to MITT Insurance. Under the Final Rule, MITT Insurance must wind down its membership with the FHLBC by February 19, 2017. On December 31, 2015, we had $396.9 million of FHLBC Advances outstanding.
Throughout Item 7, where we disclose our investment portfolio and the related repurchase agreements and FHLBC Advances that finance it, we have presented this information inclusive of unconsolidated ownership interests in affiliates that are accounted for under GAAP using the equity method, TBAs, that are accounted for as derivatives under GAAP, long and short positions in U.S. treasury securities and transactions considered linked under previous GAAP where we recorded the initial transfer and repurchase financing on a net basis and recorded a forward commitment to purchase assets as a derivative instrument. Our investment portfolio is presented along with a reconciliation to GAAP. The presentation inclusive of investments held within affiliated entities, TBAs and linked transactions is consistent with how the Company’s management evaluates the business, and the Company believes this presentation provides the most accurate depiction of its investment portfolio and financial condition.
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The following table presents a reconciliation of certain information related to investments inclusive of TBAs and investments held within affiliated entities to investments on a GAAP basis as of December 31, 2015:
| Unrealized Mark-to- | Weighted Average | Weighted | Weighted Average | |||||||||||||||||||||||||
| Instrument | Current Face | Amortized Cost | Market | Fair Value | Coupon (1) | Average Yield (2) | Life (9) (2) | |||||||||||||||||||||
| Agency RMBS: | ||||||||||||||||||||||||||||
| 30 Year Fixed Rate | $ | 782,276,607 | $ | 817,182,510 | $ | 2,954,782 | $ | 820,137,292 | 3.76 | % | 3.10 | % | 8.58 | |||||||||||||||
| Fixed Rate CMO | 76,098,478 | 76,770,854 | 1,254,658 | 78,025,512 | 3.00 | % | 2.81 | % | 5.26 | |||||||||||||||||||
| ARM | 248,169,781 | 245,510,904 | 4,298,463 | 249,809,367 | 2.37 | % | 2.84 | % | 5.44 | |||||||||||||||||||
| Inverse Interest Only | 47,861,112 | 9,382,636 | 826,972 | 10,209,608 | 5.96 | % | 9.30 | % | 5.41 | |||||||||||||||||||
| Interest Only | 474,197,132 | 43,998,722 | (738,849 | ) | 43,259,873 | 2.37 | % | 7.15 | % | 4.08 | ||||||||||||||||||
| Fixed Rate 30 Year TBA | 75,000,000 | 77,502,930 | (141,600 | ) | 77,361,330 | 3.50 | % | N/A | N/A | |||||||||||||||||||
| Credit Investments: | ||||||||||||||||||||||||||||
| Residential Investments | ||||||||||||||||||||||||||||
| Prime (3) (4) | 783,496,575 | 659,470,180 | 10,330,014 | 669,800,194 | 4.09 | % | 5.58 | % | 10.29 | |||||||||||||||||||
| Alt A (3) (5) | 258,855,964 | 221,414,910 | 2,043,783 | 223,458,693 | 3.98 | % | 5.25 | % | 9.43 | |||||||||||||||||||
| Subprime (3) (6) | 113,943,920 | 109,867,883 | 1,734,214 | 111,602,097 | 4.49 | % | 5.32 | % | 5.36 | |||||||||||||||||||
| RMBS Interest Only | 465,387,354 | 5,489,775 | 63,958 | 5,553,733 | 0.12 | % | 11.05 | % | 6.40 | |||||||||||||||||||
| Credit Risk Transfer | 36,993,762 | 36,916,025 | 39,725 | 36,955,750 | 5.75 | % | 6.83 | % | 8.17 | |||||||||||||||||||
| RPL/NPL (7) | 135,725,197 | 134,351,745 | (698,090 | ) | 133,653,655 | 4.36 | % | 5.03 | % | 1.77 | ||||||||||||||||||
| Securitized Whole Loans (8) | 86,722,548 | 62,025,088 | (1,557,289 | ) | 60,467,799 | 4.19 | % | 7.60 | % | 4.35 | ||||||||||||||||||
| Residential Mortgage Loans | 88,980,522 | 60,963,511 | 2,657,226 | 63,620,737 | 5.47 | % | 8.71 | % | 5.23 | |||||||||||||||||||
| Excess Mortgage Servicing Rights | 72,155,804 | 411,372 | 13,939 | 425,311 | N/A | 6.33 | % | 1.61 | ||||||||||||||||||||
| Commercial Investments | ||||||||||||||||||||||||||||
| CMBS | 220,742,772 | 131,308,112 | (545,260 | ) | 130,762,852 | 5.12 | % | 6.26 | % | 4.36 | ||||||||||||||||||
| Freddie Mac K-Series CMBS | 88,154,185 | 35,018,421 | (390,121 | ) | 34,628,300 | 4.83 | % | 12.88 | % | 8.04 | ||||||||||||||||||
| CMBS Interest Only | 1,774,907,989 | 17,994,891 | 576,062 | 18,570,953 | 0.20 | % | 7.33 | % | 3.18 | |||||||||||||||||||
| Commercial Loans | 72,800,000 | 72,660,971 | 139,029 | 72,800,000 | 6.80 | % | 8.30 | % | 0.58 | |||||||||||||||||||
| ABS | 56,264,253 | 55,910,560 | (1,148,723 | ) | 54,761,837 | 5.26 | % | 5.62 | % | 4.24 | ||||||||||||||||||
| Total: Non-GAAP Basis | $ | 5,958,733,955 | $ | 2,874,152,000 | $ | 21,712,893 | $ | 2,895,864,893 | 2.38 | % | 4.86 | % | 5.75 | |||||||||||||||
| Investments in Affiliates | $ | 750,815,986 | $ | 53,077,015 | $ | 157,813 | $ | 53,234,828 | 0.36 | % | 11.32 | % | 4.89 | |||||||||||||||
| TBAs | $ | 75,000,000 | $ | 77,502,930 | $ | (141,600 | ) | $ | 77,361,330 | 3.50 | % | N/A | N/A | |||||||||||||||
| Total: GAAP Basis | $ | 5,132,917,969 | $ | 2,743,572,055 | $ | 21,696,680 | $ | 2,765,268,735 | 2.64 | % | 4.73 | % | 5.88 | |||||||||||||||
(1) Equity residuals, principal only securities and MSRs with a zero coupon rate are excluded from this calculation.
(2) Fixed Rate 30 Year TBA are excluded from this calculation.
(3) Non-Agency RMBS with credit scores above 700, between 700 and 620 and below 620 at origination are classified as Prime, Alt A, and Subprime, respectively. The weighted average credit scores of our Prime, Alt-A and Subprime Non-Agency RMBS were 725, 674 and 599, respectively.
(4) Included in Prime is $169.5 million fair market value of new issue securities. New issue is defined as being issued after 2010. Included in new issue prime is $108.3 million fair market value of Prime Jumbo securities. Prime Jumbo is defined as being all of the following: a prime security, an issuance year after 2010, an original rating of AAA and a weighted average original loan balance greater than the conforming loan limits published by the FHFA.
(5) Included in Alt A is $65.9 million fair market value of new issue securities. New issue is defined as being issued after 2010.
(6) Included in Subprime is $35.4 million fair market value of new issue securities. New issue is defined as being issued after 2010.
(7) RPL/NPL MBS are collateralized by re-performing or non-performing loans whose deal structures contain an interest rate step-up feature.
(8) Whole loans purchased by a MITT related party in securitized form.
(9) Actual maturities of investments and loans are generally shorter than stated contractual maturities. Maturities are affected by the contractual lives of the underlying mortgages, periodic payments of principal and prepayments of principal.
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The following table presents a reconciliation of certain information related to investments inclusive of unlinked securities, TBAs and investments held within affiliated entities to investments on a GAAP basis as of December 31, 2014:
| Unrealized Mark-to- | Weighted Average | Weighted | Weighted Average | |||||||||||||||||||||||||
| Instrument | Current Face | Amortized Cost | Market | Fair Value | Coupon (1) | Average Yield (2) | Life (Years) (2)(9) | |||||||||||||||||||||
| Agency RMBS: | ||||||||||||||||||||||||||||
| 20 Year Fixed Rate | $ | 125,538,084 | $ | 131,547,616 | $ | 2,195,254 | $ | 133,742,870 | 3.72 | % | 2.79 | % | 5.93 | |||||||||||||||
| 30 Year Fixed Rate | 973,102,647 | 1,019,768,602 | 16,255,417 | 1,036,024,019 | 3.90 | % | 3.15 | % | 8.29 | |||||||||||||||||||
| Fixed Rate CMO | 88,345,864 | 89,226,858 | 1,548,517 | 90,775,375 | 3.00 | % | 2.81 | % | 5.86 | |||||||||||||||||||
| ARM | 421,043,957 | 420,155,852 | 7,381,515 | 427,537,367 | 2.42 | % | 2.71 | % | 5.42 | |||||||||||||||||||
| Inverse Interest Only | 359,129,451 | 65,628,075 | 3,359,820 | 68,987,895 | 6.16 | % | 8.84 | % | 4.30 | |||||||||||||||||||
| Interest Only | 395,775,789 | 51,012,794 | 234,426 | 51,247,220 | 3.02 | % | 6.38 | % | 4.64 | |||||||||||||||||||
| Fixed Rate 30 Year TBA | 225,000,000 | 235,240,234 | 1,480,471 | 236,720,705 | 3.72 | % | N/A | N/A | ||||||||||||||||||||
| Credit Investments: | ||||||||||||||||||||||||||||
| Residential Investments | ||||||||||||||||||||||||||||
| Prime (3) (4) | 714,256,334 | 593,517,111 | 12,796,485 | 606,313,596 | 4.50 | % | 5.89 | % | 6.37 | |||||||||||||||||||
| Alt A (3) (5) | 273,376,875 | 238,595,194 | 5,017,721 | 243,612,915 | 3.98 | % | 5.49 | % | 7.43 | |||||||||||||||||||
| Subprime (3) (6) | 85,373,582 | 80,683,905 | 3,043,202 | 83,727,107 | 3.97 | % | 5.44 | % | 6.59 | |||||||||||||||||||
| Credit Risk Transfer | 5,000,000 | 5,000,000 | (53,705 | ) | 4,946,295 | 4.67 | % | 6.70 | % | 8.82 | ||||||||||||||||||
| RPL/NPL (7) | 190,872,760 | 188,830,099 | 246,785 | 189,076,884 | 4.21 | % | 4.78 | % | 2.31 | |||||||||||||||||||
| Securitized Whole Loans (8) | 170,389,872 | 138,261,702 | (987,048 | ) | 137,274,654 | 3.48 | % | 5.98 | % | 6.86 | ||||||||||||||||||
| Residential Mortgage Loans | 163,726,985 | 113,854,029 | (357,289 | ) | 113,496,740 | 5.53 | % | 9.38 | % | 4.90 | ||||||||||||||||||
| Excess Mortgage Servicing Rights | 85,883,832 | 638,666 | (10,299 | ) | 628,367 | N/A | 9.78 | % | 2.01 | |||||||||||||||||||
| Commercial Investments | ||||||||||||||||||||||||||||
| CMBS | 217,481,927 | 89,788,608 | 2,173,137 | 91,961,745 | 4.84 | % | 6.90 | % | 6.71 | |||||||||||||||||||
| Freddie Mac K-Series CMBS | 54,727,772 | 30,284,115 | 612,733 | 30,896,848 | 4.05 | % | 10.00 | % | 6.96 | |||||||||||||||||||
| CMBS Interest Only | 52,357,700 | 5,932,935 | 193,014 | 6,125,949 | 1.85 | % | 5.73 | % | 3.78 | |||||||||||||||||||
| Commercial Loans | 72,800,000 | 72,303,981 | 496,019 | 72,800,000 | 6.79 | % | 8.55 | % | 2.02 | |||||||||||||||||||
| ABS | 67,696,117 | 67,316,469 | (623,226 | ) | 66,693,243 | 5.15 | % | 5.55 | % | 4.94 | ||||||||||||||||||
| Total: Non-GAAP Basis | $ | 4,741,879,548 | $ | 3,637,586,845 | $ | 55,002,949 | $ | 3,692,589,794 | 4.05 | % | 4.67 | % | 6.04 | |||||||||||||||
| Linked Transactions | $ | 150,836,900 | $ | 137,561,793 | $ | 2,216,470 | $ | 139,778,263 | 3.69 | % | 5.94 | % | 5.12 | |||||||||||||||
| Investments in Affiliates | $ | 81,027,296 | $ | 42,557,454 | $ | (591,423 | ) | $ | 41,966,031 | 5.33 | % | 12.13 | % | 5.10 | ||||||||||||||
| TBAs | $ | 225,000,000 | $ | 235,240,234 | $ | 1,480,471 | $ | 236,720,705 | 3.72 | % | N/A | N/A | ||||||||||||||||
| Total: GAAP Basis | $ | 4,285,015,352 | $ | 3,222,227,364 | $ | 51,897,431 | $ | 3,274,124,795 | 4.07 | % | 4.52 | % | 6.08 | |||||||||||||||
(1) Equity residuals, principal only securities and MSRs with a zero coupon rate are excluded from this calculation.
(2) Fixed Rate 30 Year TBA are excluded from this calculation.
(3) Non-Agency RMBS with credit scores above 700, between 700 and 620 and below 620 at origination are classified as Prime, Alt A, and Subprime, respectively. The weighted average credit scores of our Prime, Alt-A and Subprime Non-Agency RMBS were 722, 672 and 607, respectively.
(4) Included in Prime is $44.4 million fair market value of new issue securities. New issue is defined as being issued after 2010. Included in new issue prime is $18.2 million fair market value of Prime Jumbo securities. Prime Jumbo is defined as being all of the following: a prime security, an issuance year after 2010, an original rating of AAA and a weighted average original loan balance greater than the conforming loan limits published by the FHFA.
(5) Included in Alt A is $43.6 million fair market value of new issue securities. New issue is defined as being issued in 2011 or later.
(6) Included in Subprime is $17.0 million fair market value of new issue securities. New issue is defined as being issued in 2011 or later.
(7) RPL/NPL MBS are collateralized by re-performing or non-performing loans whose deal structures contain an interest rate step-up feature.
(8) Whole loans purchased by a MITT related party in securitized form.
(9) Actual maturities of investments and loans are generally shorter than stated contractual maturities. Maturities are affected by the contractual lives of the underlying mortgages, periodic payments of principal and prepayments of principal.
The following table presents certain information grouped by vintage as it relates to our credit securities portfolio inclusive of securities held within affiliated entities as of December 31, 2015. We have also presented a reconciliation to GAAP.
| Unrealized Mark-to- | Weighted Average | Weighted | Weighted Average | |||||||||||||||||||||||||
| Credit Securities: | Current Face | Amortized Cost | Market | Fair Value | Coupon (1) | Average Yield | Life (2) | |||||||||||||||||||||
| Pre 2005 | $ | 103,593,089 | $ | 99,567,269 | $ | 2,563,406 | $ | 102,130,675 | 3.33 | % | 6.23 | % | 4.81 | |||||||||||||||
| 2005 | 207,457,651 | 173,524,833 | 3,605,565 | 177,130,398 | 4.33 | % | 5.57 | % | 11.83 | |||||||||||||||||||
| 2006 | 392,439,663 | 258,661,802 | 3,403,637 | 262,065,439 | 4.20 | % | 6.03 | % | 8.76 | |||||||||||||||||||
| 2007 | 216,970,753 | 178,714,834 | 1,434,094 | 180,148,928 | 4.17 | % | 5.76 | % | 11.62 | |||||||||||||||||||
| 2008 | 16,424,000 | 13,499,033 | 429,317 | 13,928,350 | 7.00 | % | 5.80 | % | 9.90 | |||||||||||||||||||
| 2010 | 55,625,323 | 45,042,515 | 1,094,741 | 46,137,256 | N/A | 6.05 | % | 7.83 | ||||||||||||||||||||
| 2011 | 6,936,188 | 5,533,202 | 114,100 | 5,647,302 | 5.32 | % | 6.69 | % | 9.60 | |||||||||||||||||||
| 2012 | 81,928,364 | 21,147,817 | 202,330 | 21,350,147 | 2.39 | % | 5.87 | % | 3.58 | |||||||||||||||||||
| 2013 | 175,615,818 | 135,450,104 | (406,855 | ) | 135,043,249 | 3.78 | % | 4.78 | % | 6.17 | ||||||||||||||||||
| 2014 | 1,284,072,165 | 219,023,610 | (1,549,522 | ) | 217,474,088 | 0.83 | % | 6.24 | % | 2.54 | ||||||||||||||||||
| 2015 | 1,480,131,505 | 319,602,571 | (442,540 | ) | 319,160,031 | 1.06 | % | 5.93 | % | 5.64 | ||||||||||||||||||
| Total: Non-GAAP Basis | $ | 4,021,194,519 | $ | 1,469,767,590 | $ | 10,448,273 | $ | 1,480,215,863 | 1.85 | % | 5.85 | % | 5.61 | |||||||||||||||
| Investment in Affiliates | $ | 740,670,238 | $ | 46,534,959 | $ | 159,359 | $ | 46,694,318 | 0.28 | % | 11.32 | % | 4.89 | |||||||||||||||
| Total: GAAP Basis | $ | 3,280,524,281 | $ | 1,423,232,631 | $ | 10,288,914 | $ | 1,433,521,545 | 2.18 | % | 5.66 | % | 5.77 | |||||||||||||||
(1) Equity residual investments and principal only securities are excluded from this calculation.
(2) Actual maturities of mortgage-backed securities are generally shorter than stated contractual maturities. Maturities are affected by the contractual lives of the underlying mortgages, periodic payments of principal and prepayments of principal.
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The following table presents certain information grouped by vintage as it relates to our credit securities portfolio inclusive of unlinked securities and investments held within affiliated entities as of December 31, 2014. We have also presented a reconciliation to GAAP.
| Unrealized Mark-to- | Weighted Average | Weighted | Weighted | |||||||||||||||||||||||||
| Credit Securities: | Current Face | Amortized Cost | Market | Fair Value | Coupon (1) | Average Yield | Average Life (2) | |||||||||||||||||||||
| Pre 2005 | $ | 103,050,984 | $ | 96,813,884 | $ | 4,187,922 | $ | 101,001,806 | 2.61 | % | 6.88 | % | 4.99 | |||||||||||||||
| 2005 | 284,956,977 | 245,531,488 | 5,434,069 | 250,965,557 | 4.29 | % | 5.48 | % | 7.07 | |||||||||||||||||||
| 2006 | 445,802,798 | 270,820,928 | 5,767,441 | 276,588,369 | 3.32 | % | 6.01 | % | 7.21 | |||||||||||||||||||
| 2007 | 259,080,302 | 212,238,573 | 6,390,896 | 218,629,469 | 4.20 | % | 6.08 | % | 4.83 | |||||||||||||||||||
| 2008 | 16,424,000 | 13,410,657 | 543,436 | 13,954,093 | 7.00 | % | 5.79 | % | 11.46 | |||||||||||||||||||
| 2010 | 54,237,241 | 42,356,233 | (1,318,323 | ) | 41,037,910 | N/A | 6.33 | % | 8.73 | |||||||||||||||||||
| 2011 | 6,743,925 | 5,260,321 | 87,207 | 5,347,528 | 6.19 | % | 6.45 | % | 8.76 | |||||||||||||||||||
| 2012 | 72,730,989 | 25,524,080 | 436,009 | 25,960,089 | 3.05 | % | 5.95 | % | 4.27 | |||||||||||||||||||
| 2013 | 128,665,920 | 125,148,315 | 1,030,030 | 126,178,345 | 4.69 | % | 4.82 | % | 6.97 | |||||||||||||||||||
| 2014 | 459,839,803 | 401,105,659 | (139,589 | ) | 400,966,070 | 4.11 | % | 5.66 | % | 4.90 | ||||||||||||||||||
| Total: Non-GAAP Basis | $ | 1,831,532,939 | $ | 1,438,210,138 | $ | 22,419,098 | $ | 1,460,629,236 | 4.21 | % | 5.80 | % | 6.10 | |||||||||||||||
| Linked Transactions | $ | 150,836,900 | $ | 137,561,793 | $ | 2,216,470 | $ | 139,778,263 | 3.69 | % | 5.94 | % | 5.12 | |||||||||||||||
| Investment in Affiliates | $ | 37,183,147 | $ | 13,051,736 | $ | 507,414 | $ | 13,559,150 | 4.23 | % | 14.88 | % | 7.79 | |||||||||||||||
| Total: GAAP Basis | $ | 1,643,512,892 | $ | 1,287,596,609 | $ | 19,695,214 | $ | 1,307,291,823 | 4.27 | % | 5.69 | % | 6.15 | |||||||||||||||
(1) Equity residual investments and principal only securities are excluded from this calculation.
(2) Actual maturities of mortgage-backed securities are generally shorter than stated contractual maturities. Maturities are affected by the contractual lives of the underlying mortgages, periodic payments of principal and prepayments of principal.
The following table presents the fair value of our credit securities portfolio by credit rating as of December 31, 2015 and December 31, 2014:
| Credit Rating - Credit Securities | December 31, 2015 (1) | December 31, 2014 (1) | ||||||
| AAA | $ | 112,107,249 | $ | 18,161,039 | ||||
| A | 119,939,358 | 146,103,470 | ||||||
| BBB | 20,468,267 | 29,224,614 | ||||||
| BB | 43,576,568 | 43,781,140 | ||||||
| B | 110,878,213 | 89,762,889 | ||||||
| Below B | 527,154,975 | 633,638,302 | ||||||
| Not Rated | 546,091,233 | 499,957,782 | ||||||
| Total: Non-GAAP Basis | $ | 1,480,215,863 | $ | 1,460,629,236 | ||||
| Linked Transactions | $ | - | $ | 139,778,263 | ||||
| Investment in Affiliates | $ | 46,694,318 | $ | 13,559,150 | ||||
| Total: GAAP Basis | $ | 1,433,521,545 | $ | 1,307,291,823 | ||||
(1) Represents the minimum rating for rated assets of S&P, Moody and Fitch credit ratings, stated in terms of the S&P equivalent.
Our credit investments are subject to risk of loss with regard to principal and interest payments. We evaluate each investment based on the characteristics of the underlying collateral and securitization structure. We maintain a comprehensive portfolio management process that generally includes day-to-day oversight by the portfolio management team and a quarterly credit review process for each investment that examines the need for a potential reduction in accretable yield, missed or late contractual payments, significant declines in collateral performance, prepayments, projected defaults, loss severities and other data which may indicate a potential issue in our ability to recover our capital from the investment. These processes are designed to enable our Manager to evaluate and proactively manage asset-specific credit issues and identify credit trends on a portfolio-wide basis. Nevertheless, we cannot be certain that our review will identify all issues within our portfolio due to, among other things, adverse economic conditions or events adversely affecting specific assets. Therefore, potential future losses may also stem from investments that are not identified by our credit reviews.
We evaluate investments in Agency RMBS using factors including expected future prepayment trends, supply and demand, costs of financing, costs of hedging, expected future interest rate volatility and the overall shape of the U.S. Treasury and interest rate swap yield curves. Prepayment speeds, as reflected by the CPR, and interest rates vary according to the type of investment, conditions in financial markets, competition and other factors, none of which can be predicted with any certainty. In general, as prepayment speeds on our Agency RMBS portfolio increase, the related purchase premium amortization increases, thereby reducing the net yield on such assets.
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The following table presents the CPR experienced on our Agency RMBS portfolio (excluding TBAs), on an annualized basis, for the quarterly periods presented in 2015.
| Three Months Ended (1) (2) | ||||||||||||||||
| Agency RMBS | December 31, 2015 | September 30, 2015 | June 30, 2015 | March 31, 2015 | ||||||||||||
| 20 Year Fixed Rate | 3 | % | 11 | % | 11 | % | 11 | % | ||||||||
| 30 Year Fixed Rate | 8 | % | 8 | % | 11 | % | 5 | % | ||||||||
| Fixed Rate CMO | 7 | % | 10 | % | 8 | % | 6 | % | ||||||||
| ARM | 12 | % | 15 | % | 13 | % | 9 | % | ||||||||
| Interest Only | 12 | % | 15 | % | 13 | % | 10 | % | ||||||||
| Weighted Average | 9 | % | 10 | % | 11 | % | 7 | % | ||||||||
| (1) | Represents the weighted average monthly CPRs published during the quarter for our in-place portfolio during the same period. |
| (2) | Source: Bloomberg |
The following table presents the CPR experienced on our Agency RMBS portfolio (excluding TBAs), on an annualized basis, for the quarterly periods presented in 2014.
| Three Months Ended (1) (2) | ||||||||||||||||
| Agency RMBS | December 31, 2014 | September 30, 2014 | June 30, 2014 | March 31, 2014 | ||||||||||||
| 15 Year Fixed Rate | N/A | 10 | % | 9 | % | 8 | % | |||||||||
| 20 Year Fixed Rate | 11 | % | 9 | % | 6 | % | 4 | % | ||||||||
| 30 Year Fixed Rate | 8 | % | 10 | % | 8 | % | 6 | % | ||||||||
| Fixed Rate CMO | 5 | % | 9 | % | 6 | % | 3 | % | ||||||||
| ARM | 9 | % | 9 | % | 7 | % | 4 | % | ||||||||
| Interest Only | 10 | % | 10 | % | 8 | % | 7 | % | ||||||||
| Weighted Average | 9 | % | 9 | % | 8 | % | 6 | % | ||||||||
| (1) | Represents the weighted average monthly CPRs published during the quarter for our in-place portfolio during the same period. |
| (2) | Source: Bloomberg |
Real estate securities and loans in an unrealized loss position as of December 31, 2015 are not considered other than temporarily impaired as we have the ability and intent to hold the investments to maturity or for a period of time sufficient for a forecasted market price recovery up to or above the amortized cost of the investments, and we are not required to sell for regulatory or other reasons. Any decline in fair value of these securities and loans is solely due to market conditions and not the quality of the assets. Further, all of the principal and interest payments on the Agency RMBS have an explicit guarantee by either an agency of the U.S. government or a U.S. government-sponsored entity.
Financing activities
We use leverage to complete the purchase of real estate securities and loans in our investment portfolio. Through December 31, 2015, leverage has been in the form of repurchase agreements, securitized debt and FHLBC Advances. Repurchase agreements involve the sale and a simultaneous agreement to repurchase the transferred assets or similar assets at a future date. FHLBC Advances involve loan advances made to us by the FHLBC in exchange for real estate securities as collateral. The amount borrowed generally is equal to the fair value of the assets pledged less an agreed-upon discount, referred to as a “haircut.” Our FHLBC Advances collateralized by Agency RMBS have lower effective “haircuts” than those required under the Company’s repurchase agreements. As of the FHFA’s Final Ruling, the FHLBC is prohibited from making any new advances or extending any existing advances to us.
Our repurchase agreements and FHLBC Advances are accounted for as financings and require the repurchase of the transferred securities or loans or repayment of the advance at the end of each agreement’s term, typically 30 to 90 days. If we maintain the beneficial interest in the specific assets pledged during the term of the borrowing, we receive the related principal and interest payments. If we do not maintain the beneficial interest in the specific assets pledged during the term of the borrowing, we will have the related principal and interest payments remitted to us by the lender. Interest rates on borrowings are fixed based on prevailing rates corresponding to the terms of the borrowings, and interest is paid at the termination of the borrowing at which time we may enter into a new borrowing arrangement at prevailing market rates with the same counterparty or repay that counterparty and negotiate financing with a different counterparty. In response to declines in fair value of pledged assets due to changes in market conditions or the publishing of monthly security paydown factors, lenders typically require us to post additional assets as collateral, pay down borrowings or establish cash margin accounts with the counterparties in order to re-establish the agreed-upon collateral requirements, referred to as margin calls.
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On April 13, 2015, the Company, AG MIT, LLC and AG MIT CMO, LLC, two of our subsidiaries, entered into an Amendment Number 2 to the Master Repurchase and Securities Contract (the “Second Renewal”) with Wells Fargo to finance AG MIT’s or AG MIT CMO’s acquisition of certain consumer asset-backed securities and commercial mortgage-backed securities as well as residential, Non-Agency Securities. The Second Renewal amends the repurchase agreement entered into by the Company, AG MIT and AG MIT CMO with Wells Fargo Bank, National Association, in 2014. Each transaction under the Second Renewal will have its own specific terms, such as identification of the assets subject to the transaction, sale price, repurchase price and rate. The Second Renewal includes a 270 day evergreen structure providing for the automatic renewal of the agreement each day for a new term of 270 days unless Wells Fargo notifies AG MIT and AG MIT CMO that it has decided not to renew, at which point the agreement will terminate 270 days after the date of nonrenewal. The Second Renewal also increased the aggregate maximum borrowing capacity to $200 million and extended the maturity date to April 13, 2017. At the request of AG MIT and AG MIT CMO, Wells Fargo may grant a 90 day extension of the maturity date. The Second Renewal contains representations, warranties, covenants, events of default and indemnities that are substantially identical to those in the previous repurchase agreements and are customary for agreements of this type. As of December 31, 2015, we had $102.3 million of debt outstanding under this facility.
On February 27, 2015, AG MIT WFB1 2014 LLC, (“AG MIT WFB1”), one of our subsidiaries, entered into Amendment Number Three of the Master Repurchase Agreement and Securities Contract, (as amended, the “WFB1 Repurchase Agreement”) with Wells Fargo to finance the ownership and acquisition of certain beneficial interests in trusts owning participation interests in one or more pools of residential mortgage loans. Each transaction under the WFB1 Repurchase Agreement has its own specific terms, such as identification of the assets subject to the transaction, sale price, repurchase price and rate. The WFB1 Repurchase Agreement provides for a funding period ending February 26, 2016 and a facility termination date of February 27, 2017. The maximum aggregate borrowing capacity available under the WFB1 Repurchase Agreement is $100.0 million. At our request, Wells Fargo may grant a one year extension of the facility termination date. The WFB1 Repurchase Agreement contains representations, warranties, covenants, events of default and indemnities that are customary for agreements of this type. The WFB1 Repurchase Agreement also contains financial covenants that are the same as those in the Second Renewal Agreement. As of December 31, 2015, we had $50.6 million of debt outstanding under the WFB1 Repurchase Agreement.
On September 17, 2014, AG MIT CREL, LLC (“AG MIT CREL”), one of our subsidiaries, entered into a Master Repurchase Agreement and Securities Contract (the “CREL Repurchase Agreement”), with Wells Fargo to finance AG MIT CREL’s acquisition of certain beneficial interests in one or more commercial mortgage loans. Each transaction under the CREL Repurchase Agreement will have its own specific terms, such as identification of the assets subject to the transaction, sale price, repurchase price and rate. The CREL Repurchase Agreement provides for a funding period ending September 17, 2016 and an initial facility termination date of September 17, 2016 (the “Initial Termination Date”), subject to satisfaction of certain terms of the extensions. AG MIT CREL has three (3) one-year options to extend the term of the CREL Repurchase Agreement: (i) the first for an additional one year period (the “First Extension Period”) ending September 17, 2017 (the “First Extended Termination Date”), (ii) the second for an additional one year period (the “Second Extension Period”) ending September 17, 2018 (the “Second Extended Termination Date”) and (iii) the third for an additional one year period ending September 17, 2019 (the “Third Extended Termination Date”). For each of the Initial Termination Date, the First Extended Termination Date, the Second Extended Termination Date and the Third Extended Termination Date, if such day is not a Business Day, such date shall be the next succeeding Business Day. Each option shall be exercisable in each case no more than ninety days and no fewer than thirty days prior to the initial facility termination date, the First Extended Termination Date or the Second Extended Termination Date, as the case may be. The maximum aggregate borrowing capacity available under the CREL Repurchase Agreement is $150.0 million. Under the CREL Repurchase Agreement, Wells Fargo’s recourse against the Company and AG MIT, LLC in the event of a default is limited to $80 million.
On August 4, 2015, the Company, AG MIT CREL and AG MIT, LLC, entered into an Omnibus Amendment No. 1 to Master Repurchase and Securities Contract, Guarantee Agreement and Fee and Pricing Letter (the “Amendment”) with Wells Fargo. The Amendment amended certain terms in the CREL Repurchase Agreement, the Guarantee, delivered by the Company and AG MIT to Wells Fargo (the “Guarantee”), and the Fee and Pricing Letter, between AG MIT CREL and Wells Fargo. The Amendment lowered the maximum aggregate borrowing capacity available under the CREL Repurchase Agreement from $150 million to approximately $42.8 million. The Amendment also provided that the CREL Repurchase Agreement become full recourse to the Company and AG MIT, LLC. By amending the recourse of the CREL Repurchase Agreement to the Company and AG MIT, LLC, we were able to remove certain financial covenants on AG MIT CREL that limited the amount that could be borrowed under the CREL Repurchase Agreement. The Amendment also eliminated the fee for the portion of the repurchase facility that was unused. In connection with the execution of the Amendment, AG MIT CREL borrowed an additional $20.3 million so that as of August 4, 2015 the outstanding borrowings under the Repurchase Agreement totaled approximately $42.8 million. We record our financing at cost, which approximates its estimated fair value. As of December 31, 2015, we had $42.8 million of debt outstanding under this facility.
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The CREL Repurchase Agreement contains representations, warranties, covenants, events of default and indemnities that are customary for agreements of this type. It also contains financial covenants that are the same as the financial covenants in the Second Renewal Agreement.
The following table presents a reconciliation of certain information related to repurchase agreements secured by real estate securities, inclusive of repurchase agreements through affiliated entities, to information on a GAAP basis as of December 31, 2015:
| Weighted Average | Weighted Average | Weighted | ||||||||||||||
| Repurchase Agreements Maturing Within: | Balance | Rate | Days to Maturity | Average Haircut | ||||||||||||
| 30 days or less | $ | 1,052,983,000 | 1.43 | % | 14 | 15.4 | % | |||||||||
| 31-60 days | 245,124,000 | 1.23 | % | 47 | 11.8 | % | ||||||||||
| 61-90 days | 76,739,000 | 1.98 | % | 74 | 21.1 | % | ||||||||||
| Greater than 90 days | 372,341,865 | 1.60 | % | 380 | 9.8 | % | ||||||||||
| Total: Non-GAAP Basis | $ | 1,747,187,865 | 1.46 | % | 99 | 14.0 | % | |||||||||
| Investments In Affiliates | $ | 7,989,207 | 3.00 | % | 314 | 28.7 | % | |||||||||
| Total: GAAP Basis | $ | 1,739,198,658 | 1.46 | % | 98 | 13.9 | % | |||||||||
The following table presents a reconciliation of certain information related to repurchase agreements secured by real estate securities, inclusive of unlinked repurchase agreements and repurchase agreements through affiliated entities to information on a GAAP basis as of December 31, 2014:
| Weighted Average | Weighted Average | Weighted | ||||||||||||||
| Repurchase Agreements Maturing Within: | Balance | Rate | Days to Maturity | Average Haircut | ||||||||||||
| 30 days or less | $ | 2,067,279,000 | 0.80 | % | 13 | 9.9 | % | |||||||||
| 31-60 days | 229,635,000 | 1.13 | % | 43 | 12.3 | % | ||||||||||
| 61-90 days | 58,366,000 | 1.34 | % | 68 | 13.0 | % | ||||||||||
| Greater than 90 days | 329,966,103 | 2.70 | % | 609 | 28.5 | % | ||||||||||
| Total: Non-GAAP Basis | $ | 2,685,246,103 | 1.07 | % | 90 | 12.4 | % | |||||||||
| Linked Transactions | $ | 113,363,873 | 1.74 | % | 20 | 18.2 | % | |||||||||
| Total: GAAP Basis | $ | 2,571,882,230 | 0.93 | % | 58 | 11.5 | % | |||||||||
The following table presents certain information related to FHLBC Advances secured by Agency RMBS, as of December 31, 2015:
| Weighted Average | Weighted Average | Weighted | ||||||||||||||
| FHLBC Advances Maturing Within: | Balance | Rate | Days to Maturity | Average Haircut | ||||||||||||
| 30 days or less | $ | 186,449,500 | 0.36 | % | 10 | 0.2 | % | |||||||||
| 31-60 days | 39,750,000 | 0.44 | % | 54 | 2.7 | % | ||||||||||
| 61-90 days | 170,694,500 | 0.49 | % | 66 | 0.3 | % | ||||||||||
| Greater than 90 days | - | - | - | - | ||||||||||||
| Total / Weighted Average | $ | 396,894,000 | 0.42 | % | 39 | 0.5 | % | |||||||||
We did not have any FHLBC Advances as of December 31, 2014.
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The following table presents a reconciliation of certain information related to repurchase agreements secured by residential mortgage loans and real estate owned, inclusive of repurchase agreements through affiliated entities to information on a GAAP basis as of December 31, 2015:
| Weighted | ||||||||||||||||||||
| Weighted Average | Weighted Average | Average Days to | Weighted Average | |||||||||||||||||
| Repurchase Agreements Maturing Within: | Balance | Rate | Funding Cost | Maturity | Haircut (1) | |||||||||||||||
| 30 days or less | $ | - | - | - | - | - | ||||||||||||||
| 31-60 days | - | - | - | - | - | |||||||||||||||
| 61-90 days | - | - | - | - | - | |||||||||||||||
| Greater than 90 days | 61,255,214 | 2.94 | % | 3.15 | % | 390 | N/A | |||||||||||||
| Total: Non-GAAP Basis | $ | 61,255,214 | 2.94 | % | 3.15 | % | 390 | N/A | ||||||||||||
| Investment In Affiliates | $ | 10,648,912 | 3.00 | % | 3.00 | % | 314 | 25.0 | % | |||||||||||
| Total: GAAP Basis | $ | 50,606,302 | 2.93 | % | 3.18 | % | 406 | N/A | ||||||||||||
(1) As of December 31, 2015, we had a total of $88.2 million of collateral pledged, comprised of $64.9 million of financial instruments and $23.3 million of cash from loan sales, which at December 31, 2015 was held by our broker. The Non-GAAP and GAAP haircut based on total collateral pledged is 30.1% and 31.1%, respectively, as of December 31, 2015.
The following table presents a reconciliation of certain information related to repurchase agreements secured by residential mortgage loans inclusive of repurchase agreements through affiliated entities to information on a GAAP basis as of December 31, 2014:
| Weighted | ||||||||||||||||||||
| Weighted Average | Weighted Average | Average Days to | Weighted Average | |||||||||||||||||
| Repurchase Agreements Maturing Within: | Balance | Rate | Funding Cost | Maturity | Haircut | |||||||||||||||
| 30 days or less | $ | - | - | - | - | - | ||||||||||||||
| 31-60 days | - | - | - | - | - | |||||||||||||||
| 61-90 days | - | - | - | - | - | |||||||||||||||
| Greater than 90 days | 71,878,879 | 2.95 | % | 3.06 | % | 744 | 29.3 | % | ||||||||||||
| Total: Non-GAAP Basis | $ | 71,878,879 | 2.95 | % | 3.06 | % | 744 | 29.3 | % | |||||||||||
| Investments In Affiliates | $ | 21,305,161 | 3.00 | % | 3.00 | % | 679 | 25.0 | % | |||||||||||
| Total: GAAP Basis | $ | 50,573,718 | 2.93 | % | 3.08 | % | 771 | 31.1 | % | |||||||||||
The following table presents certain information related to repurchase agreements secured by commercial loans as of December 31, 2015:
| Weighted | ||||||||||||||||||||
| Weighted | Weighted Average | Average Days to | Weighted | |||||||||||||||||
| Repurchase Agreements Maturing Within: | Balance | Average Rate | Funding Cost | Maturity | Average Haircut | |||||||||||||||
| 30 days or less | $ | - | - | - | - | - | ||||||||||||||
| 31-60 days | - | - | - | - | - | |||||||||||||||
| 61-90 days | - | - | - | - | - | |||||||||||||||
| Greater than 90 days | 42,796,000 | 2.67 | % | 3.62 | % | 1,356 | 31.8 | % | ||||||||||||
| Total / Weighted Average | $ | 42,796,000 | 2.67 | % | 3.62 | % | 1,356 | 31.8 | % | |||||||||||
The following table presents certain information related to repurchase agreements secured by commercial loans as of December 31, 2014:
| Weighted | ||||||||||||||||||||
| Weighted Average | Weighted Average | Average Days to | Weighted Average | |||||||||||||||||
| Repurchase Agreements Maturing Within: | Balance | Rate | Funding Cost | Maturity | Haircut | |||||||||||||||
| 30 days or less | $ | - | - | - | - | - | ||||||||||||||
| 31-60 days | - | - | - | - | - | |||||||||||||||
| 61-90 days | - | - | - | - | - | |||||||||||||||
| Greater than 90 days | 22,500,000 | 2.50 | % | 2.83 | % | 1,721 | 64.2 | % | ||||||||||||
| Total / Weighted Average | $ | 22,500,000 | 2.50 | % | 2.83 | % | 1,721 | 64.2 | % | |||||||||||
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The following table presents certain information related to repurchase agreements secured by interests in U.S. Treasury securities as of December 31, 2015:
| Weighted Average | Weighted Average | Weighted | ||||||||||||||
| Repurchase Agreements Maturing Within: | Balance | Rate | Days to Maturity | Average Haircut | ||||||||||||
| Overnight | $ | 202,362,500 | 0.42 | % | 4 | 0.57 | % | |||||||||
| 30 days or less | - | - | - | - | ||||||||||||
| 31-60 days | - | - | - | - | ||||||||||||
| 61-90 days | - | - | - | - | ||||||||||||
| Greater than 90 days | - | - | - | - | ||||||||||||
| Total / Weighted Average | $ | 202,362,500 | 0.42 | % | 4 | 0.57 | % | |||||||||
We did not hold any positions in U.S. Treasury securities on December 31, 2014.
As mentioned above, the amount borrowed represents the fair value of the assets pledged less an agreed-upon discount, referred to as a “haircut.” Our FHLBC Advances have lower effective “haircuts” than those required under the Company’s repurchase agreements. The size of the haircut reflects the perceived risk associated with the pledged asset. Haircuts may change as our repurchase agreements mature or roll and are sensitive to governmental regulations. Recent governmental regulations address, among other things, maintenance margin and variation margin requirements for U.S. broker dealers. We have not experienced fluctuations in our haircuts that altered our business and financing strategies for the years ended December 31, 2015 and 2014, but we continue to monitor the regulatory environment, which may influence the timing and amount of repurchase agreement activity.
In 2014, we entered into a resecuritization transaction that resulted in the us consolidating the Variable Interest Entity (“VIE”) created with the Special Purpose Entity (“SPE”) which was used to facilitate the transaction. We concluded that the entity created to facilitate this transaction was a VIE. We also determined the VIE created to facilitate the resecuritization transaction should be consolidated by us and treated as a secured borrowing, based on consideration of our involvement in the VIE, including the design and purpose of the SPE, and whether its involvement reflected a controlling financial interest that resulted in us being deemed the primary beneficiary of each VIE. As of December 31, 2015 and December 31, 2014, the principal balance of the consolidated tranche was $30.4 million and $40.7 million, respectively. As of December 31, 2015, and December 31, 2014 the fair value of the consolidated tranche issued by the consolidated VIE was $30.0 million and $39.8 million, respectively, which is classified as an asset in the “Non-Agency” line item and as a liability in the “Securitized debt” line item on our consolidated balance sheet. The cost of financing on December 31, 2015 and December 31, 2014 on the consolidated tranche was 3.7% and 3.8%, respectively.
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The following table presents the quarter-end balance, average quarterly balance and maximum balance at any month-end for the Company’s repurchase agreements and FHLBC Advances inclusive of unlinked repurchase agreements and repurchase agreements through affiliated entities with a reconciliation of all quarterly figures to GAAP.
| Quarter-End | Average Quarterly | Maximum Balance at | ||||||||||
| Quarter Ended | Balance | Balance | Any Month-End | |||||||||
| December 31, 2015 | ||||||||||||
| Non-GAAP Basis | $ | 2,450,495,579 | $ | 2,611,418,224 | $ | 2,737,440,514 | ||||||
| Less: Investments in Affiliates | 18,638,119 | 19,119,157 | 19,643,832 | |||||||||
| GAAP Basis | $ | 2,431,857,460 | $ | 2,592,299,067 | $ | 2,717,796,682 | ||||||
| September 30, 2015 | ||||||||||||
| Non-GAAP Basis | $ | 2,585,828,163 | $ | 2,509,992,155 | $ | 2,585,828,163 | ||||||
| Less: Investments in Affiliates | 20,212,522 | 20,566,999 | 20,876,667 | |||||||||
| GAAP Basis | $ | 2,565,615,641 | $ | 2,489,425,156 | $ | 2,564,951,496 | ||||||
| June 30, 2015 | ||||||||||||
| Non-GAAP Basis | $ | 2,534,309,367 | $ | 2,618,201,220 | $ | 2,689,179,519 | ||||||
| Less: Investments in Affiliates | 21,091,153 | 21,209,044 | 21,267,990 | |||||||||
| GAAP Basis | $ | 2,513,218,214 | $ | 2,596,992,176 | $ | 2,667,911,529 | ||||||
| March 31, 2015 | ||||||||||||
| Non-GAAP Basis | $ | 2,691,920,394 | $ | 2,713,017,544 | $ | 2,807,851,545 | ||||||
| Less: Investments in Affiliates | 21,305,161 | 21,305,161 | 21,305,161 | |||||||||
| GAAP Basis | $ | 2,670,615,233 | $ | 2,691,712,383 | $ | 2,786,546,384 | ||||||
| December 31, 2014 | ||||||||||||
| Non-GAAP Basis | $ | 2,779,624,982 | $ | 2,809,867,811 | $ | 2,838,591,258 | ||||||
| Less: Linked Transactions | 113,363,873 | 130,264,304 | 142,279,249 | |||||||||
| Less: Investments in Affiliates | 21,305,161 | 18,880,600 | 21,305,161 | |||||||||
| GAAP Basis | $ | 2,644,955,948 | $ | 2,660,722,907 | $ | 2,675,006,848 | ||||||
| September 30, 2014 | ||||||||||||
| Non-GAAP Basis | $ | 2,871,453,629 | $ | 2,956,548,421 | $ | 3,102,782,512 | ||||||
| Less: Linked Transactions | 131,106,935 | 142,459,846 | 149,986,999 | |||||||||
| GAAP Basis | $ | 2,740,346,694 | $ | 2,814,088,575 | $ | 2,952,795,513 | ||||||
| June 30, 2014 | ||||||||||||
| Non-GAAP Basis | $ | 3,134,086,525 | $ | 3,094,449,312 | $ | 3,134,086,525 | ||||||
| Less: Linked Transactions | 158,275,177 | 170,448,011 | 187,381,609 | |||||||||
| GAAP Basis | $ | 2,975,811,348 | $ | 2,924,001,301 | $ | 2,946,704,916 | ||||||
| March 31, 2014 | ||||||||||||
| Non-GAAP Basis | $ | 3,255,756,359 | $ | 3,178,572,989 | $ | 3,255,756,359 | ||||||
| Less: Linked Transactions | 186,578,959 | 193,237,584 | 206,433,270 | |||||||||
| GAAP Basis | $ | 3,069,177,400 | $ | 2,985,335,405 | $ | 3,049,323,089 | ||||||
| December 31, 2013 | ||||||||||||
| Non-GAAP Basis | $ | 3,114,480,731 | $ | 3,119,928,016 | $ | 3,145,191,941 | ||||||
| Less: Linked Transactions | 222,846,315 | 237,576,633 | 249,165,657 | |||||||||
| GAAP Basis | $ | 2,891,634,416 | $ | 2,882,351,383 | $ | 2,896,026,284 | ||||||
| September 30, 2013 | ||||||||||||
| Non-GAAP Basis | $ | 3,194,360,409 | $ | 3,294,030,740 | $ | 3,495,343,985 | ||||||
| Less: Linked Transactions | 229,265,000 | 246,331,778 | 259,343,915 | |||||||||
| GAAP Basis | $ | 2,965,095,409 | $ | 3,047,698,962 | $ | 3,236,000,070 | ||||||
| June 30, 2013 | ||||||||||||
| Non-GAAP Basis | $ | 4,226,403,356 | $ | 4,380,568,623 | $ | 4,613,620,097 | ||||||
| Less: Linked Transactions | 404,759,166 | 418,500,534 | 431,172,099 | |||||||||
| GAAP Basis | $ | 3,821,644,190 | $ | 3,962,068,089 | $ | 4,182,447,998 | ||||||
| March 31, 2013 | ||||||||||||
| Non-GAAP Basis | $ | 4,357,022,229 | $ | 4,292,089,859 | $ | 4,357,022,229 | ||||||
| Less: Linked Transactions | 375,195,253 | 318,334,369 | 375,195,253 | |||||||||
| GAAP Basis | $ | 3,981,826,976 | $ | 3,973,755,490 | $ | 3,981,826,976 | ||||||
As of December 31, 2015, we financed the purchase of our investments with repurchase agreements and FHLBC Advances. Due to the Final Rule issued by the FHFA in January 2016, we will no longer continue to finance the purchase of our investments with FHLBC Advances. It can be reasonably expected that our repurchase agreement balance will increase if we raise equity capital and decrease upon reduction of the portfolio size through asset sales. In response to a sharp increase in interest rates resulting from the market’s reaction to the announcement that tapering of QE3 could occur earlier than expected, we sold a significant amount of our fixed-rate Agency RMBS and subsequently terminated the related repurchase agreements, accounting for the reduction in repurchase agreement balance from the maximum balance at any month-end within both the second and third quarter of 2013. During the remainder of 2013 and throughout 2014 and 2015, we have gradually increased our investment allocation to credit investments. Our credit portfolio as a percentage of our total portfolio increased from 34.9% as of December 31, 2013 to 55.8% as of December 31, 2015. Due to their inherent risk of loss, credit investments have lower leverage ratios than Agency RMBS.
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We define “Non-GAAP Leverage” as the sum of repurchase agreements, inclusive of repurchase agreements accounted for as linked transactions and those held through affiliated entities, FHLBC Advances, the payable on unsettled buys less the financing on unsettled sells, and the consolidated tranche issued by the consolidated VIE which is classified as “Securitized debt” on our consolidated balance sheet. Leverage excludes repurchase agreements and net receivables/payables on unsettled trades pertaining to U.S. Treasury securities due to the highly liquid and temporary nature of these investments. We define “at risk” leverage as non-GAAP leverage inclusive of our net TBA position (at cost). These calculations divide leverage by our GAAP stockholders equity. The following tables present a reconciliation of our leverage ratio on a GAAP basis on December 31, 2015 and December 31, 2014 to both our non-GAAP leverage and our “at risk” leverage.
| December 31, 2015 | Leverage | Stockholders’ Equity | Leverage Ratio | |||||||||
| GAAP Leverage | $ | 2,259,541,821 | $ | 666,944,713 | 3.39 | x | ||||||
| Repurchase agreements through affiliated entities | 18,638,119 | - | ||||||||||
| Non-GAAP Leverage | $ | 2,278,179,940 | $ | 666,944,713 | 3.42 | x | ||||||
| Net TBA payable adjustment | 77,502,930 | - | ||||||||||
| Non-GAAP “At Risk” Leverage | $ | 2,355,682,870 | $ | 666,944,713 | 3.53 | x | ||||||
| December 31, 2014 | Leverage | Stockholders’ Equity | Leverage Ratio | |||||||||
| GAAP Leverage | $ | 2,684,733,862 | $ | 732,675,143 | 3.66 | x | ||||||
| Repurchase agreements accounted for as linked transactions | 113,363,873 | - | ||||||||||
| Repurchase agreements through affiliated entities | 21,305,161 | - | ||||||||||
| Non-GAAP Leverage | $ | 2,819,402,896 | $ | 732,675,143 | 3.85 | x | ||||||
| Net TBA payable adjustment | 235,240,234 | - | ||||||||||
| Non-GAAP “At Risk” Leverage | $ | 3,054,643,130 | $ | 732,675,143 | 4.17 | x | ||||||
We seek to transact with several different counterparties in order to reduce the exposure to any single counterparty. We have entered into financing arrangements, either directly or through equity method investments in affiliates with 38 and 35 counterparties, under which we had outstanding debt from 21 and 24 counterparties on December 31, 2015 and December 31, 2014, respectively, inclusive of repurchase agreements accounted for as linked transactions and repurchase agreements in affiliated entities, if any. We had outstanding debt with 21 and 22 counterparties on December 31, 2015 and December 31, 2014, respectively, on a GAAP basis.
On December 31, 2015, the following table reflects amounts at risk under its repurchase agreements greater than 5% of our equity with any counterparty, inclusive of repurchase agreements through affiliated entities greater than 5% of our equity with any counterparty.
| Weighted Average | Percentage of | |||||||||||
| Counterparty | Amount at Risk | Maturity (days) | Stockholders’ Equity | |||||||||
| Wells Fargo Bank, N.A. | $ | 59,863,639 | 543 | 9 | % | |||||||
| JP Morgan Securities, LLC | 45,341,579 | 187 | 7 | % | ||||||||
| RBC (Barbados) Trading Bank Corporation | 41,788,752 | 44 | 6 | % | ||||||||
| Credit Suisse Securities, LLC | 40,797,732 | 44 | 6 | % | ||||||||
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On December 31, 2014, the following table reflects amounts at risk under its repurchase agreements, inclusive of repurchase agreements accounted for as linked transactions and through affiliated entities greater than 5% of our equity with any counterparty, with reconciliation to GAAP.
| Weighted Average | Percentage of | |||||||||||
| Counterparty | Amount at Risk | Maturity (days) | Stockholders’ Equity | |||||||||
| Wells Fargo Bank, N.A - Non-GAAP | $ | 92,478,572 | 509 | 13 | % | |||||||
| Non-GAAP Adjustments | - | - | - | |||||||||
| Wells Fargo Bank, N.A - GAAP | $ | 92,478,572 | 509 | 13 | % | |||||||
| Credit Suisse Securities, LLC - Non-GAAP | $ | 88,273,237 | 114 | 12 | % | |||||||
| Non-GAAP Adjustments | (2,794,234 | ) | 3 | - | ||||||||
| Credit Suisse Securities, LLC - GAAP | $ | 85,479,003 | 117 | 12 | % | |||||||
| JP Morgan Securities, LLC - Non-GAAP | $ | 52,782,788 | 165 | 7 | % | |||||||
| Non-GAAP Adjustments | (1,280,157 | ) | 3 | - | ||||||||
| JP Morgan Securities, LLC - GAAP | $ | 51,502,631 | 168 | |||||||||