BIMINI CAPITAL MANAGEMENT, INC. The following discussion of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and notes to those statements included in Item 8 of this Form 10-K. The discussion may contain certain forward-looking statements that involve risks and uncertainties. Forward-looking statements are those that are not historical in nature. As a result of many factors, such as those set forth under "Risk Factors" in this Form 10-K, our actual results may differ materially from those anticipated in such forward-looking statements. OverviewBimini Capital Management, Inc. ("Bimini Capital " or the "Company") is a holding company that was formed inSeptember 2003 . The Company's principal wholly-owned operating subsidiary isRoyal Palm Capital, LLC . We operate in two business segments: the asset management segment, which includes (a) the investment advisory services provided by Royal Palm's wholly-owned subsidiary,Bimini Advisors Holdings, LLC , to Orchid, and (b) the investment portfolio segment, which includes the investment activities conducted by Royal Palm.Bimini Advisors Holdings, LLC and its wholly-owned subsidiary,Bimini Advisors, LLC (an investment advisor registered with theSecurities and Exchange Commission ), are collectively referred to as "Bimini Advisors ."Bimini Advisors serves as the external manager of the portfolio of Orchid Island Capital, Inc. ("Orchid"). From this arrangement, the Company receives management fees and expense reimbursements. As manager,Bimini Advisors is responsible for administering Orchid's business activities and day-to-day operations and commencingApril 1, 2022 , provides certain repurchase agreement trading, clearing and administrative services. Pursuant to the terms of the management agreement,Bimini Advisors provides Orchid with its management team, including its officers, along with appropriate support personnel.Bimini Advisors is at all times subject to the supervision and oversight of Orchid's board of directors and has only such functions and authority as delegated to it.Royal Palm Capital, LLC (collectively with its wholly-owned subsidiaries referred to as "Royal Palm") maintains an investment portfolio, consisting primarily of residential mortgage-backed securities ("MBS") issued and guaranteed by a federally chartered corporation or agency ("Agency MBS"). We also invest in the common stock of Orchid. Our investment strategy focuses on, and our portfolio consists of, two categories of Agency MBS: (i) traditional pass-through Agency MBS, such as mortgage pass-through certificates issued by the "GSEs" and collateralized mortgage obligations ("CMOs") issued by the GSEs ("PT MBS") and (ii) structured Agency MBS, such as interest only securities ("IOs"), inverse interest only securities ("IIOs") and principal only securities ("POs"), among other types of structured Agency MBS. In addition, Royal Palm receives dividends from its investment in Orchid common shares. Stock Repurchase Plans OnMarch 26, 2018 , the Board of Directors of the Company approved a Stock Repurchase Plan the "2018 Repurchase Plan"). Pursuant to the 2018 Repurchase Plan, we could purchase up to 500,000 shares of the Company's Class A Common Stock from time to time, subject to certain limitations imposed by Rule 10b-18 of the Securities Exchange Act of 1934. The 2018 Repurchase Plan was terminated onSeptember 16, 2021 . During the period beginningJanuary 1, 2021 throughSeptember 16, 2021 , the Company repurchased a total of 1,195 shares under the 2018 Repurchase Plan at an aggregate cost of approximately$2,298 , including commissions and fees, for a weighted average price of$1.92 per share. From commencement of the 2018 Repurchase Plan, through its termination, the Company repurchased a total of 71,598 shares at an aggregate cost of approximately$169,243 , including commissions and fees, for a weighted average price of$2.36 per share. OnSeptember 16, 2021 , the Board authorized a share repurchase plan pursuant to Rule 10b5-1 of the Securities Exchange Act of 1934 (the "2021 Repurchase Plan"). Pursuant to the 2021 Repurchase Plan, we may purchase shares of our Class A Common Stock from time to time for an aggregate purchase price not to exceed$2.5 million . Share repurchases may be executed through various means, including, without limitation, open market transactions. The 2021 Repurchase Plan does not obligate the Company to purchase any shares, and it expires onSeptember 16, 2023 . The authorization for the 2021 Repurchase Plan may be terminated, increased or decreased by the Company's Board of Directors in its discretion at any time. From the commencement of the 2021 Repurchase Plan, throughDecember 31, 2022 , we repurchased a total of 774,593 shares at an aggregate cost of approximately$1.2 million , including commissions and fees, for a weighted average price of$1.61 per share. During the year endedDecember 31, 2022 , the Company repurchased a total of 682,306 shares at an aggregate cost of approximately$1.1 million , including commissions and fees, for a weighted average price of$1.54 per share. - 34 -
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The Inflation Reduction Act of 2022 signed into law during inAugust 2022 includes a provision for an excise tax equal to 1% of the fair market value of any stock repurchased by covered corporations during a taxable year, subject to certain limits and provisions. The excise tax is effective beginning in 2023. While we may complete transactions subject to the new excise tax, we do not expect a material impact to our financial condition or result of operations. Tender Offer InJuly 2021 , we completed a "modified Dutch auction" tender offer and paid$1.5 million , excluding fees and related expenses, to repurchase 812,879 shares of our Class A common stock, which were retired, at a price of$1.85 per share.
Factors that Affect our Results of Operations and Financial Condition
A variety of industry and economic factors may impact our results of operations and financial condition. These factors include:
? interest rate trends;
? increases in our cost of funds resulting from increases in the Federal Funds
rate that are controlled by the Fed that occurred in 2022 and are likely to
occur in 2023;
? the difference between Agency MBS yields and our funding and hedging costs;
? competition for, and supply of, investments in Agency MBS; ? actions taken by theU.S. government, including the presidential administration, the Fed, theFOMC , the FHFA and theU.S. Treasury ;
? prepayment rates on mortgages underlying our Agency MBS, and credit trends
insofar as they affect prepayment rates;
? the equity markets and the ability of Orchid to raise additional capital;
? other market developments.
In addition, a variety of factors relating to our business may also impact our results of operations and financial condition. These factors include:
? our degree of leverage; ? our access to funding and borrowing capacity; ? our borrowing costs; ? our hedging activities; ? the market value of our investments;
? the requirements to qualify for a registration exemption under the Investment
Company Act;
? our ability to use net operating loss carryforwards and net capital loss
carryforwards to reduce our taxable income;
? the impact of possible future changes in tax laws or tax rates;? increases in or cost of funds resulting from increases in the Fed Funds rate
that are controlled by the Fed which have occurred in 2022, and are likely to
continue to occur, in 2023;
? our ability to manage the portfolio of Orchid and maintain our role as
manager; and
? the financial performance of Orchid and resulting changes in Orchid'sshareholders equity, the carrying value of our investment, dividend income and
our advisory services revenue.
Results of Operations
Described below are the Company's results of operations for the year ended
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Table of Contents Net (Loss) Income Summary Consolidated net loss for the year endedDecember 31, 2022 was$19.8 million , or$1.90 basic and diluted income per share of Class A Common Stock, as compared to consolidated net income of$0.3 million , or$0.02 basic and diluted loss per share of Class A Common Stock, for the year endedDecember 31, 2021 . The components of net (loss) income for the years endedDecember 31, 2022 and 2021, along with the changes in those components are presented in the table below: (in thousands) 2022 2021 Change Advisory services revenue$ 12,996 $ 9,788 $ 3,208 Interest and dividend income 3,155 4,262 (1,107 ) Interest expense (2,131 ) (1,113 ) (1,018 ) Net revenues 14,020 12,937 1,083 Other expense (12,146 ) (4,744 ) (7,402 ) Expenses (9,839 ) (8,286 ) (1,553 ) Net loss before income tax provision (benefit) (7,965 ) (93 ) (7,872 ) Income tax provision (benefit) 11,858 (368 ) 12,226 Net (loss) income$ (19,823 ) $ 275 $ (20,098 )
GAAP and Non-GAAP Reconciliation
Economic Interest Expense and Economic Net Interest Income
We use derivative instruments, specifically Eurodollar and Treasury Note ("T-Note") futures contracts and TBA short positions to hedge a portion of the interest rate risk on repurchase agreements in a rising rate environment.
We have not designated our derivative financial instruments as hedge accounting
relationships, but rather hold them for economic hedging purposes. Changes in
fair value of these instruments are presented in a separate line item in our
consolidated statements of operations and not included in interest expense. As
such, for financial reporting purposes, interest expense and cost of funds are
not impacted by the fluctuation in value of the derivative instruments.
For the purpose of computing economic net interest income and ratios relating to
cost of funds measures, GAAP interest expense, as reflected in our consolidated
statements of operations, is adjusted to reflect the realized and unrealized
gains or losses on certain derivative instruments the Company uses that pertain
to each period presented. We believe that adjusting our GAAP interest expense
for the periods presented by the gains or losses on these derivative instruments
may not accurately reflect our economic interest expense for these periods. The
reason is that these derivative instruments may cover periods that extend into
the future, not just the current period. Any realized or unrealized gains or
losses on the derivative instruments reflect the change in market value of the
instrument caused by changes in underlying interest rates applicable to the term
covered by the instrument, which changes are reflected of the future periods
covered by the derivative instrument, not just the current period.
For each period presented, we have combined the effects of the derivative
financial instruments in place for the respective period with the actual
interest expense incurred on our borrowings to reflect total economic interest
expense for the applicable period. Interest expense, including the effect of
derivative instruments for the period, is referred to as economic interest
expense. Net interest income, when calculated to include the effect of
derivative instruments for the period, is referred to as economic net interest
income.
We believe that economic interest expense and economic net interest income
provide meaningful information to consider, in addition to the respective
amounts prepared in accordance with GAAP. The non-GAAP measures help management
to evaluate our financial position and performance without the effects of
certain transactions and GAAP adjustments that are not necessarily indicative of
our current investment portfolio or operations. The gains or losses on
derivative instruments presented in our consolidated statements of operations
are not necessarily representative of the total interest expense that we will
ultimately realize. This is because as interest rates move up or down in the
future, the gains or losses we ultimately realize, and which will affect our
total interest expense in future periods, may differ from the unrealized gains
or losses recognized as of the reporting date.
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Our presentation of the economic value of our hedging strategy has important limitations. First, other market participants may calculate economic interest expense and economic net interest income differently than the way we calculate them. Second, while we believe that the calculation of the economic value of our hedging strategy described above helps to present our financial position and performance, it may be of limited usefulness as an analytical tool. Therefore, the economic value of our investment strategy should not be viewed in isolation and is not a substitute for interest expense and net interest income computed in accordance with GAAP. The tables below present a reconciliation of the adjustments discussed above to interest expense shown for each period relative to our derivative instruments, and the consolidated statements of operations line item, gains (losses) on derivative instruments, calculated in accordance with GAAP for the years endedDecember 31, 2022 and 2021 and for each quarter during 2022 and 2021. Gains (Losses) on Futures Contracts (in thousands) Attributed to Current Period (Non-GAAP) Attributed to Future Periods (Non-GAAP) Junior Repurchase Junior Repurchase Subordinated Statement of Three Months Ended Agreements Subordinated Debt Total Agreements Debt Total
Operations
December 31, 2022 $ (185 ) $ (48 ) $ (233 ) $ 192 $ 48 $ 240 $ 7
September 30, 2022 (184 ) (48 ) (232 ) 1,028 48 1,076 844
June 30, 2022 (186 ) (48 ) (234 ) 136 48 184 (50 )
March 31, 2022 (185 ) (48 ) (233 ) 185 48 233 -
December 31, 2021 (707 ) (60 ) (767 ) 707 60 767 -
September 30, 2021 (709 ) (57 ) (766 ) 709 57 766 -
June 30, 2021 (708 ) (58 ) (766 ) 708 58 766 -
March 31, 2021 (708 ) (58 ) (766 ) 708 58 766 -
Years Ended
December 31, 2022 $ (740 ) $ (192 ) $ (932 ) $ 1,541 $ 192 $ 1,733 $ 801
December 31, 2021 (2,832 ) (233 ) (3,065 ) 2,832 233 3,065 -
(in thousands)
Interest Expense on Repurchase Agreements Net Portfolio Interest Income
Effect of
Interest Non-GAAP Economic Economic
Three Months Ended Income GAAP Basis Hedges(1) Basis(2) GAAP Basis Basis(3)
December 31, 2022 $ 534 $ 401 $ 185 $ 586 $ 133 $ (52 )
September 30, 2022 445 210 184 394 235 51
June 30, 2022 392 73 186 259 319 133
March 31, 2022 491 31 185 216 460 275
December 31, 2021 511 21 707 728 490 (217 )
September 30, 2021 537 24 709 733 513 (196 )
June 30, 2021 578 31 708 739 547 (161 )
March 31, 2021 611 40 708 748 571 (137 )
Years Ended
December 31, 2022 $ 1,862 $ 715 $ 740 $ 1,455 $ 1,147 $ 407
December 31, 2021 2,237 116 2,832 2,948 2,121 (711 )
(1) Reflects the effect of derivative instrument hedges for only the period
presented.
(2) Calculated by subtracting the effect of derivative instrument hedges
attributed to the period presented from GAAP interest expense.
(3) Calculated by adding the effect of derivative instrument hedges attributed to
the period presented to GAAP net portfolio interest income.
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Economic Net Interest Income
(in thousands)
Net Portfolio Interest Expense on Long-Term Debt
Interest Income Net Interest Income
Effect of
Economic Non-GAAP Economic Economic
Three Months Ended GAAP Basis Basis(1) GAAP Basis Hedges(2) Basis(3) GAAP Basis Basis(4)
December 31, 2022 $ 133 $ (52 ) $ 477 $ 48 $ 525 $ (344 ) $ (577 )
September 30, 2022 235 51 379 48 427 (144 ) (376 )
June 30, 2022 319 133 304 48 352 15 (219 )
March 31, 2022 460 275 256 48 304 204 (29 )
December 31, 2021 490 (217 ) 249 60 309 241 (526 )
September 30, 2021 513 (196 ) 248 57 305 265 (501 )
June 30, 2021 547 (161 ) 250 58 308 297 (469 )
March 31, 2021 571 (137 ) 250 58 308 321 (445 )
Years Ended
December 31, 2022 $ 1,147 $ 407 $ 1,416 $ 192 $ 1,608 $ (269 ) $ (1,201 )
December 31, 2021 2,121 (711 ) 997 233 1,230 1,124 (1,941 )
(1) Calculated by adding the effect of derivative instrument hedges attributed to
the period presented to GAAP net portfolio interest income.
(2) Reflects the effect of derivative instrument hedges for only the period
presented.
(3) Calculated by subtracting the effect of derivative instrument hedges
attributed to the period presented from GAAP interest expense.
(4) Calculated by adding the effect of derivative instrument hedges attributed to
the period presented to GAAP net interest income.
Segment Information
We have two operating segments. The asset management segment includes the
investment advisory services provided by Bimini Advisors to Orchid and Royal
Palm. The investment portfolio segment includes the investment activities
conducted by Royal Palm. Segment information for the years ended December 31,
2022 and 2021 is as follows:
(in thousands)
Investment
Asset Management Portfolio Corporate Eliminations Total
2022
Advisory services, external
customers $ 12,996 $ - $ - $ - $ 12,996
Advisory services, other
operating segments(1) 115 - - (115 ) -
Interest and dividend income - 3,155 - - 3,155
Interest expense - (715 ) (1,416 ) (2) - (2,131 )
Net revenues 13,111 2,440 (1,416 ) (115 ) 14,020
Other (expense) income - (12,212 ) 66 (3) - (12,146 )
Operating expenses(4) (7,805 ) (2,034 ) - - (9,839 )
Intercompany expenses(1) - (115 ) - 115 -
Income (loss) before income
taxes $ 5,306 $ (11,921 ) $ (1,350 ) $ - $ (7,965 )
Year end assets $ 1,970 $ 77,483 $ 6,864 $ - $ 86,317
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Investment
Asset Management Portfolio Corporate Eliminations Total
2021
Advisory services, external
customers $ 9,788 $ - $ - $ - $ 9,788
Advisory services, other
operating segments(1) 147 - - (147 ) -
Interest and dividend income - 4,262 - - 4,262
Interest expense - (116 ) (997 ) (2) - (1,113 )
Net revenues 9,935 4,146 (997 ) (147 ) 12,937
Other expense - (4,898 ) 154 (3) - (4,744 )
Operating expenses(4) (5,676 ) (2,609 ) - - (8,285 )
Intercompany expenses(1) - (147 ) - 147 -
Income (loss) before income
taxes $ 4,259 $ (3,508 ) $ (843 ) $ - $ (92 )
Year end assets $ 1,901 $ 111,022 $ 9,162 $ - $ 122,085 (1) Includes advisory services revenue received by
Palm.
(2) Includes interest on long-term debt.
(3) Includes income recognized on the forgiveness of the PPP loan and gains
(losses) on Eurodollar futures contracts entered into as a hedge on junior
subordinated notes.
(4) Corporate expenses are allocated based on each segment's proportional share
of total revenues.
Asset Management Segment
Advisory Services Revenue
Advisory services revenue consists of management fees and overhead
reimbursements charged to Orchid for the management of its portfolio pursuant to
the terms of a management agreement. We receive a monthly management fee in the
amount of:
? One-twelfth of 1.50% of the first
as defined in the management agreement,
? One-twelfth of 1.25% of Orchid's month-end equity that is greater than
million and less than or equal to
? One-twelfth of 1.00% of Orchid's month-end equity that is greater than
million.
On April 1, 2022 , pursuant to the third amendment to the management agreement
entered into on November 16, 2021 , the Company began providing certain
repurchase agreement trading, clearing and administrative services to Orchid
that had been previously provided by AVM, L.P. under an agreement terminated on
March 31, 2022 . In consideration for such services, Orchid pays the following
fees to the Company:
? A daily fee equal to the outstanding principal balance of repurchase
agreement funding in place as of the end of such day multiplied by 1.5
basis points for the amount of aggregate outstanding principal balance
less than or equal to $5 billion , and multiplied by 1.0 basis point for
any amount of aggregate outstanding principal balance in excess of $5
billion , and
? A fee for the clearing and operational services provided by personnel of
the Manager equal to $10,000 per month.
In addition, Orchid is obligated to reimburse us for any direct expenses
incurred on its behalf and to pay to us an amount equal to Orchid's pro rata
portion of certain overhead costs set forth in the management agreement. The
management agreement has been renewed through February 2024 and provides for
automatic one-year extension options. Should Orchid terminate the management
agreement without cause, it will be obligated to pay to us a termination fee
equal to three times the average annual management fee, as defined in the
management agreement, before or on the last day of the automatic renewal term.
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The following table summarizes the advisory services revenue received from Orchid for the years endedDecember 31, 2022 and 2021 and each quarter during 2022 and 2021. ($ in thousands) Advisory Services Average Average Repurchase, Orchid Orchid Management Overhead Clearing and Three Months Ended MBS Equity Fee Allocation Administrative Total December 31, 2022$ 3,370,608 $ 823,516 $ 2,566 $ 560 $ 150$ 3,276 September 30, 2022 3,571,037 839,935 2,616 522 174 3,312 June 30, 2022 4,260,727 866,539 2,631 519 183 3,333 March 31, 2022 5,545,844 853,577 2,634 441 0 3,075 December 31, 2021 6,056,259 806,382 2,587 443 0 3,030 September 30, 2021 5,136,331 672,384 2,157 390 0 2,547 June 30, 2021 4,504,887 542,679 1,791 395 0 2,186 March 31, 2021 4,032,716 456,687 1,621 404 0 2,025 Years Ended December 31, 2022$ 4,187,054 $ 845,892 $ 10,447 $ 2,042 $ 507$ 12,996 December 31, 2021 4,932,548 619,533 8,156 1,632 - 9,788 Investment Portfolio Segment Net Portfolio Interest Income We define net portfolio interest income as interest income on MBS less interest expense on repurchase agreement funding. During the year endedDecember 31, 2022 , we generated$1.1 million of net portfolio interest income, consisting of$1.9 million of interest income from MBS assets offset by$0.7 million of interest expense on repurchase liabilities. For the year endedDecember 31, 2021 , we generated$2.1 million of net portfolio interest income, consisting of$2.2 million of interest income from MBS assets offset by$0.1 million of interest expense on repurchase liabilities. The$0.4 million decrease in interest income for the year endedDecember 31, 2022 was due to a$19.6 million decrease in average MBS balances, partially offset by a 58 basis point ("bp") increase in yields earned on the portfolio. The$0.6 million increase in interest expense for the year endedDecember 31, 2022 was due to a 136 bp increase in cost of funds, partially offset by a$20.8 million decrease in average repurchase liabilities.
Our economic interest expense on repurchase liabilities for the years ended
The tables below provide information on our portfolio average balances, interest income, yield on assets, average repurchase agreement balances, interest expense, cost of funds, net interest income and net interest rate spread for each quarter in 2022 and 2021 and for the years endedDecember 31, 2022 and 2021 on both a GAAP and economic basis. ($ in thousands) Average Yield on Average Interest Expense Average Cost of Funds MBS Interest Average Repurchase GAAP Economic GAAP Economic Three Months Ended Held(1) Income(2) MBS Agreements(1) Basis Basis(2) Basis Basis(3) December 31, 2022$ 45,081 $ 534 4.74 %$ 43,656 $ 401 $ 586 3.68 % 5.37 % September 30, 2022 41,402 445 4.30 % 40,210 210 394 2.09 % 3.92 % June 30, 2022 46,607 392 3.36 % 45,870 73 259 0.63 % 2.25 % March 31, 2022 57,741 491 3.40 % 56,846 31 216 0.22 % 1.52 % December 31, 2021 62,597 511 3.27 % 61,019 21 728 0.14 % 4.77 % September 30, 2021 66,692 537 3.22 % 67,253 24 733 0.14 % 4.36 % June 30, 2021 70,925 578 3.26 % 72,241 31 739 0.17 % 4.09 % March 31, 2021 69,017 611 3.54 % 69,104 40 748 0.23 % 4.33 % Years Ended December 31, 2022$ 47,708 $ 1,862 3.90 %$ 46,646 $ 715 $ 1,455 1.53 % 3.12 % December 31, 2021 67,308 2,237 3.32 % 67,404 116 2,948 0.17 % 4.37 % - 40 -
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($ in thousands)
Net Portfolio Net Portfolio
Interest Income Interest Spread
GAAP Economic GAAP Economic
Three Months Ended Basis Basis(2) Basis Basis(4)
December 31, 2022 $ 133 $ (52 ) 1.06 % (0.63 )%
September 30, 2022 235 51 2.21 % 0.38 %
June 30, 2022 319 133 2.73 % 1.11 %
March 31, 2022 460 275 3.18 % 1.88 %
December 31, 2021 490 (217 ) 3.13 % (1.50 )%
September 30, 2021 513 (196 ) 3.08 % (1.14 )%
June 30, 2021 547 (161 ) 3.09 % (0.83 )%
March 31, 2021 571 (137 ) 3.31 % (0.79 )%
Years Ended
(711 ) 3.15 % (1.05 )%
(1) Portfolio yields and costs of borrowings presented in the tables above and
the tables on pages 43 and 44 are calculated based on the average balances of
the underlying investment portfolio/repurchase agreement balances and are
annualized for the periods presented.
(2) Economic interest expense and economic net interest income presented in the
tables above and the tables on page 44 include the effect of derivative
instrument hedges for only the period presented.
(3) Represents interest cost of our borrowings and the effect of derivative
instrument hedges attributed to the period related to hedging activities
divided by average MBS held.
(4) Economic net interest spread is calculated by subtracting average economic
cost of funds from yield on average MBS.
Interest Income and Average Earning Asset Yield
Our interest income was$1.9 million for the year endedDecember 31, 2022 and$2.2 million for year endedDecember 31, 2021 . Average MBS holdings were$47.7 million and$67.3 million for the years endedDecember 31, 2022 and 2021, respectively. The$0.4 million decrease in interest income was due to a$19.6 million decrease in average MBS holdings, partially offset by a 58 bp increase in yields. The table below presents the average portfolio size, income and yields of our respective sub-portfolios, consisting of structured MBS and pass-through MBS ("PT MBS") for the years endedDecember 31, 2022 and 2021 and each quarter during 2022 and 2021. ($ in thousands) Average MBS Held Interest Income Realized Yield on Average MBS PT Structured PT Structured PT Structured Three Months Ended MBS MBS Total MBS MBS Total MBS MBS Total
December 31, 2022$ 42,125 $ 2,956 $ 45,081 $ 473 $ 61$ 534 4.49 % 8.31 % 4.74 % September 30, 2022 38,384 3,018 41,402 383 62 445 3.99 % 8.17 % 4.30 % June 30, 2022 43,568 3,039 46,607 333 59 392 3.06 % 7.75 % 3.36 % March 31, 2022 54,836 2,905 57,741 472 19 491 3.45 % 2.61 % 3.40 % December 31, 2021 59,701 2,896 62,597 500 11 511 3.35 % 1.55 % 3.27 % September 30, 2021 64,641 2,051 66,692 533 4 537 3.30 % 0.91 % 3.22 % June 30, 2021 70,207 718 70,925 579 (1 ) 578 3.30 % (0.11 )% 3.26 % March 31, 2021 68,703 314 69,017 605 6 611 3.53 % 6.54 % 3.54 %
Years Ended
6.74 % 3.90 %
December 31, 2021 65,813 1,495 67,308 2,217 20 2,237 3.37 % 1.39 % 3.32 %
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Interest Expense on Repurchase Agreements and the Cost of Funds
Our average outstanding repurchase agreements were$46.7 million and$67.4 million , generating interest expense of$0.7 million and$0.1 million for the years endedDecember 31, 2022 and 2021, respectively. Our average cost of funds was 1.53% and 0.17% for the years endedDecember 31, 2022 and 2021, respectively. There was a 136 bp increase in the average cost of funds and a$20.7 million decrease in average outstanding repurchase agreements during the year endedDecember 31, 2022 as compared to the year endedDecember 31, 2021 . Our economic interest expense was$1.5 million and$3.0 million for the years endedDecember 31, 2022 and 2021, respectively. There was a 125 bp decrease in the average economic cost of funds to 3.12% for the year endedDecember 31, 2022 from 4.37% for the previous year. Since all of our repurchase agreements are short-term, changes in market rates directly affect our interest expense. Our average cost of funds calculated on a GAAP basis was 42 bps below the one-month average SOFR and 33 bps above the six-month average SOFR for the quarter endedDecember 31, 2022 . Our average economic cost of funds was 117 bps above the one-month average SOFR and 192 bps above the six-month average SOFR for the quarter endedDecember 31, 2022 . The average term to maturity of the outstanding repurchase agreements decreased from 16 days atDecember 31, 2021 to 15 days atDecember 31, 2022 . The tables below present the average outstanding balance under all repurchase agreements, interest expense and average economic cost of funds, and one-month average and six-month average SOFR rates for each quarter in 2022 and 2021 and for the yearsDecember 31, 2022 and 2021 on both a GAAP and economic basis. ($ in thousands) Average Balance of Interest Expense
Average Cost of Funds
Repurchase GAAP Economic GAAP Economic
Three Months Ended Agreements Basis Basis Basis Basis
December 31, 2022 $ 43,656 $ 401 $ 586 3.68 % 5.37 %
September 30, 2022 40,210 210 394 2.09 % 3.92 %
June 30, 2022 45,870 73 259 0.63 % 2.25 %
March 31, 2022 56,846 31 216 0.22 % 1.52 %
December 31, 2021 61,019 21 728 0.14 % 4.77 %
September 30, 2021 67,253 24 733 0.14 % 4.36 %
June 30, 2021 72,241 31 739 0.17 % 4.09 %
March 31, 2021 69,104 40 748 0.23 % 4.33 %
Years Ended
December 31, 2022 $ 46,646 $ 715 $ 1,455 1.53 % 3.12 %
December 31, 2021 67,404 116 2,948 0.17 % 4.37 %
Average GAAP Cost of Funds Average Economic Cost of Funds
Relative to Average Relative to Average
Average SOFR One-Month Six-Month One-Month Six-Month
Three Months Ended One-Month Six-Month SOFR SOFR SOFR SOFR
December 31, 2022 4.06 % 2.89 % (0.38 )% 0.79 % 1.31 % 2.48 %
September 30, 2022 2.47 % 1.43 % (0.38 )% 0.66 % 1.45 % 2.49 %
June 30, 2022 1.09 % 0.39 % (0.46 )% 0.24 % 1.16 % 1.86 %
March 31, 2022 0.16 % 0.07 % 0.06 % 0.15 % 1.36 % 1.45 %
December 31, 2021 0.05 % 0.05 % 0.09 % 0.09 % 4.72 % 4.72 %
September 30, 2021 0.05 % 0.03 % 0.09 % 0.11 % 4.31 % 4.33 %
June 30, 2021 0.03 % 0.03 % 0.14 % 0.14 % 4.06 % 4.06 %
March 31, 2021 0.01 % 0.06 % 0.22 % 0.17 % 4.32 % 4.27 %
Years Ended
December 31, 2022 1.95 % 1.20 % (0.42 )% 0.33 % 1.17 % 1.92 %
December 31, 2021 0.04 % 0.04 % 0.13 % 0.13 % 4.33 % 4.33 %
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Table of Contents Dividend Income from Orchid
Effective
We owned 569,071 and 519,071 shares of Orchid common stock as ofDecember 31, 2022 and 2021, respectively. Orchid paid total dividends of$2.475 per share during 2022 and$3.90 per share during 2021. During the years endedDecember 31, 2022 and 2021, we received dividends on this common stock investment of approximately$1.3 million and$2.0 million , respectively. Long-Term Debt Junior Subordinated Debt Interest expense on our junior subordinated debt securities was approximately$1.4 million and$1.0 million for the years endedDecember 31, 2022 and 2021, respectively. The average rate of interest paid for the year endedDecember 31, 2022 was 5.25% compared to 3.66% for the year endedDecember 31, 2021 . The junior subordinated debt securities pay interest at a floating rate. The rate is adjusted quarterly and set at a spread of 3.50% over the prevailing three-month LIBOR rate on the determination date. As ofDecember 31, 2022 , the interest rate was 8.27%. Note Payable OnOctober 30, 2019 , the Company borrowed$680,000 from a bank. The note is payable in equal monthly principal and interest installments of approximately$4,500 throughOctober 30, 2039 . Interest accrues at 4.89% throughOctober 30, 2024 . Thereafter, interest accrues based on the weekly average yield to the United States Treasury securities adjusted to a constant maturity of 5 years, plus 3.25%. The note is secured by a mortgage on the Company's office building.
Paycheck Protection Plan Loan
On
Gains or Losses and Other Income
The table below presents our gains or losses and other income for the years
ended
(in thousands)
2022 2021 Change
Realized (losses) gains on sales of MBS
$ (927 ) Unrealized losses on MBS (5,916 ) (3,099 ) (2,817 ) Total losses on MBS (6,774 ) (3,030 ) (3,744 ) Gains on derivative instruments 801 - 801 Gains on retained interests in securitizations 66 - 66 Unrealized losses on Orchid Island Capital, Inc. common stock (6,239 ) (1,869 ) (4,370 ) - 43 -
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We invest in MBS with the intent to earn net income from the realized yield on those assets over their related funding and hedging costs, and not for the purpose of making short term gains from trading in these securities. However, we have sold, and may continue to sell, existing assets to acquire new assets, which our management believes might have higher risk-adjusted returns in light of current or anticipated interest rates, federal government programs or general economic conditions or to manage our balance sheet as part of our asset/liability management strategy. During the year endedDecember 31, 2022 , we received proceeds of$23.1 million from the sales of MBS compared to$13.1 million for the year endedDecember 31, 2021 . The fair value of our MBS portfolio and derivative instruments, and the gains (losses) reported on those financial instruments, are driven in part by changes in yields and interest rates, the spreads that MBS trade relative to comparable durationU.S. Treasuries or swaps, as well as varying levels of demand for MBS, which affect the pricing of the securities in our portfolio. The unrealized gains and losses on MBS may also include the premium lost as a result of prepayments on the underlying mortgages, decreasing unrealized gains or increasing unrealized losses as prepayment speeds or premiums increase. To the extent MBS are carried at a discount to par, unrealized gains or losses on MBS would also include discount accreted as a result of prepayments on the underlying mortgages, increasing unrealized gains or decreasing unrealized losses as speeds on discounts increase. The table below presents historical interest rate data as of the end of each quarter end during 2022 and 2021. 15 Year 30 Year 90 Day 5 Year 10 Year Fixed-Rate Fixed-Rate Average Treasury Rate(1) Treasury Rate(1) Mortgage Rate(2) Mortgage Rate(2) SOFR(3) December 31, 2022 4.00% 3.88% 5.68% 6.42% 3.62% September 30, 2022 4.04% 3.80% 5.96% 6.70% 2.13% June 30, 2022 3.00% 2.97% 4.83% 5.70% 0.70% March 31, 2022 2.42% 2.33% 3.83% 4.67% 0.09% December 31, 2021 1.26% 1.51% 2.33% 3.11% 0.05% September 30, 2021 1.00% 1.53% 2.28% 3.01% 0.05% June 30, 2021 0.87% 1.44% 2.34% 3.02% 0.02% March 31, 2021 0.94% 1.75% 2.45% 3.17% 0.04%
(1) Historical 5 Year and 10 Year Treasury Rates are obtained from quoted end of
day prices on the
(2) Historical 30 Year and 15 Year Fixed Rate Mortgage Rates are obtained from
Freddie Mac's
(3) Historical SOFR is obtained from the
Operating Expenses
For the year ended
(in thousands)
2022 2021 Change
Compensation and benefits $ 6,530 $ 5,721 $ 809
Legal fees 101 137 (36 )
Accounting, auditing and other professional fees 404 377 27
Directors' fees and liability insurance 804 763
41
Administrative and other expenses 2,000 1,287 713
$ 9,839 $ 8,285 $ 1,554
Beginning with the second quarter of 2022, Bimini began providing certain
repurchase agreement trading, clearing and administrative services to Orchid.
Providing these services required Bimini to increase staffing and other
resources, causing an increase in compensation related expenses of approximately
$0.6 million for year ended December 31, 2022 , and increases in other
administrative expenses of approximately $0.6 million for the year ended
December 31, 2022 , as compared to the year ended December 31, 2021 .
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Table of Contents Income Taxes In 2022, we recorded an income tax provision of$11.9 million , including a$12.2 million increase in the deferred tax asset valuation allowance as a result of management's reassessment, as ofDecember 31, 2022 , of the Company's ability to utilize tax net operating losses ("NOLs") to offset future taxable income. In 2021, we recorded an income tax benefit of$0.4 million , including a$2.2 million decrease in the deferred tax asset valuation allowance as a result of management's reassessment, as ofDecember 31, 2021 , of the Company's ability to utilize NOLs to offset future taxable income. Financial Condition:Mortgage-Backed Securities As ofDecember 31, 2022 , our MBS portfolio consisted of$45.9 million of agency or government MBS at fair value and had a weighted average coupon of 3.67%. During the year endedDecember 31, 2022 , we received principal repayments of$8.2 million compared to$14.5 million for the year endedDecember 31, 2021 . The average prepayment speeds for the quarters endedDecember 31, 2022 and 2021 were 8.3% and 21.1%, respectively. The following table presents the three-month constant prepayment rate ("CPR") experienced on our structured and PT MBS sub-portfolios, on an annualized basis, for the quarterly periods presented. CPR is a method of expressing the prepayment rate for a mortgage pool that assumes that a constant fraction of the remaining principal is prepaid each month or year. Specifically, the CPR in the chart below represents the three month prepayment rate of the securities in the respective asset category. Structured PT MBS MBS Total Three Months Ended Portfolio (%) Portfolio (%) Portfolio (%) December 31, 2022 8.2 8.4 8.3 September 30, 2022 13.1 7.5 10.8 June 30, 2022 17.2 22.9 20.0 March 31, 2022 18.5 25.6 20.9 December 31, 2021 13.7 35.2 21.1 September 30, 2021 15.5 26.9 18.3 June 30, 2021 21.0 31.3 21.9 March 31, 2021 18.5 16.4 18.3
The following tables summarize certain characteristics of our PT MBS and
structured MBS as of
($ in thousands)
Weighted
Percentage Average
of Weighted Maturity
Fair Entire Average in Longest
Asset Category Value Portfolio Coupon Months Maturity
December 31, 2022
Fixed Rate MBS $ 42,974 93.6 % 4.07 % 329 1-Aug-52
Structured MBS 2,919 6.4 % 2.84 % 300 15-May-51
Total MBS Portfolio $ 45,893 100.0 % 3.67 % 327 1-Aug-52
December 31, 2021
Fixed Rate MBS $ 58,029 95.4 % 3.69 % 330 1-Sep-51
Structured MBS 2,774 4.6 % 2.88 % 306 15-May-51
Total MBS Portfolio $ 60,803 100.0 % 3.41 % 329 1-Sep-51
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($ in thousands)
December 31, 2022 December 31, 2021
Percentage of Percentage of
Agency Fair Value Entire Portfolio Fair Value Entire Portfolio Fannie Mae$ 33,883 73.8 %$ 39,703 65.3 % Freddie Mac 12,010 26.2 % 21,100 34.7 % Total Portfolio$ 45,893 100.0 %$ 60,803 100.0 % December 31, December 31, 2022 2021 Weighted Average Pass-through Purchase Price$ 105.30 $ 109.33 Weighted Average Structured Purchase Price$ 4.48 $ 4.81 Weighted Average Pass-through Current Price$ 95.58 $ 109.30 Weighted Average Structured Current Price$ 13.37 $ 9.87 Effective Duration (1) 4.323 2.103
(1) Effective duration is the approximate percentage change in price for a 100 bp
change in rates. An effective duration of 4.323 indicates that an interest
rate increase of 1.0% would be expected to cause a 4.323% decrease in the
value of the MBS in our investment portfolio at
effective duration of 2.103 indicates that an interest rate increase of 1.0%
would be expected to cause a 2.103% decrease in the value of the MBS in our
investment portfolio at
structured securities in the portfolio but do include the effect of our
funding cost hedges. Effective duration quotes for individual investments are
obtained from The Yield Book, Inc. The following table presents a summary of our portfolio assets acquired during
the years ended
($ in thousands)
2022 2021
Weighted Weighted
Total Cost Average Price Average Yield Total Cost Average Price Average Yield
PT MBS $ 23,192 $ 99.13 4.22 % $ 23,338 $ 106.48 1.41 %
Structured MBS - - - 2,852 10.01 3.44 %
Our portfolio of PT MBS is typically comprised of adjustable-rate MBS,
fixed-rate MBS and hybrid adjustable-rate MBS. We generally seek to acquire low
duration assets that offer high levels of protection from mortgage prepayments
provided that they are reasonably priced by the market. The stated contractual
final maturity of the mortgage loans underlying our portfolio of PT MBS
generally ranges up to 30 years. However, the effect of prepayments of the
underlying mortgage loans tends to shorten the resulting cash flows from our
investments substantially. Prepayments occur for various reasons, including
refinancing of underlying mortgages, loan payoffs in connection with home sales,
and borrowers paying more than their scheduled loan payments, which accelerates
the amortization of the loans.
The duration of our IO and IIO portfolio will vary greatly depending on the
structural features of the securities. While prepayment activity will always
affect the cash flows associated with the securities, the interest only nature
of IO's may cause their durations to become extremely negative when prepayments
are high, and less negative when prepayments are low. Prepayments affect the
durations of IIO's similarly, but the floating rate nature of the coupon of IIOs
(which is inversely related to the level of one month LIBOR) cause their price
movements - and model duration - to be affected by changes in both prepayments
and one month LIBOR - both current and anticipated levels. As a result, the
duration of IIO securities will also vary greatly.
Prepayments on the loans underlying our MBS can alter the timing of the cash
flows received by us. As a result, we gauge the interest rate sensitivity of its
assets by measuring their effective duration. While modified duration measures
the price sensitivity of a bond to movements in interest rates, effective
duration captures both the movement in interest rates and the fact that cash
flows to a mortgage related security are altered when interest rates move.
Accordingly, when the contract interest rate on a mortgage loan is substantially
above prevailing interest rates in the market, the effective duration of
securities collateralized by such loans can be quite low because of expected
prepayments.
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We face the risk that the market value of our PT MBS assets will increase or decrease at different rates than that of our structured MBS or liabilities, including our hedging instruments. Accordingly, we assess our interest rate risk by estimating the duration of our assets and the duration of our liabilities. We generally calculate duration and effective duration using various third-party models or obtain these quotes from third-parties. However, empirical results and various third-party models may produce different duration numbers for the same securities. The following sensitivity analysis shows the estimated impact on the fair value of our interest rate-sensitive investments and hedge positions as ofDecember 31, 2022 , assuming rates instantaneously fall 100 bps, rise 100 bps and rise 200 bps, adjusted to reflect the impact of convexity, which is the measure of the sensitivity of our hedge positions and Agency MBS' effective duration to movements in interest rates. ($ in thousands) $ Change in Fair Value % Change in Fair Value MBS Portfolio Fair Value -100BPS +100BPS +200BPS -100BPS +100BPS +200BPS Fixed Rate MBS$ 42,974 $ 1,948 $ (2,164 ) $ (4,468 ) 4.53 % (5.04 )% (10.40 )% Interest-Only MBS 2,914 (131 ) 68 92 (4.50 )% 2.33 % 3.16 % Inverse Interest-Only MBS 5 2 (2 )
(3 ) 40.00 % (40.00 )% (60.00 )%
Total MBS Portfolio $ 45,893 $ 1,819 $ (2,098 ) $ (4,379 ) 3.96 % (4.57 )% (9.54 )%
In addition to changes in interest rates, other factors impact the fair value of
our interest rate-sensitive investments and hedging instruments, such as the
shape of the yield curve, market expectations as to future interest rate changes
and other market conditions. Accordingly, in the event of changes in actual
interest rates, the change in the fair value of our assets would likely differ
from that shown above and such difference might be material and adverse to our
stockholders.
Repurchase Agreements
As of
As ofDecember 31, 2022 , we had obligations outstanding under the repurchase agreements of approximately$43.8 million with a net weighted average borrowing cost of 4.48%. The remaining maturity of our outstanding repurchase agreement obligations ranged from 12 to 31 days, with a weighted average maturity of 15 days. Securing the repurchase agreement obligation as ofDecember 31, 2022 are MBS with an estimated fair value, including accrued interest, of$45.9 million and a weighted average maturity of 328 months, and cash posted as collateral of$0.5 million . ThroughMarch 10, 2023 , we have been able to maintain our repurchase facilities with comparable terms to those that existed atDecember 31, 2022 with maturities throughApril 28, 2023 .
The table below presents information about our period-end and average repurchase agreement obligations for each quarter in 2022 and 2021.
($ in thousands)
Difference Between Ending Repurchase
Ending Balance Maximum Balance Average Balance Agreements and Average Repurchase
of Repurchase of Repurchase of Repurchase Agreements
Three Months Ended Agreements Agreements Agreements Amount Percent
December 31, 2022 $ 43,818 $ 44,780 $ 43,656 $ 162 0.37 %
September 30, 2022 43,494 46,977 40,210 3,284 8.17 %
June 30, 2022 36,926 53,289 45,870 (8,944 ) (19.50 )%
March 31, 2022 54,815 58,772 56,846 (2,031 ) (3.57 )%
December 31, 2021 58,878 62,139 61,019 (2,141 ) (3.51 )%
September 30, 2021 63,160 72,047 67,253 (4,093 ) (6.09 )%
June 30, 2021 71,346 72,372 72,241 (895 ) (1.24 )%
March 31, 2021 73,136 76,004 69,104 4,032 5.83 %
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Liquidity and Capital Resources
Liquidity is our ability to turn non-cash assets into cash, purchase additional investments, repay principal and interest on borrowings, fund overhead and fulfill margin calls. We have both internal and external sources of liquidity. However, our material unused sources of liquidity include cash balances, unencumbered assets and our ability to sell encumbered assets to raise cash. Our balance sheet also generates liquidity on an on-going basis through payments of principal and interest we receive on our MBS portfolio and dividends we receive on our investment in Orchid common stock. Internal Sources of Liquidity Our internal sources of liquidity include our cash balances, unencumbered assets and our ability to liquidate our encumbered security holdings. Our balance sheet also generated liquidity on an ongoing basis through payments of principal and interest we receive on our MBS portfolio and dividends we receive on our investment in Orchid common stock. We employ a hedging strategy that typically involves taking short positions in Eurodollar futures, T-Note futures, TBAs or other instruments. When the market causes these short positions to decline in value we are required to meet margin calls with cash. This can reduce our liquidity position to the extent other securities in our portfolio move in price in such a way that we do not receive enough cash through margin calls to offset the Eurodollar related margin calls. If this were to occur in sufficient magnitude, the loss of liquidity might force us to reduce the size of the levered portfolio, pledge additional structured securities to raise funds or risk operating the portfolio with less liquidity. External Sources of Liquidity Our primary external sources of liquidity are our ability to (i) borrow under master repurchase agreements and (ii) use the TBA security market. Our borrowing capacity will vary over time as the market value of our interest earning assets varies. Our master repurchase agreements have no stated expiration, but can be terminated at any time at our option or at the option of the counterparty. However, once a definitive repurchase agreement under a master repurchase agreement has been entered into, it generally may not be terminated by either party. A negotiated termination can occur, but may involve a fee to be paid by the party seeking to terminate the repurchase agreement transaction. Under our repurchase agreement funding arrangements, we are required to post margin at the initiation of the borrowing. The margin posted represents the haircut, which is a percentage of the market value of the collateral pledged. To the extent the market value of the asset collateralizing the financing transaction declines, the market value of our posted margin will be insufficient and we will be required to post additional collateral. Conversely, if the market value of the asset pledged increases in value, we would be over collateralized and we would be entitled to have excess margin returned to us by the counterparty. Our lenders typically value our pledged securities daily to ensure the adequacy of our margin and make margin calls as needed, as do we. Typically, but not always, the parties agree to a minimum threshold amount for margin calls so as to avoid the need for nuisance margin calls on a daily basis. Our master repurchase agreements do not specify the haircut; rather haircuts are determined on an individual repo transaction basis. We did not experience any significant margin call activity during 2022. We invest a portion of our capital in structured MBS. We generally do not apply leverage to this portion of our portfolio. The leverage inherent in structured securities replaces the leverage obtained by acquiring PT securities and funding them in the repo market. This structured MBS strategy has been a core element of the Company's overall investment strategy since 2008. However, we have and may continue to pledge a portion of our structured MBS in order to raise our cash levels, but generally will not pledge these securities in order to acquire additional assets. In future periods we expect to continue to finance our activities through repurchase agreements and through revenues from our advisory services business. As ofDecember 31, 2022 , we had cash and cash equivalents of$6.0 million . We generated cash flows of$10.1 million from principal and interest payments on our MBS portfolio and had average repurchase agreements outstanding of$46.6 million during the year endedDecember 31, 2022 . In addition, during the year endedDecember 31, 2022 , we received approximately$13.0 million in management fees and expense reimbursements as manager of Orchid and approximately$1.3 million in dividends from our investment in Orchid common stock. - 48 -
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Table of Contents Outlook Orchid Island Capital Inc. Orchid Island Capital reported fourth quarter 2022 income of$34.9 million and its shareholders equity increased from$400.4 million to$438.8 million fromSeptember 30, 2022 toDecember 31, 2022 . The market conditions described below led to the increase in income as agency MBS generally outperformed comparable duration treasuries during the period and Orchid's hedge positions also benefited from increases in interest rates. Orchid is obligated to reimburse us for direct expenses paid on its behalf and to pay to us Orchid's pro rata share of overhead as defined in the management agreement. As a stockholder of Orchid, we will also continue to share in distributions, if any, paid by Orchid to its stockholders. Our operating results are also impacted by changes in the market value of our holdings of Orchid common shares, although these market value changes do not impact our cash flows from Orchid. Economic Summary As 2022 ended, the markets' and the Fed's outlook for the economy, inflation and the path of monetary policy began to diverge. The seeds for the divergence were planted as the third quarter of 2022 came to an end and the Fed had finally succeeded in convincing the market that they had much work to do in removing accommodation and that the process would take longer than the market had expected. Public comments by Fed officials became uniformly hawkish - pointing to substantially more rate increases - and the incoming inflation data for July, August and September of 2022 was quite strong. The combined effect of the data and the clear intentions of the Fed to aggressively fight to prevent inflation from spiraling out of control and becoming entrenched in consumer behavior dispelled any notion that the Fed would not succeed in their pursuit of their dual mandate - price stability and full employment. In fact, the Fed was so successful at convincing the market it would aggressively remove accommodation and slow inflation that the market began to look beyond this step in the process and instead focus on the ramifications of such policy removal - namely a slowing of the economy. The change of focus - or "pivot" - on the part of the market occurred in late October and early November of 2022, largely in response to inflation data. The consumer price index ("CPI") for October and November of 2022, released in November and December of 2022, were much lower than previous months. While such figures were revised higher in earlyFebruary 2023 , at the time, the market interpreted this development as evidence that inflation had peaked and was coming down quickly. The market reaction reflected an assumption that the Fed would succeed in taming inflation quicker than the Fed was expecting and that the rate hikes envisioned by the Fed and reflected in their summary of economic projections would instead cause the economy to slow too much and that the Fed would have to lower rates beginning in late 2023. The divergence in expectations emanated from service sector inflation expectations. As the first quarter of 2023 began, it became clear goods inflation was dropping quickly. This was a result of Covid-19 induced supply constraints abating and consumer demand shifting from goods to services. The market expected that the real estate sector, always very sensitive to interest rates, was in decline and would no longer be a source of inflation outside of the lagged effects of rents, which was anticipated to ebb soon. What remained was non-shelter related services inflation.The Fed recognizes wage pressures are the primary source of inflation in this case. Accordingly measures of labor market tightness and wage inflation have become the Fed's focus. To the extent such measures remain elevated, Fed actions will likely continue to reflect their tightening bias. As we move further into 2023, incoming economic data implies inflation is not slowing as appeared to be the case during the fourth quarter of 2022 nor has economic activity slowed materially. Hence, market expectations for additional rate hikes and the possible time frame over which the Fed will be required to maintain higher rates has converged with the Fed's expectations. Interest RatesThe Fed raised the Fed Funds target range twice during the fourth quarter of 2022 and the high end of the range was 4.50% at the end of the year - an increase of 125 basis points during the quarter.The Fed raised the target rate by another 25 basis points inFebruary 2023 . Moreover, the market expects the Fed will continue to raise the target further in 2023, perhaps as much as 100 basis points including theFebruary 2023 increase. Importantly, the Fed, as evidenced by their own "dot plot", a summary of committee members' expectations of the Fed Funds rate over their forecast period, anticipates the Fed Funds rate will peak at approximately 5.125% by mid-2023 and remain above 5% throughout the balance of 2023. The market now appears to agree with this outcome as evidenced by current pricing in the futures market. Yields onU.S. Treasury securities with maturities of one year or less increased substantially during the fourth quarter of 2022, with the shortest maturities increasing the most - reflective of the actual and anticipated increases in overnight funding levels driven by the Fed. Such increases were as much as 134 basis points in the case of the one-monthU.S. Treasury bill. - 49 -
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As the fourth quarter unfolded, with the market expecting the Fed to succeed in containing inflation and ultimately slowing the economy in the process, longer maturity interest rates were essentially unchanged during the fourth quarter. During the month ofOctober 2022 , the hawkish rhetoric from the Fed and strong inflation data initially caused long-term rates to increase substantially fromAugust 2022 levels near 2.6% to approximately 4.25% in lateOctober 2022 in the case of the 10-yearU.S. Treasury . However, longer-term rates slowly declined for much of the balance of the fourth quarter before a 40-basis point increase over the last two weeks of the year. The lateDecember 2022 increase was triggered by additional hawkish comments by the Fed at their December meeting reinforced by similar language by theEuropean Central Bank and illiquid holiday trading conditions. For the fourth quarter of 2022,U.S. Treasury maturities beyond the 2-year point were largely unchanged. The combination of the extreme upward movement in short maturity yields described above and the essentially unchanged yields for longer maturityU.S. Treasuries resulted in an extreme flattening of the yield curve to the point the curve became inverted. This continued the trend that began in early July of 2022. Over the course of the fourth quarter of 2022, the extent of the inversion increased substantially. In the case of the spread between the 2-year and 10-yearU.S. Treasuries the inversion reached 84 basis points in early December and 88 basis points in the case of the spread between the 10-yearU.S. Treasury and the Fed Funds rate. Historically such inversions signaled market expectations of a recession on the horizon, as was the case in late 2022. The Agency MBS Market The Agency MBS market returns for 2022 were negative - down 11.9%. However, the sector posted positive returns for the fourth quarter of 2.1%, which was 110 bps higher than comparable duration swaps. As described above, expectations for the economy and rates diverged between those of the Fed and the markets during the last two months of the fourth quarter of 2022. During the fourth quarter, the markets' appetite for riskier assets improved in anticipation that the Fed was nearing the end of its tightening cycle and would be easing monetary conditions by the end of 2023. This led the higher risk sectors of the fixed income markets to outperform, as investment and non-investment grade corporates outperformedU.S. Treasuries,Agency MBS and Agency debt by a considerable margin. The performance of the Agency MBS sector was not uniformly positive for the fourth quarter. As described above, early in the quarterU.S. Treasury yields achieved their highest levels in many years in late October of 2022. Agency MBS spreads to comparable duration spreads also reached their widest levels since the great financial crisis, easily surpassing the levels observed in March of 2020. As market sentiment turned mid-quarter and risk appetite improved the attractive levels of Agency MBS, like most other asset classes, were viewed as very attractive. The sector's performance was driven to a large extent by the extremes reached in lateOctober 2022 . However, the spreads available in the sector remain wider than those observed prior to the onset of the pandemic in early 2020. The absence of the largest of the traditional buyers of the asset class - banks, and since March of 2020, the Fed, may result in the sector recovering slowly towards pre-pandemic levels, if it can do so at all. Within the Agency MBS sector, 30-year fixed rate coupons slightly outperformed 15-year and GNMA fixed rate securities, both in absolute and relative terms. Within the 30-year fixed rate sector lower/discount coupon securities generated the best relative/excess returns to comparable durationU.S. Treasuries and swaps.
Recent Legislative and Regulatory Developments
In response to the deterioration in the markets forU.S. Treasuries, Agency MBS and other mortgage and fixed income markets resulting from the impacts of the COVID-19 pandemic, the Fed implemented a program of quantitative easing. Through November of 2021, the Fed was committed to purchasing$80 billion ofU.S. Treasuries and$40 billion of Agency MBS each month. In November of 2021, it began tapering its net asset purchases each month, ended net asset purchases by early March of 2022, and ended asset purchases entirely in September of 2022. OnMay 4, 2022 , theFOMC announced a plan for reducing the Fed's balance sheet. In June of 2022, in accordance with this plan, the Fed began reducing its balance sheet by a maximum of$30 billion ofU.S. Treasuries and$17.5 billion of Agency MBS each month. OnSeptember 21, 2022 , theFOMC announced the Fed's decision to continue reducing the balance sheet by a maximum of$60 billion ofU.S Treasuries and$35 billion of Agency MBS per month. OnJanuary 29, 2021 , theCenter for Disease Control and Prevention issued guidance extending eviction moratoriums for covered persons put in place by the CARES Act throughMarch 31, 2021 . The FHFA subsequently extended the foreclosure moratorium for loans backed by the Enterprises and the eviction moratorium for real estate owned by the Enterprises untilJuly 31, 2021 andSeptember 30, 2021 , respectively.The U.S. Housing and Urban Development Department subsequently extended the FHA foreclosure and eviction moratoria toJuly 31, 2021 , andSeptember 30, 2021 , respectively. Despite the expirations of these foreclosure moratoria, a final rule adopted by theCFPB onJune 28, 2021 , effectively prohibited servicers from initiating a foreclosure beforeJanuary 1, 2022 , in most instances. Foreclosure activity has risen since the end of the moratorium, with foreclosure starts in 2022 up 169% from 2021, but remaining 26% lower than pre-pandemic levels in 2019 and 88% lower than the peak in 2009. - 50 -
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OnSeptember 30, 2019 , the FHFA announced that the Enterprises were allowed to increase their capital buffers to$25 billion and$20 billion , respectively, from the prior limit of$3 billion each. This step could ultimately lead to the Enterprises being privatized and represents the first concrete step on the road to Enterprise reform. InDecember 2020 , the FHFA released a final rule on a new regulatory framework for the Enterprises which seeks to implement both a risk-based capital framework and minimum leverage capital requirements. OnJanuary 14, 2021 , theU.S. Treasury and the FHFA executed letter agreements allowing the Enterprises to continue to retain capital up to their regulatory minimums, including buffers, as prescribed in the December rule. These letter agreements provide, in part, (i) there will be no exit from conservatorship until all material litigation is settled and the Enterprise has common equity Tier 1 capital of at least 3% of its assets, (ii) the Enterprises will comply with the FHFA's regulatory capital framework, (iii) higher-risk single-family mortgage acquisitions will be restricted to current levels, and (iv) theU.S. Treasury and the FHFA will establish a timeline and process for future Enterprise reform. However, no definitive proposals or legislation have been released or enacted with respect to ending the conservatorship, unwinding the Enterprises, or materially reducing the roles of the Enterprises in theU.S. mortgage market. OnSeptember 14, 2021 , theU.S. Treasury and the FHFA suspended certain policy provisions in the January agreement, including limits on loans acquired for cash consideration, multifamily loans, loans with higher risk characteristics and second homes and investment properties. OnFebruary 25, 2022 , the FHFA published a final rule, effective as ofApril 26, 2022 , amending the Enterprise capital framework established inDecember 2020 by, among other things, replacing the fixed leverage buffer equal to 1.5% of an Enterprise's adjusted total assets with a dynamic leverage buffer equal to 50% of an Enterprise's stability capital buffer, reducing the risk weight floor from 10% to 5%, and removing the requirement that the Enterprises must apply an overall effectiveness adjustment to their credit risk transfer exposures. OnJune 14, 2022 , the Enterprises announced that they would each charge a 50 bps fee for commingled securities issued on or afterJuly 1, 2022 to cover the additional capital required for such securities under the Enterprise capital framework, which was subsequently reduced onJanuary 19, 2023 to 9.375 bps for commingled securities issued on or afterApril 1, 2023 to address industry concern that the fee posed a risk to the fungibility of the Uniform Mortgage-Backed Security ("UMBS") and negatively impacted liquidity and pricing in the market for TBA securities. In 2017, policymakers announced that LIBOR will be replaced byDecember 31, 2021 . The directive was spurred by the fact that banks are uncomfortable contributing to the LIBOR panel given the shortage of underlying transactions on which to base levels and the liability associated with submitting an unfounded level. However, theICE Benchmark Administration , in its capacity as administrator of USD LIBOR, has announced that it intends to extend publication of USD LIBOR (other than one-week and two-month tenors) by 18 months toJune 2023 . Notwithstanding this extension, a joint statement by key regulatory authorities calls on banks to cease entering into new contracts that use USD LIBOR as a reference rate by no later thanDecember 31, 2021 . OnDecember 7, 2021 , theCFPB released a final rule that amends Regulation Z, which implemented the Truth in Lending Act, aimed at addressing cessation of LIBOR for both closed-end (e.g., home mortgage) and open-end (e.g., home equity line of credit) products. The rule, which mostly became effective in April of 2022, establishes requirements for the selection of replacement indices for existing LIBOR-linked consumer loans. Although the rule does not mandate the use of SOFR as the alternative rate, it identifies SOFR as a comparable rate for closed-end products and states that for open-end products, theCFPB has determined that ARRC's recommended spread-adjusted indices based on SOFR for consumer products to replace the one-month, three-month, or six-month USD LIBOR index "have historical fluctuations that are substantially similar to those of the LIBOR indices that they are intended to replace." TheCFPB reserved judgment, however, on a SOFR-based spread-adjusted replacement index to replace the one-year USD LIBOR until it obtained additional information. OnMarch 15, 2022 , the Adjustable Interest Rate (LIBOR) Act (the "LIBOR Act") was signed into law as part of the Consolidated Appropriations Act, 2022 (H.R. 2471). The LIBOR Act provides for a statutory replacement benchmark rate for contracts that use LIBOR as a benchmark and do not contain any fallback mechanism independent of LIBOR. Pursuant to the LIBOR Act, SOFR becomes the new benchmark rate by operation of law for any such contract. The LIBOR Act establishes a safe harbor from litigation for claims arising out of or related to the use of SOFR as the recommended benchmark replacement. The LIBOR Act makes clear that it should not be construed to disfavor the use of any benchmark on a prospective basis. OnJuly 28, 2022 , the Fed published a proposed rule to implement the LIBOR Act, which was adopted onDecember 16, 2022 . The final rule, which went into effect onFebruary 27, 2023 , sets benchmark SOFR rates to replace overnight, one-month, three-month, six-month and 12-month LIBOR contracts and provides mechanisms for converting most existing LIBOR contracts, including Agency MBS, to SOFR no later thanJune 30, 2023 . The LIBOR Act also attempts to forestall challenges that it is impairing contracts. It provides that the discontinuance of LIBOR and the automatic statutory transition to a replacement rate neither impairs or affects the rights of a party to receive payment under such contracts, nor allows a party to discharge their performance obligations or to declare a breach of contract. It amends the Trust Indenture Act of 1939 to state that the "the right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security shall not be deemed to be impaired or affected" by application of the LIBOR Act to any indenture security. - 51 -
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The scope and nature of the actions the
Effect on Us
Regulatory developments, movements in interest rates and prepayment rates affect us in many ways, including the following:
Effects on our Assets
A change in or elimination of the guarantee structure of Agency MBS may increase
our costs (if, for example, guarantee fees increase) or require us to change our
investment strategy altogether. For example, the elimination of the guarantee
structure of Agency MBS may cause us to change our investment strategy to focus
on non-Agency MBS, which in turn would require us to significantly increase our
monitoring of the credit risks of our investments in addition to interest rate
and prepayment risks.
If prepayment rates are relatively low (due, in part, to the refinancing
problems described above), lower long-term interest rates can increase the value
of our Agency MBS. This is because investors typically place a premium on
assets with coupon/yields that are higher than coupon /yields available in the
market. To the extent such securities per-pay slower than would otherwise be the
case, we benefit from an above market coupon/yield for longer, enhancing the
return from the security. Although lower long-term interest rates may increase
asset values in our portfolio, we may not be able to invest new funds in
similarly-yielding assets.
If prepayment levels increase, the value of our Agency MBS affected by such
prepayments may decline. This is because a principal prepayment accelerates the
effective term of an Agency MBS, which would shorten the period during which an
investor would receive above-market returns (assuming the yield on the prepaid
asset is higher than market yields). Also, prepayment proceeds may not be able
to be reinvested in similar-yielding assets. Agency MBS backed by mortgages with
high interest rates are more susceptible to prepayment risk because holders of
those mortgages are most likely to refinance to a lower rate. IOs and IIOs,
however, may be the types of Agency MBS most sensitive to increased prepayment
rates. Because the holder of an IO or IIO receives no principal payments, the
values of IOs and IIOs are entirely dependent on the existence of a principal
balance on the underlying mortgages. If the principal balance is eliminated due
to prepayment, IOs and IIOs essentially become worthless. Although increased
prepayment rates can negatively affect the value of our IOs and IIOs, they have
the opposite effect on POs. Because POs act like zero-coupon bonds, meaning they
are purchased at a discount to their par value and have an effective interest
rate based on the discount and the term of the underlying loan, an increase in
prepayment rates would reduce the effective term of our POs and accelerate the
yields earned on those assets, which would increase our net income.
Higher long-term rates can also affect the value of our Agency MBS. As
long-term rates rise, rates available to borrowers also rise. This tends to
cause prepayment activity to slow and extend the expected average life of
mortgage cash flows. As the expected average life of the mortgage cash flows
increases, coupled with higher discount rates, the value of Agency MBS
declines. Some of the instruments we use to hedge our Agency MBS assets, such
as interest rate futures, swaps and swaptions, are stable average life
instruments. This means that to the extent we use such instruments to hedge our
Agency MBS assets, our hedges may not adequately protect us from price declines,
and therefore may negatively impact our book value. It is for this reason we
use interest only securities in our portfolio. As interest rates rise, the
expected average life of these securities increases, causing generally positive
price movements as the number and size of the cash flows increase the longer the
underlying mortgages remain outstanding. This makes interest only securities
desirable hedge instruments for pass-through Agency MBS.
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As described above, the Agency MBS market began to experience severe dislocations inmid-March 2020 as a result of the economic, health and market turmoil brought about by COVID-19. OnMarch 23, 2020 , the Fed announced that it would purchase Agency MBS andU.S. Treasuries in the amounts needed to support smooth market functioning, which largely stabilized the Agency MBS market, but ended these purchases inMarch 2022 and announced plans to reduce its balance sheet.The Fed's planned reduction of its balance sheet could negatively impact our investment portfolio. Further, the moratoriums on foreclosures and evictions described above will likely delay potential defaults on loans that would otherwise be bought out of Agency MBS pools as described above. Depending on the ultimate resolution of the foreclosure or evictions, when and if it occurs, these loans may be removed from the pool into which they were securitized. If this were to occur, it would have the effect of delaying a prepayment on our securities until such time. To the extent our Agency MBS assets were acquired at a premium to par, this will tend to increase the realized yield on the asset in question. To the extent they were acquired at a discount, this will tend to decrease the realized yield on the asset in question. Because we base our investment decisions on risk management principles rather than anticipated movements in interest rates, in a volatile interest rate environment we may allocate more capital to structured Agency MBS with shorter durations. We believe these securities have a lower sensitivity to changes in long-term interest rates than other asset classes. We may attempt to mitigate our exposure to changes in long-term interest rates by investing in IOs and IIOs, which typically have different sensitivities to changes in long-term interest rates than PT MBS, particularly PT MBS backed by fixed-rate mortgages.
Effects on our borrowing costs
We leverage our PT MBS portfolio and a portion of our structured Agency MBS with principal balances through the use of short-term repurchase agreement transactions. The interest rates on our debt are determined by the short term interest rate markets. Increases in the Fed Funds rate, SOFR or LIBOR typically increase our borrowing costs, which could affect our interest rate spread if there is no corresponding increase in the interest we earn on our assets. This would be most prevalent with respect to our Agency MBS backed by fixed rate mortgage loans because the interest rate on a fixed-rate mortgage loan does not change even though market rates may change.
In order to protect our net interest margin against increases in short-term interest rates, we may enter into interest rate swaps, which economically convert our floating-rate repurchase agreement debt to fixed-rate debt, or utilize other hedging instruments such as Eurodollar, Fed Funds and T-Note futures contracts or interest rate swaptions.
Summary During the fourth quarter of 2022 the trends in incoming economic data began to change, indicating the actions of the Fed to remove accommodation and slow demand were starting to take hold. The most interest rate sensitive sectors of the economy, mainly housing and housing related, were slowing precipitously. Demand and consumption for goods - reflected in sales and production data - were clearly slowing. Even inflation data, as evidenced by the CPI and Personal Consumption Expenditures data, slowed during the quarter as well although such data was subsequently revised higher in early February of 2023. The one big exception was the labor market and wages - which were still tight in the case of the labor market and increasing in the case of wages. To central bankers, and in particular the Fed, this was problematic. As consumers migrated their consumption from goods to services as the effects of the pandemic wore off service inflation remained elevated due to persistent worker shortages and the resulting wage pressures as employers struggled to fill positions.The Fed identified non-shelter related services inflation as the focus of their efforts to contain inflation and inflation expectations. In their efforts to rein in service related inflation, the Fed has continued to raise the Fed Funds rate - and plans to continue doing so into 2023. In fact, the Fed raised the Fed Funds rate at theirFebruary 2023 meeting and indicated additional hikes were likely while simultaneously stating their intention to hold rates at what they deem to be restrictive territory into 2024. The financial markets were reluctant to accept that the Fed would be so aggressive in their tightening until late in the third quarter of 2022 when the Fed appeared to finally convince the markets of the extent and timing of the tightening plans. The market reacted swiftly as interest rates increased rapidly from August through late October of 2022. Short maturity rates increased the most, in anticipation of the Fed raising Fed Funds as high as 5.0% in 2023. However, the market view, as expressed in interest rates, futures and the shape of theU.S. Treasury curve, differed from the view of the Fed, during the last two months of 2022 and early 2023. Market pricing at the end of 2022 indicated a belief that the Fed would succeed in reining in inflation sooner than the Fed did, and that in so doing it would ultimately slow the economy so much that the Fed would have to pivot and move to lower rates by the end of 2023. The result of this view was a deeply invertedU.S. Treasury yield curve, with short term rates of maturities of two-years or less far in excess of longer maturityU.S. Treasuries. However, economic data released in early 2023 has not been consistent with the market's view, as inflation measures remain stubbornly high, the economy does not appear to be slowing and wage pressures have not abated. The market's view has moved into alignment with the Fed's expectations as evidenced by pricing in the futures markets. - 53 -
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The Agency MBS market returns for 2022 were -11.9%. However, the sector returned +2.1% for the fourth quarter of 2022. The turning point coincided with the markets pivot towards believing the Fed tightening cycle was nearing its end and that the economy would slow in 2023. InOctober 2022 , spreads on Agency MBS reached levels not seen since the great financial crisis. However, as market sentiment turned in November and December of 2022, these spread levels appeared quite attractive. This was also true of most risk assets. As a result, the sector performed very well over the balance of the fourth quarter of 2022, which resulted in an increase in the valuation of our assets. In the case of even riskier asset classes the performance has been even better. As the first quarter of 2023 unfolds, the Agency MBS sector is still trading at spread levels well above levels observed prior to the COVID-19 pandemic. However, the absence of two of the largest buyers of the sector, banks and, since the onset of the pandemic, the Fed may result in the sector recovering more slowly towards pre-pandemic levels, if such levels are even obtained at all. The risk to the sector would be a re-acceleration of inflation and the need for the Fed to tighten monetary policy even further. Data released in February of 2023 heightens this concern. Critical Accounting Estimates
Our consolidated financial statements are prepared in accordance with GAAP. GAAP requires our management to make some complex and subjective decisions and assessments. Our most critical accounting policies involve decisions and assessments which could significantly affect reported assets, liabilities, revenues and expenses. Management has identified the following as its most critical accounting estimates:
Mortgage-Backed Securities
Our investments in MBS are accounted for at fair value. We acquire our MBS for the purpose of generating long-term returns, and not for the short-term investment of idle capital.
As discussed in Note 14 to the financial statements, our MBS are valued using Level 2 valuations, and such valuations currently are determined based on independent pricing sources and/or third party broker quotes, when available. Because the price estimates may vary, management must make certain judgments and assumptions about the appropriate price to use to calculate the fair values. Alternatively, the Company could opt to have the value of all of our positions in MBS determined by either an independent third-party or do so internally. In managing our portfolio, the Company employs the following four-step process at each valuation date to determine the fair value of our MBS.
? First, the Company obtains fair values from subscription-based independent
pricing services.
? Second, the Company requests non-binding quotes from one to fourbroker-dealers for certain MBS in order to validate the values obtained by the
pricing service. The Company requests these quotes from broker-dealers that
actively trade and make markets in the respective asset class for which the
quote is requested.
? Third, the Company reviews the values obtained by the pricing source and the
broker-dealers for consistency across similar assets.
? Finally, if the data from the pricing services and broker-dealers is not
homogenous or if the data obtained is inconsistent with management's market
observations, the Company makes a judgment to determine which price appears
the most consistent with observed prices from similar assets and selects that
price. To the extent management believes that none of the prices are
consistent with observed prices for similar assets, which is typically the
case for only an immaterial portion of our portfolio each quarter, the Company
may use a third price that is consistent with observed prices for identical or
similar assets. In the case of assets that have quoted prices such as Agency
MBS backed by fixed-rate mortgages, the Company generally uses the quoted or
observed market price. For assets such as Agency MBS backed by ARMs or
structured Agency MBS, the Company may determine the price based on the yield
or spread that is identical to an observed transaction or a similar asset for
which a dealer mark or subscription-based price has been obtained.
Management believes its pricing methodology to be consistent with the definition
of fair value described in Financial Accounting Standards Board (the "FASB")
Accounting Standards Codification ("ASC") Topic 820, Fair Value Measurements.
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Table of Contents Income Recognition All of our MBS are either PT MBS or structured MBS, including CMOs, IOs, IIOs or POs. Income on PT MBS, POs and CMOs that contain principal balances is based on the stated interest rate of the security. As a result of accounting for our MBS under the fair value option, premium or discount present at the date of purchase is not amortized. For IOs, IIOs and CMOs that do not contain principal balances, income is accrued based on the carrying value and the effective yield. As cash is received it is first applied to accrued interest and then to reduce the carrying value of the security. At each reporting date, the effective yield is adjusted prospectively from the reporting period based on the new estimate of prepayments, current interest rates and current asset prices. The new effective yield is calculated based on the carrying value at the end of the previous reporting period, the new prepayment estimates and the contractual terms of the security. Changes in fair value of all of our MBS during the period are recorded in earnings and reported as unrealized gains or losses on mortgage-backed securities in the accompanying consolidated statements of operations. For IIO securities, effective yield and income recognition calculations also take into account the index value applicable to the security. Income Taxes Income taxes are provided for using the asset and liability method. Deferred tax assets and liabilities represent the differences between the financial statement and income tax bases of assets and liabilities using enacted tax rates. The measurement of net deferred tax assets is adjusted by a valuation allowance if, based on the Company's evaluation, it is more likely than not that they will not be realized. A majority of the Company's net deferred tax assets, which consist primarily of NOLs, are expected to be realized over an extended number of years. Management's conclusion is supported by taxable income projections which include forecasts of management fees, Orchid dividends and net interest income, and the subsequent reinvestment of those amounts into the MBS portfolio. However, management reassesses its valuation allowance conclusions whenever there is a material change in taxable income projections. Capital Expenditures
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