The following discussion should be read in conjunction with our unaudited consolidated financial statements and the accompanying notes included in Part I, Item 1 "Financial Statements" in this Quarterly Report on Form 10-Q and our audited consolidated financial statements and the accompanying notes included in Part II, Item 8 in our 2020 Form 10-K. References herein to "Dynex," the "Company," "we," "us," and "our" includeDynex Capital, Inc. and its consolidated subsidiaries, unless the context otherwise requires. In addition to current and historical information, the following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our future business, financial condition or results of operations. For a description of certain factors that may have a significant impact on our future business, financial condition or results of operations, see "Forward-Looking Statements" at the end of this discussion and analysis.
For more information about our business including our operating policies, investment philosophy and strategy, financing and hedging strategies, and other important information, please refer to Part I, Item 1 of our 2020 Form 10-K.
EXECUTIVE OVERVIEWDynex Capital, Inc. is an internally managed mortgage real estate investment trust, or mortgage REIT, which primarily invests in residential and commercial mortgage-backed securities ("MBS") on a leveraged basis. We finance our investments principally with borrowings under repurchase agreements. Our objective is to provide attractive risk-adjusted returns to our shareholders over the long term that are reflective of a leveraged, high quality fixed income portfolio with a focus on capital preservation. We seek to provide returns to our shareholders primarily through the payment of regular dividends and also potentially through capital appreciation of our investments. Market Conditions and Recent Activity Conditions continued to be volatile during the third quarter of 2021 as the global economy transitioned to a post-pandemic environment. Economic data in theU.S. points to stronger growth, higher inflation and a tighter labor market, but the durability of these trends remains unclear. On the strength of this information, theFederal Reserve has indicated that it plans to taper its purchase of assets, including Agency MBS, in the fourth quarter this year. While most global central bank policy remains highly accommodative, several have begun to raise interest rates and moved to hawkish language as inflation has accelerated. The evolving economic outlook, the uncertainty of the impact of variants of COVID-19 on real economic activity, and the shifting policy of theFederal Reserve and global central banks, contributed to increased volatility inU.S. interest rates during the third quarter of 2021, with the 10-yearU.S. Treasury yield touching a low of 1.13% and trading in a range of over 40 basis points before ending the quarter virtually unchanged at 1.49%. Spreads on risk assets owned by the Company were less volatile for the third quarter compared to the prior quarter, with Agency RMBS ending the quarter slightly tighter and CMBS and CMBS IO modestly wider. The table below shows changes in market spreads in basis points for certain investment types in our MBS portfolio during the three months endedSeptember 30, 2021 : 26 --------------------------------------------------------------------------------
Third Quarter 2021 As of As of Investment Type: Change in Spreads September 30, 2021 June 30, 2021 Agency RMBS: (1) 2.0% coupon (4) (10) (6) 2.5% coupon (5) (4) 1 4.0% coupon (15) 39 54 Agency DUS (Agency CMBS) (2) 8 26 18 Freddie K AAA IO (Agency CMBS IO) (2) - 65 65 AAA CMBS IO (Non-Agency CMBS IO) (2) 3 108 105 (1) Option adjusted spreads are based on Company estimates using third-party models and market data. (2) Data represents the spread to swap rate on newly issued securities and is sourced from JP Morgan. The charts below show the highest and lowestU.S. Treasury and swap rates during the three months endedSeptember 30, 2021 as well as the rates as ofSeptember 30, 2021 andJune 30, 2021 : [[Image Removed: dx-20210930_g1.jpg]] 27 -------------------------------------------------------------------------------- [[Image Removed: dx-20210930_g2.jpg]]
Third Quarter 2021 Performance
Comprehensive income to common shareholders was$3.0 million , or$0.09 per common share, for the third quarter of 2021 versus a loss of$(31.4) million , or$(0.98) per common share in the second quarter of 2021. The Company benefited in the third quarter from maintaining its hedge positioning for a steeperU.S. Treasury yield curve as rates increased in the 5-10 year portion of the curve since the end of the second quarter. As a result, realized and unrealized losses on investments, net of hedges was$(2.7) million , or ($0.08 ) per common share during the third quarter versus a loss of$(35.6) million , or ($1.11 ) per common share for the previous quarter. The Company also benefited from a higher average balance of interest-earning assets due to Agency RMBS purchases late in the second quarter of 2021 which increased net interest income by$2.3 million , or$0.03 per common share, for the third quarter. The increase in net interest income was partially offset by an increase in general and administrative expenses of$0.8 million to$6.5 million , or$(0.19) per common share, a portion of which is related to litigation fees as well as expansion of the Company's operating platform used to manage its investment and hedging portfolios as the Company continues to grow. Earnings available for distribution ("EAD") to common shareholders (a non-GAAP measure formerly referred to as "core net operating income to common shareholders") increased$0.03 from the prior quarter to$0.54 per common share for the third quarter of 2021 due to the increase in net interest income discussed above. An increase in average TBA dollar roll transactions during the third quarter of 2021 also drove an increase in drop income of$1.1 million compared to the prior quarter, but the impact to EAD on a per common share basis was unchanged from$0.38 per common share due to the higher weighted average common shares outstanding. Total economic return of$0.06 per common share, or 0.3%, consisted of$0.39 in dividends declared per common share offset by a$(0.33) decline in book value per common share to$18.42 as ofSeptember 30, 2021 . The decline in book value was driven by unrealized losses on our assets (excluding drop income from TBAs) exceeding the gains from hedging instruments by$(0.46) per common share, which was partially offset by earnings available for distribution to common shareholders exceeding dividends declared by$0.15 per common share. The remaining$(0.02) per share decline was due to common stock issuances and other equity transactions during the third quarter. Leverage as ofSeptember 30, 2021 was 5.9 times shareholders' equity, down from 6.7 as ofJune 30, 2021 . We lowered leverage during the third quarter by reducing our TBA position in 2.5% coupons in order to protect book value from the potential for additional losses in the fair value of our investments while increasing the flexibility to redeploy capital in 28 -------------------------------------------------------------------------------- future investments with higher returns. Our leverage was also impacted during the quarter as a result of the increase in our equity due primarily to the$27.9 million of capital raised through at-the-market offerings of common stock. Current Outlook Throughout the third quarter, we maintained our portfolio structure with hedges for the long end of the yield curve and relatively low leverage on our capital, and we continue to hold that position into the fourth quarter. SinceSeptember 30, 2021 , the yield curve has steepened, and our book value is estimated to have improved to a current range of$18.80 to$19.00 per common share. While we expect book value will continue to fluctuate with the level of interest rates and mortgage spreads, we believe it to be cushioned by our low leverage and substantial liquidity. As it relates to credit spreads, in the near-term, fundamentals for Agency RMBS are soft as we see factors that may keep refinancing levels elevated including originator capacity and government policy. Agency RMBS spreads could also widen as much as 20 basis points as theFederal Reserve begins to taper their purchases, assuming demand by banks and other institutions and investors does not materialize. Finally, in our assessment, it is too early to arrive at conclusions on long term trends for inflation, labor market and growth and for this reason, the timing and pace of hikes is less clear. We believe that short-term interest rates will remain low through at least the first half of 2022, providing us with historically cheap financing as a base to generate returns. Given the high degree of uncertainty of economic outcomes, inflation and monetary policy, we will continue to maintain a lower leverage profile with our capital allocated to highly liquid investments. Non-GAAP Financial Measures In addition to the Company's operating results presented in accordance with GAAP, the information presented within Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Quarterly Report on Form 10-Q contains the following non-GAAP financial measures: earnings available for distribution ("EAD") to common shareholders (formerly core net operating income to common shareholders) (including per common share), adjusted net interest income and the related metric adjusted net interest spread. Because these measures are used in the Company's internal analysis of financial and operating performance, management believes that they provide greater transparency to our investors of management's view of our economic performance. Management also believes the presentation of these measures, when analyzed in conjunction with the Company's GAAP operating results, allows investors to more effectively evaluate and compare the performance of the Company to that of its peers, although the Company's presentation of its non-GAAP measures may not be comparable to other similarly-titled measures of other companies. Reconciliations of EAD to common shareholders and adjusted net interest income to the related GAAP financial measures are provided below and within "Results of Operations". Beginning this quarter, the Company has renamed its non-GAAP measure "core net operating income to common shareholders" to "EAD to common shareholders" in order to clarify what the measure represents. The adjustments made to reconcile "comprehensive income to common shareholders" to "EAD to common shareholders" are identical to the adjustments previously used to calculate "core net operating income." EAD to common shareholders is a non-GAAP metric used by the Company as a measure of the investment portfolio's return based on the effective yield of its investments, net of financing costs and other normal recurring operating income/expenses, net. It is one of several factors the Board considers in determining the appropriate level of distributions to common shareholders. In addition to the non-GAAP reconciliation set forth below, which derives EAD to common shareholders from GAAP comprehensive income (loss) to common shareholders, EAD to common shareholders can also be determined by adjusting net interest income to include interest rate swap periodic interest benefit/cost, drop income on TBA securities, general and administrative expenses, preferred dividends, and other normal recurring operating income or expense. Drop income generated by TBA dollar roll positions, which is included in "gain (loss) on derivatives instruments, net" on the Company's consolidated statements of comprehensive income, is included in EAD to common shareholders and in adjusted net interest income because management views drop income as the economic equivalent of net interest income (interest income less implied financing cost) on the underlying Agency security from trade date to settlement date. Management also includes interest rate swap periodic interest benefit/cost, which is also included in "gain (loss) on derivatives instruments, net", in adjusted net interest income because interest rate swaps are used by the Company to economically hedge the impact of changing interest rates on its borrowing costs from repurchase agreements, and therefore represent a cost of financing in addition to GAAP interest expense. However, these non-GAAP measures do not provide a full perspective on our results of operations, and therefore, their usefulness is limited. For example, these non-GAAP measures do not include the changes in fair value of investments or changes in fair value of and 29 -------------------------------------------------------------------------------- costs of terminating derivative instruments used by management to economically hedge the impact of changing interest rates on the fair value of the Company's portfolio and book value per common share. As a result, these non-GAAP measures should be considered as a supplement to, and not as a substitute for, the Company's GAAP results as reported on its consolidated statements of comprehensive income. Three Months Ended Reconciliations of GAAP to Non-GAAP Financial Measures: September 30, 2021 June 30, 2021 ($s in thousands except per share data) Comprehensive income (loss) to common shareholders $ 2,971$ (31,412) Less: Change in fair value of investments (1) 12,224 (17,362) Change in fair value of derivative instruments, net (2) 3,716 65,117 EAD to common shareholders $ 18,911$ 16,343 Average common shares outstanding 34,924,449 31,973,587 Comprehensive income (loss) per common share $ 0.09$ (0.98) EAD per common share $ 0.54 $ 0.51 Net interest income $ 14,394$ 12,118 TBA drop income (3) 13,319 12,177 Adjusted net interest income $ 27,713$ 24,295 Other operating expense, net (330) (323) General and administrative expenses (6,549) (5,706) Preferred stock dividends (1,923) (1,923) EAD to common shareholders $ 18,911$ 16,343 (1) Amount includes realized and unrealized gains and losses recorded in net income and OCI due to changes in the fair value of the Company's MBS and other investments. (2) Amount includes unrealized gains and losses from changes in fair value of derivatives and realized gains and losses on terminated derivatives and excludes TBA drop income. (3) TBA drop income is calculated by multiplying the notional amount of the TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates. The impact of TBA drop income on adjusted net interest spread includes the implied average funding cost of TBA dollar roll transactions during the periods indicated. 30 -------------------------------------------------------------------------------- FINANCIAL CONDITION Investment Portfolio The following chart compares the composition of our MBS portfolio including TBA securities as of the dates indicated: [[Image Removed: dx-20210930_g3.jpg]] (1) Includes TBA securities at their implied market value, as if settled, of$2.0 billion and$1.6 billion , respectively. TBA securities are recorded within "derivative assets (liabilities)" on our consolidated balance sheet at their net carrying value, which represents the difference between the implied market value and the implied cost basis of the TBA security as of the date indicated. RMBS. As ofSeptember 30, 2021 , the majority of our investments in RMBS were Agency-issued pass-through securities collateralized primarily by pools of fixed-rate single-family mortgage loans. Monthly payments of principal and interest made by the individual borrowers on the mortgage loans underlying the pools are "passed through" to the security holders, after deducting GSE orU.S. Government agency guarantee and servicer fees. Mortgage pass-through certificates generally distribute cash flows from the underlying collateral on a pro-rata basis among the security holders. Security holders also receive guarantor advances of principal and interest for delinquent loans in the mortgage pools. In addition to specified pools of Agency RMBS, we are also currently investing in TBA securities. Please refer to Notes 1 and 5
of
the Notes to the Consolidated Financial Statements for a description of these transactions and information regarding their accounting treatment. As noted in the table below, as ofSeptember 30, 2021 , we are invested in lower coupon securities to mitigate the risk of loss of premiums due to early prepayment. Our lower coupon investments also have lower premiums relative to higher coupon assets which further protects our earnings when prepayments occur. Our investment in TBA securities has increased relative to prior periods as implied financing rates for dollar roll transactions have been lower than the financing rates for repurchase agreement borrowings we typically use to finance specified pools. Because TBA securities have higher relative liquidity, these transactions allow more flexibility should we decide or find it necessary to reduce leverage. The following tables compare our fixed-rate Agency RMBS investments including TBA dollar roll positions as of the dates indicated: 31 -------------------------------------------------------------------------------- September 30, 2021 Amortized Cost/ Weighted Average Par/Notional-Long Implied Cost Fair Loan Age 3 Month Coupon (Short) Basis (1)(3) Value (2)(3) (in months)(4) CPR (4)(5) Estimated Duration (6) 30-year fixed-rate: ($s in thousands) 2.0% $ 880,915$ 898,303 $ 887,089 13 9.0 % 7.09 2.5% 1,209,644 1,261,935 1,256,721 12 8.4 % 6.20 4.0% 181,897 187,356 197,413 42 40.5 % 3.04 TBA 2.0% 1,415,000 1,424,661 1,415,276 n/a n/a 6.87 TBA 2.5% 190,000 196,591 195,418 n/a n/a 5.33 15-year fixed-rate: TBA 1.5% 375,000 379,238 377,212 n/a n/a 4.75 Total $ 4,252,456$ 4,348,084 $ 4,329,129 15 11.3 % 6.29 December 31, 2020 Amortized Cost/ Weighted Average Par/Notional-Long Implied Cost Fair Loan Age 3 Month Coupon (Short) Basis (1)(3) Value (2)(3) (in months)(4) CPR (4)(5) Estimated Duration (6) 30-year fixed-rate: ($s in thousands) TBA 2.0% $ 765,000$ 789,945 $ 792,957 n/a n/a 4.89 2.0% 620,238 635,096 646,744 8 7.7 % 5.31 2.5% 938,334 973,116 995,889 10 13.5 % 3.53 4.0% 280,474 288,831 303,758 33 46.8 % 2.48 15-year fixed-rate: TBA 1.5% 250,000 255,068 257,305 n/a n/a 4.73 TBA 2.0% 500,000 519,047 522,687 n/a n/a 3.09 Total $ 3,354,046$ 3,461,103 $ 3,519,340 13 17.1 % 4.10 (1) Implied cost basis of TBAs represents the forward price to be paid for the underlying Agency MBS. (2) Fair value of TBAs is the implied market value of the underlying Agency security as of the end of the period. (3) TBAs are included on the consolidated balance sheet within "derivative assets/liabilities" at their net carrying value which is the difference between their implied market value and implied cost basis. Please refer to Note 5
of
the Notes to the Consolidated Financial Statements for additional information. (4) TBAs are excluded from this calculation as they do not have a defined weighted-average loan balance or age until mortgages have been assigned to the pool. (5) Constant prepayment rate ("CPR") represents the 3-month CPR of Agency RMBS held as of date indicated. Securities with no prepayment history are excluded from this calculation. (6) Duration measures the sensitivity of a security's price to the change in interest rates and represents the percent change in price of a security for a 100-basis point increase in interest rates. We calculate duration using third-party financial models and empirical data. Different models and methodologies can produce different estimates of duration for the same securities. CMBS. Substantially all of our CMBS investments as ofSeptember 30, 2021 were fixed-rate Agency-issued securities backed by multifamily housing loans. The loans underlying CMBS are generally fixed-rate with scheduled principal payments generally assuming a 30-year amortization period, but typically requiring balloon payments on average approximately 10 years from origination. These loans typically have some form of prepayment protection provisions (such as prepayment lock-out) or prepayment compensation provisions (such as yield maintenance or prepayment penalty), which provide us compensation if underlying loans prepay prior to us earning our expected return on our investment. Yield maintenance and prepayment penalty requirements are intended to create an economic disincentive for the loans to prepay, which we believe makes the fair value of CMBS less costly to hedge relative to RMBS. 32 --------------------------------------------------------------------------------
The following table presents information about our CMBS investments by year of origination as of the dates indicated:
September 30, 2021 December 31, 2020 Months to Estimated Months to Estimated ($s in thousands) Par Value Amortized Cost Maturity (1) WAC (2) Par Value Amortized Cost Maturity (1) WAC (2) Year of Origination: Prior to 2009 (3)$ 5,714 $ 5,564 15 5.75 %$ 9,132 $ 8,964 36 5.69 % 2009 to 2012 10,789 11,289 31 4.63 % 11,424 12,085 65 5.56 % 2013 to 2014 9,707 9,840 37 3.29 % 9,865 10,033 44 3.61 % 2015 109,613 110,881 60 2.94 % 155,760 157,137 69 2.85 % 2017 30,833 31,175 108 3.18 % 30,907 31,294 91 3.18 % 2019 19,702 19,970 143 3.17 % 19,702 19,988 151 3.12 %$ 186,358 $ 188,719 72 3.21 %$ 236,790 $ 239,501 77 3.19 % (1) Months to estimated maturity is an average weighted by the amortized cost of the investment. (2) The weighted average coupon ("WAC") is the gross interest rate of the security weighted by the outstanding principal balance. (3) The Company has one non-Agency CMBS originally issued in 1998 with an amortized cost and fair value of less than$1.0 million as ofSeptember 30, 2021 andDecember 31, 2020 . CMBS IO. CMBS IO are interest-only securities issued as part of a CMBS securitization and represent the right to receive a portion of the monthly interest payments (but not principal cash flows) on the unpaid principal balance of the underlying pool of commercial mortgage loans. We invest in both Agency-issued and non-Agency issued CMBS IO. Agency-issued CMBS IO pools are backed by multifamily housing loans, and our non-Agency issued CMBS IO are backed by loans secured by a number of different property types including office buildings, hospitality, and retail, among others. Since CMBS IO securities have no principal associated with them, the interest payments received are based on the unpaid principal balance of the underlying pool of mortgage loans, which is often referred to as the notional amount. Yields on CMBS IO securities are dependent upon the performance of the underlying loans. Similar to CMBS described above, the Company receives prepayment compensation as most loans in these securities have some form of prepayment protection from early repayment; however, there are no prepayment protections if the loan defaults and is partially or wholly repaid earlier because of loss mitigation actions taken by the underlying loan servicer. Because Agency CMBS IO generally contain higher credit quality loans, they have a lower risk of default than non-Agency CMBS IO. The majority of our CMBS IO investments are investment grade-rated with the majority rated 'AAA ' by at least one of the nationally recognized statistical rating organizations. 33 --------------------------------------------------------------------------------
The following tables present our CMBS IO investments by year of origination as of the dates indicated:
September 30, 2021 Agency Non-Agency ($s in thousands) Amortized Cost Fair Value Remaining WAL (1) Amortized Cost Fair Value Remaining WAL (1) Year of Origination: 2010-2012 $ 4,062$ 3,838 4 $ 928$ 877 4 2013 12,544 14,559 8 6,854 6,919 9 2014 18,560 19,393 17 37,684 38,597 15 2015 24,662 25,845 21 42,796 44,216 21 2016 19,372 20,307 25 14,179 14,346 16 2017 23,393 24,589 37 6,560 6,793 29 2018 3,487 3,802 56 - - - 2019 82,044 86,223 54 - - - 2020 2,936 2,997 47 - - - 2021 4,313 4,303 51 - - -$ 195,373 $ 205,856 37$ 109,001 $ 111,748 19 December 31, 2020 Agency Non-Agency ($s in thousands) Amortized Cost Fair Value Remaining WAL (1) Amortized Cost Fair Value Remaining WAL (1) Year of Origination: 2010-2012$ 12,037 $ 11,932 9 $ 3,237$ 3,263 8 2013 22,367 24,165 13 10,875 10,912 15 2014 24,841 25,749 22 50,777 51,175 20 2015 31,875 33,404 26 53,176 54,020 27 2016 23,072 24,203 31 16,705 16,906 16 2017 26,493 27,952 42 7,733 7,808 34 2018 3,792 3,983 62 - - - 2019 88,757 91,303 60 - - - 2020 3,203 3,264 53 - - -$ 236,437 $ 245,955 39$ 142,503 $ 144,084 24 (1) Remaining weighted average life ("WAL") represents an estimate of the number of months of contractual cash flows remaining for the investments by year of origination. The weighted average interest coupon rate for our CMBS IO was 0.70% as ofSeptember 30, 2021 and 0.56% as ofDecember 31, 2020 . Effective yields on CMBS IO securities are dependent upon the performance of the underlying loans. Our return on these investments may be negatively impacted if the loans default, resulting in foreclosures, or liquidations of the loan collateral. Non-Agency-issued securities are generally expected to have a higher risk of default than Agency CMBS IO. We are mostly invested in senior tranches of these securities where we have evaluated the credit profile of the underlying loan pool and can monitor credit performance in order to mitigate our exposure to losses. The majority of our non-Agency CMBS IO investments are investment grade-rated with the majority rated 'AAA ' by at least one of the nationally recognized statistical rating organizations. All of our non-Agency CMBS IO were originated prior to 2017, the majority of which we believe have had underlying property value appreciation. 34 -------------------------------------------------------------------------------- Since the economic impacts of COVID-19 began in 2020, servicers are reporting an increase in delinquencies on loans underlying our non-Agency CMBS IO and have taken loss mitigation actions including loan forbearance or allowing the borrower to make loan payments using replacement reserve or similar property related funds. Most of the increases in delinquencies thus far have been in the retail and hotel sectors and have nominally impacted cash flows and yields on the securities. Considering the characteristics of our non-Agency CMBS IO and the actions taken by servicers so far to work with borrowers through various relief measures, we have not seen evidence of and do not currently expect a material adverse effect on our future cash flows for non-Agency CMBS IO. However, the ultimate impact of COVID-19 on the global economy and on the loans underlying any of our securities remains uncertain and cannot be predicted at this time. The property type for the loans securing our non-Agency CMBS IO, which has not changed materially sinceDecember 31, 2020 , are shown in the table below as ofSeptember 30, 2021 : September 30, 2021 ($s in thousands) Fair Value Percentage of Portfolio Property Type: Retail $ 31,367 28.1 % Office 24,632 22.0 % Multifamily 18,133 16.2 % Hotel 15,134 13.5 % Mixed use 7,858 7.0 % Other (1) 14,623 13.2 % Total non-Agency CMBS IO $ 111,747 100.0 %
(1) Other property types collateralizing non-Agency CMBS IO do not comprise more than 5% individually.
Repurchase Agreements We use leverage to enhance the returns on our invested capital by pledging our investments as collateral for borrowings primarily through the use of uncommitted repurchase agreements with major financial institutions and broker-dealers. Repurchase agreements generally have original terms to maturity of overnight to six months, though in some instances we may enter into longer-dated maturities depending on market conditions. We pay interest on our repurchase agreement borrowings based on short-term rate indices that historically closely track LIBOR and are fixed for the term of the borrowing. Please refer to Note 4 of the Notes to the Consolidated Financial Statements contained within this Quarterly Report on Form 10-Q as well as "Results of Operations" and "Liquidity and Capital Resources" contained within this Item 2 for additional information relating to our repurchase agreement borrowings. Derivative Assets and Liabilities We use derivative instruments to economically hedge our exposure to adverse changes in interest rates resulting from our ownership of primarily fixed-rate investments financed with short-term repurchase agreements. Changes in interest rates can impact net interest income, the market value of our investments, and book value per common share. We regularly monitor and frequently adjust our hedging portfolio in response to many factors including, but not limited to, changes in our investment portfolio as well as our expectation of future interest rates, including the absolute level of rates and the slope of the yield curve versus market expectations. As ofSeptember 30, 2021 , approximately 88% of our MBS portfolio including TBA securities were hedged compared to approximately 62% as of December 31, 2020. Please refer to Note 5 of the Notes to the Consolidated Financial Statements for details on our interest rate derivative instruments as well as "Quantitative and Qualitative Disclosures about Market Risk" in Part I, Item 3 of this Quarterly Report on Form 10-Q. 35 -------------------------------------------------------------------------------- RESULTS OF OPERATIONS The discussion below includes both GAAP and non-GAAP financial measures that management utilizes in its internal analysis of financial and operating performance. Please read the section "Non-GAAP Financial Measures" contained in "Executive Overview" of Part I, Item 2 of this Quarterly Report on Form 10-Q for additional important information about these financial measures.
Three Months Ended
The following table summarizes the results of operations for the periods indicated:
Three Months Ended $s in thousands September 30, 2021 June 30, 2021 Net interest income $ 14,394$ 12,118 Realized gain on sale of investments, net - 2,008 Unrealized (loss) gain on investments, net (3,085) 1,084 (Loss) gain on derivative instruments, net 9,603 (52,940) General and administrative expenses (6,549) (5,706) Other operating expenses, net (330) (323) Preferred stock dividends (1,923) (1,923) Net income (loss) to common shareholders 12,110 (45,682) Other comprehensive (loss) income (9,139) 14,270 Comprehensive income (loss) to common shareholders $
2,971
Net Interest Income The increases in net interest income of$2.3 million and in net interest spread of 6 basis points were driven primarily by purchases of Agency RMBS made in the latter half of the second quarter of 2021, which are fully weighted in the average balance of our interest-earning assets for the third quarter of 2021. In addition, these purchases also earned higher effective yields relative to the remainder of the Agency RMBS portfolio, driving an increase in the effective yield on Agency RMBS by 19 basis points for the three months endedSeptember 30, 2021 compared to the three months endedJune 30, 2021 . Though we financed a portion of these Agency RMBS purchases using repurchase agreement borrowings, which resulted in a higher average balance of borrowings for the third quarter of 2021, we incurred a nominal increase in interest expense because our borrowing rate declined 3 basis points for the third quarter of 2021 compared to the second quarter of 2021. The weighted average original term to maturity on our borrowings has extended since the second quarter of 2021, allowing us to finance our investments at lower rates. The following table presents certain information about our interest-earning assets and interest-bearing liabilities and their performance for the periods indicated: 36 -------------------------------------------------------------------------------- Three Months Ended September 30, 2021 June 30, 2021 Effective Yield/ Effective Yield/ Interest Average Balance Cost of Interest Average Balance Cost of ($s in thousands) Income/Expense (1)(2) Funds (3)(4) Income/Expense (1)(2) Funds (3)(4) Interest-earning assets: Agency RMBS $ 10,336$ 2,338,172 1.77 % $ 7,373$ 1,863,420 1.58 % Agency CMBS 1,675 189,498 3.02 % 1,959 233,815 2.97 % CMBS IO (5) 3,572 313,039 4.23 % 3,918 339,288 4.24 % Non-Agency MBS and other investments 131 5,968 7.11 % 143 6,617 6.94 % Total: $ 15,714$ 2,846,677 2.13 % $ 13,393$ 2,443,140 2.10 % Interest-bearing liabilities: (6) (1,320) 2,529,023 (0.20) % (1,275) 2,155,200 (0.23) % Net interest income/net interest spread $ 14,394 1.93 % $ 12,118 1.87 % (1) Average balance for assets is calculated as a simple average of the daily amortized cost and excludes unrealized gains and losses as well as securities pending settlement if applicable. (2) Average balance for liabilities is calculated as a simple average of the daily borrowings outstanding during the period. (3) Effective yield is calculated by dividing the sum of gross interest income and scheduled premium amortization/discount accretion (both of which are annualized for any reporting period less than 12 months) and prepayment compensation and premium amortization/discount accretion adjustments (collectively, "prepayment adjustments"), which are not annualized, by the average balance of asset type outstanding during the reporting period. (4) Cost of funds is calculated by dividing annualized interest expense by the total average balance of borrowings outstanding during the period with an assumption of 360 days in a year. (5)Includes Agency and non-Agency issued securities. (6) Interest-bearing liabilities consist primarily of repurchase agreement borrowings.
The following table presents the estimated impact on our net interest income due to changes in rate (effective yield/cost of funds) and changes in volume (average balance) of our interest-earning assets and interest-bearing liabilities for the periods indicated:
Three Months Ended
September
30, 2021 Compared to
Increase (Decrease) Due to Change In Total Change in Prepayment Interest ($s in thousands) Rate Volume Adjustments (1) Income/Expense Interest-earning assets: Agency RMBS$ 1,085 $ 1,878 $ - $ 2,963 Agency CMBS 6 (305) 15 (284) CMBS IO (2) 13 (275) (84) (346) Non-Agency MBS and other investments (1) (11) - (12) Change in interest income 1,103 1,287 (69) 2,321 Change in interest expense (160) 205 - 45
Total net change in net interest income
$ (69) $ 2,276 (1) Prepayment adjustments represent effective interest amortization adjustments related to changes in actual prepayment speeds and prepayment compensation, net of amortization adjustments for CMBS and CMBS IO. (2)Includes Agency and non-Agency issued securities. 37 -------------------------------------------------------------------------------- Adjusted Net Interest Income Please refer to "Non-GAAP Financial Measures" at the end of the "Executive Overview" section of this Quarterly Report on Form 10-Q for additional information about this non-GAAP financial measure used by management to evaluate results of operations. Three Months Ended September 30, 2021 June 30, 2021 ($s in thousands) Amount Rate Amount Rate Net interest income$ 14,394 1.93 %$ 12,118 1.87 % Add: TBA drop income (1) (2) (3) 13,319 0.17 % 12,177 0.19 % Adjusted net interest income (3)$ 27,713 2.10 %$ 24,295 2.06 % (1) TBA drop income is calculated by multiplying the notional amount of the TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates. (2) The impact of TBA drop income on adjusted net interest spread includes the implied average funding cost of TBA dollar roll transactions during the periods indicated. (3) Percentages shown for adjusted net interest spread and for the impact from TBA drop income on net interest spread have changed as a result of a correction to the calculation of the average notional balance of TBA dollar roll positions outstanding during the three months endedJune 30, 2021 . This correction to the calculation of the notional balance did not impact the financial statements as of or for the three months endedJune 30, 2021 . Drop income from TBAs for the three months endedSeptember 30, 2021 increased$1.2 million compared to the three months endedJune 30, 2021 as a result of a higher average balance of TBA dollar roll transactions. Though the increase in TBA drop income drove adjusted net interest income higher for the third quarter of 2021 compared to the prior quarter, the lower effective yield for these transactions reduced the impact on adjusted net interest spread by 2 basis points compared to the prior quarter. We have continued to increase our investment in TBA securities in recent quarters because the financing cost imputed in TBA dollar roll transactions continues to be lower than the average repurchase agreement financing rate. This is commonly referred to in the industry as TBA dollar rolls "trading special" or "dollar roll specialness." Dollar roll specialness happens primarily as a result of supply/demand imbalances or volatility in market prepayment expectations, and in management's view, the pace of bank andFederal Reserve purchases is currently resulting in implied financing costs dropping below 0%. The implied financing rate for our TBA long positions was (0.47)% compared to our repurchase agreement financing cost for specified pools of Agency RMBS of 0.13% for the three months endedSeptember 30, 2021 , an increase of 11 basis points in dollar roll specialness versus the prior quarter. Changes in Fair Value of Investments Changes in the fair value of our investments result in realized and unrealized gains and losses. The fair value of our investments are impacted by a number of factors including, among others, market volatility, changes in credit spreads, spot and forward interest rates, actual and anticipated prepayments, and supply/demand dynamics which are in turn impacted by, among other things, interest rates, capital flows, economic conditions, and government policies and actions, such as purchases and sales by theFederal Reserve Bank of New York . The following table provides details on unrealized gains and losses on our investments measured and reported at fair value through net income within "unrealized gain (loss) on investments, net" and available-for-sale investments measured and reported at fair value through "other comprehensive income (loss)" for the periods indicated: 38 -------------------------------------------------------------------------------- Three Months Ended ($s in thousands) September 30, 2021 June 30, 2021 MBS purchased after December 31, 2020 $ (3,127) $
997
Mortgage loans held for investment 32
86
Other 10
1
Unrealized (loss) gain on investments, net (3,085) 1,084 Agency RMBS (4,894) 12,429 Agency CMBS (2,069) (259) CMBS IO (2,129) 2,148 Non-Agency other (47) (48) Other comprehensive (loss) income (9,139)
14,270
Total unrealized (losses) gains $ (12,224) $
15,354
Sales of our investments happen in the ordinary course of business as we manage our risk, capital and liquidity profiles, and as we reallocate capital to various investments. We did not sell any investments during the three months endedSeptember 30, 2021 . The following table provides information related to our "realized gains (losses) on sales of investments, net" for the periods indicated: Three Months Ended September 30, 2021 June 30, 2021 Amortized Realized Amortized Realized ($s in thousands) cost sold Gain cost sold Gain Agency RMBS-designated as AFS $ - $ -$ 213,339 $ (759) Agency CMBS-designated as AFS - - 35,106 2,767 Total $ - $ -$ 248,445 $ 2,008 Gain (Loss) on Derivative Instruments, Net Changes in the fair value of derivative instruments are impacted by changing market interest rates and adjustments that we may make to our hedging positions in any given period. Because of the changes made to our derivatives portfolio from one reporting period to the next, results of any given reporting period are generally not comparable to results of another. The yield curve flattened during the three months endedJune 30, 2021 when longer-term interest rates declined, which resulted in losses on our interest rate hedges of$(93.8) million . However, because we maintained our hedge position for a steeper yield curve, we recognized gains of$12.0 million for the three months endedSeptember 30, 2021 as longer-term interest rates reversed direction from the prior quarter.The following table provides information on our financial instruments accounted for as derivative instruments for the periods indicated: 39 -------------------------------------------------------------------------------- Three Months Ended ($s in thousands) September 30, 2021 June 30, 2021 Change in fair value of interest rate hedges: Interest rate swaptions $ 3,985$ (19,062) U.S. Treasury futures 11,209 (63,184) Options on U.S. Treasury futures (3,226) (11,531) Total gain (loss) on interest rate hedges 11,968 (93,777) TBA dollar roll positions: Change in fair value (1) (15,684) 28,660 TBA drop income (2) 13,319 12,177 Total TBA dollar roll gain (loss), net (2,365) 40,837 Total gain (loss) on derivative instruments, net $
9,603
(1) Changes in fair value for TBA dollar roll positions include unrealized gains (losses) from open TBA contracts and realized gains (losses) on paired off or terminated positions. (2) TBA drop income represents a portion of the change in fair value and is calculated by multiplying the notional amount of the net TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates.
The following table provides information regarding realized gains (losses) on derivative instruments for the periods indicated:
Three Months Ended ($s in thousands) September 30, 2021 June 30, 2021 Interest rate swaptions $ 2,828 $ - U.S. Treasury futures (76,089) 36,679 Options on U.S. Treasury futures (5,578) (3,633) TBA long positions 14,880 16,309
Total realized (losses) gains on derivative instruments $ (63,959)
General and Administrative Expenses General and administrative expenses increased$0.8 million for the three months endedSeptember 30, 2021 compared to the three months endedJune 30, 2021 due primarily to litigation expenses related to the ongoing legal proceeding discussed in Part II, Item 1 as well as expansion of our operating platform used to manage our investment and hedging portfolios as the Company continues to grow. This increase was partially offset by a$(0.3) million decrease in compensation and benefits due primarily to adjusting the accrual for annual bonuses which is based on year-to-date performance of the Company. 40 -------------------------------------------------------------------------------- Nine Months EndedSeptember 30, 2021 Compared to the Nine Months EndedSeptember 30, 2020 Net Interest Income Net interest income declined$(10.7) million for the nine months endedSeptember 30, 2021 compared to the nine months endedSeptember 30, 2020 because we held a smaller average balance of lower yielding investments during the nine months endedSeptember 30, 2021 compared to the same period in 2020. Net interest spread increased 26 basis points for the nine months endedSeptember 30, 2021 compared to the nine months endedSeptember 30, 2020 as the decline in our repurchase agreement borrowing costs was higher than the decline in the effective yield earned on our investments. The following table presents information about our interest-earning assets and interest-bearing liabilities and their performance for the periods indicated: Nine Months Ended September 30, 2021 2020 Effective Yield/ Effective Yield/ Interest Average Balance Cost of Interest Average Balance Cost of ($s in thousands) Income/Expense (1)(2) Funds (3)(4) Income/Expense (1)(2) Funds (3)(4) Interest-earning assets: Agency RMBS $ 25,090$ 2,009,728 1.66 % $ 40,734$ 2,143,728 2.53 % Agency CMBS 5,467 220,312 3.17 % 23,319 1,058,847 2.89 % CMBS IO (5) 12,007 339,212 4.57 % 14,616 448,254 4.18 % Non-Agency MBS and other investments (6) 436 6,625 7.86 % 1,095 9,516 8.25 % Total: $ 43,000$ 2,575,877 2.19 % $ 79,764$ 3,660,345 2.85 % Interest-bearing liabilities: (7) (4,228) 2,282,140 (0.24) % (30,327) 3,422,287 (1.16) % Net interest income/net interest spread $ 38,772 1.95 % $ 49,437 1.69 % (1) Average balance for assets is calculated as a simple average of the daily amortized cost and excludes unrealized gains and losses as well as securities pending settlement if applicable. (2) Average balance for liabilities is calculated as a simple average of the daily borrowings outstanding during the period. (3) Effective yield is calculated by dividing the sum of gross interest income and scheduled premium amortization/discount accretion (both of which are annualized for any reporting period less than 12 months) and prepayment compensation and premium amortization/discount accretion adjustments (collectively, "prepayment adjustments"), which are not annualized, by the average balance of asset type outstanding during the reporting period. (4) Cost of funds is calculated by dividing annualized interest expense by the total average balance of borrowings outstanding during the period with an assumption of 360 days in a year. (5)Includes Agency and non-Agency issued securities. (6) Interest income for non-Agency and other investments for the nine months endedSeptember 30, 2020 includes$0.5 million of interest income from cash and cash equivalents. Average balance and effective yield for non-Agency MBS and other investments excludes cash and cash equivalents. (7) Interest-bearing liabilities consist primarily of repurchase agreement borrowings.
The following table presents the estimated impact on our net interest income due to changes in rate (effective yield/cost of funds) and changes in volume (average balance) of our interest-earning assets and interest-bearing liabilities for the periods indicated:
41 --------------------------------------------------------------------------------
Nine Months Ended
September 30 ,
2021 Compared to
Increase (Decrease) Due to Change In Total Change in Prepayment Interest ($s in thousands) Rate Volume Adjustments (1) Income/Expense Interest-earning assets: Agency RMBS$ (13,103) $ (2,541) $ - $ (15,644) Agency CMBS (21) (18,330) 499 (17,852) CMBS IO (2) 1,145 (3,020) (734) (2,609) Non-Agency MBS and other investments (82) (545) (32) (659) Change in interest income$ (12,061) $ (24,436) $ (267) $ (36,764) Change in interest expense (16,119) (9,980) - (26,099)
Total net change in net interest income
(1) Prepayment adjustments represent effective interest amortization adjustments related to changes in actual prepayment speeds and prepayment compensation, net of amortization adjustments for CMBS and CMBS IO. (2)Includes Agency and non-Agency issued securities. Adjusted Net Interest Income Please refer to "Non-GAAP Financial Measures" at the end of the "Executive Overview" section of this Quarterly Report on Form 10-Q for additional information about this non-GAAP financial measure used by management to evaluate results of operations. Nine Months Ended September 30, 2021 2020 ($s in thousands) Amount Rate Amount Rate Net interest income$ 38,772 1.95 %$ 49,437 1.69 % Add: TBA drop income (1) (2) 34,065 0.10 % 8,622 0.02 % Add: net periodic interest benefit (3) - - % 1,586 0.06 % Adjusted net interest income$ 72,837 2.05 %$ 59,645 1.77 % (1) TBA drop income is calculated by multiplying the notional amount of the TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates. (2) The impact of TBA drop income on adjusted net interest spread includes the implied average funding cost of TBA dollar roll transactions during the periods indicated. (3) Amount represents net periodic interest cost/benefit of effective interest rate swaps outstanding during the period and excludes realized and unrealized gains and losses from changes in fair value of derivatives. The increase of$13.2 million in adjusted net interest income for the nine months endedSeptember 30, 2021 compared to the nine months endedSeptember 30, 2020 is due to our increased investment in TBA securities at lower implied funding costs relative to the nine months endedSeptember 30, 2020 , which resulted in an increase in TBA drop income of$25.4 million . This increase in TBA drop income offset the decline of$(10.7) million in net interest income and$(1.6) million in net periodic interest benefit from interest rate swaps. As discussed previously, we have increased our investment in TBA securities relative to prior periods due to dollar roll specialness, and also given the current market environment. TBA securities allow us more flexibility should we decide or find it necessary to reduce leverage. The decline in net periodic interest benefit from interest rate swaps is because we are not currently using interest rate swaps to hedge our interest rate risk. 42 -------------------------------------------------------------------------------- Changes in Fair Value of Investments The following table provides details on unrealized gains or losses on our investments recorded within "unrealized gain (loss) on investments, net" and "other comprehensive income (loss)" for the periods indicated: Nine Months Ended ($s in thousands) September 30, 2021 September 30, 2020 MBS purchased after December 31, 2020 $ (3,090) $
-
Mortgage loans held for investment 82
193
Other 27
(39)
Unrealized (loss) gain on investments, net (2,981) 154 Agency RMBS (52,640) (70,262) Agency CMBS (9,374) (11,690) CMBS IO 2,140 (2,878) Non-Agency other (151) (247) Other comprehensive loss (60,025) (85,077) Total unrealized losses $ (63,006) $ (84,923)
The following table provides information related to our realized gains on sales of investments, net for the periods indicated:
Nine Months Ended September 30, 2021 September 30, 2020 Amortized Realized Amortized Realized ($s in thousands) cost sold Gain cost sold Gain Agency RMBS-designated as AFS$ 283,471 $ 3,938 $ 2,112,132 $ 75,824 Agency CMBS-designated as AFS 35,106 2,767 1,992,194 222,904 Total$ 318,577 $ 6,705 $ 4,104,326 $ 298,728 Gain (Loss) on Derivative Instruments, Net The following table provides information on our financial instruments accounted for as derivative instruments for the periods indicated: 43 --------------------------------------------------------------------------------
Nine Months Ended September 30, September 30, ($s in thousands) 2021 2020 Change in fair value of interest rate hedges: Interest rate swaps (1) $ -$ (182,941) Interest rate swaptions 42,686 (162) U.S. Treasury futures 43,673 (25,140) Options on U.S. Treasury futures (2,141) (23,815) Total gain (loss) on interest rate hedges 84,218 (232,058) TBA dollar roll positions: Change in fair value (2) (53,819) 27,280 TBA drop income (3) 34,065 8,622 Total TBA dollar roll (loss) gain, net (19,754) 35,902 Total gain (loss) on derivative instruments, net$ 64,464
(1) Amount for interest rate swaps for nine months endedSeptember 30, 2020 is net of periodic interest benefit of$1.6 million . (2) Changes in fair value for TBA dollar roll positions include unrealized gains (losses) from open TBA contracts and realized gains (losses) on paired off or terminated positions. (3) TBA drop income represents a portion of the change in fair value and is calculated by multiplying the notional amount of the net TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates.
The following table provides information regarding realized gains (losses) on derivative instruments for the periods indicated:
Nine Months Ended September 30, ($s in thousands) September 30, 2021 2020 Interest rate swaps $ -$ (185,985) Interest rate swaptions 2,828 (1,934) U.S. Treasury futures (18,013) (19,976) Options on U.S. Treasury futures (7,339) (19,724) TBA long positions 1,717 43,309 TBA short positions - (11,016) Total realized losses on derivative instruments $
(20,807)
General and Administrative Expenses General and administrative expenses increased$3.5 million for the nine months endedSeptember 30, 2021 compared to the nine months endedSeptember 30, 2020 due primarily to higher bonus accruals and expansion of our operating platform used to manage our investment and hedging portfolios as the Company continues to grow. LIQUIDITY AND CAPITAL RESOURCES Our primary sources of liquidity include borrowings under repurchase arrangements and monthly principal and interest payments we receive on our investments. Additional sources may also include proceeds from the sale of investments, equity offerings, and payments received from counterparties for derivative instruments. We use our liquidity to purchase investments and to pay our operating expenses and dividends on our common and preferred stock. We also use our liquidity 44 -------------------------------------------------------------------------------- to meet margin requirements for our repurchase agreements and derivative transactions, including TBA contracts, under the terms of the related agreements. We may also periodically use liquidity to repurchase shares of the Company's stock. Our liquidity fluctuates based on our investment activities, our financing and capital raising activities, and changes in the fair value of our investments and derivative instruments. Our most liquid assets include unrestricted cash and cash equivalents and unencumbered Agency RMBS, CMBS, and CMBS IO which were$559.7 million as ofSeptember 30, 2021 compared to$415.3 million as ofDecember 31, 2020 . We have increased our available liquidity in recent periods principally to protect against bouts of extreme market volatility, which we believe has a higher potential of occurring given market conditions. Furthermore, there are a number of potential risk events on the horizon including, but not limited to, the fiscal policy debt ceiling resolution, a potential leadership transition at theFederal Reserve , and international risks such as Japanese elections. We analyze our liquidity under various scenarios based on changes in the fair value of our investments and derivative instruments due to market factors such as changes in the absolute level of interest rates and the shape of the yield curve, credit spreads, lender haircuts, and prepayment speeds. In performing these analyses, we will also consider the current state of the fixed income markets and the repurchase agreement markets in order to determine if market forces such as supply-demand imbalances or structural changes to these markets could change the liquidity of MBS or the availability of financing. The objective of our analyses is to assess the adequacy of our liquidity to withstand potential adverse events, such as the current COVID-19 pandemic. We may change our leverage targets based on market conditions and our perceptions of the liquidity of our investments. Our leverage, which we calculate using total liabilities plus the cost basis of TBA long positions, was 5.9x shareholders' equity as ofSeptember 30, 2021 compared to 6.3x as ofDecember 31, 2020 . This decline in leverage sinceDecember 31, 2020 is the result of a 22% increase in shareholders' equity, which increased primarily as a result of the$224.4 million in capital we have raised sinceDecember 31, 2020 . The impact from the increase in shareholders' equity was partially offset by an increase in our total liabilities including the cost basis of our TBA securities of approximately 14%. We include the cost basis of our TBA securities in evaluating the Company's leverage because it is possible under certain market conditions that it may be uneconomical for us to roll a TBA long position into future months, which may result in us having to take physical delivery of the underlying securities and use cash or other financing sources to fund our total purchase commitment. In general, our leverage will increase if we view the risk-reward opportunity of higher leverage is appropriately balanced in our favor. Our repurchase agreement borrowings are principally uncommitted with terms renewable at the discretion of our lenders and generally have original terms to maturity of overnight to six months, though in some instances we may enter into longer-dated maturities depending on market conditions. As such, we attempt to maintain unused capacity under our existing repurchase agreement credit lines with multiple counterparties, which helps protect us in the event of a counterparty's failure to renew existing repurchase agreements. As part of our continuous evaluation of counterparty risk, we maintain our highest counterparty exposures with broker dealer subsidiaries of regulated financial institutions or primary dealers whom we believe are better capitalized and more durable counterparties. The following table presents information regarding the balances of our repurchase agreement borrowings as of and for the periods indicated: Repurchase Agreements Balance Average Balance Maximum Balance Outstanding As of Outstanding For the Outstanding During ($s in thousands) Quarter End Quarter Ended the Quarter Ended September 30, 2021$ 2,527,065 $ 2,529,023 $ 2,590,185 June 30, 2021 2,321,043 2,155,200 2,415,037 March 31, 2021 2,032,089 2,158,121 2,437,163 December 31, 2020 2,437,163 2,500,639 2,594,683 September 30, 2020 2,594,683 2,984,946 3,314,991 June 30, 2020 3,314,991 2,580,296 4,408,106 March 31, 2020 4,408,106 4,701,010 4,917,731 December 31, 2019 4,752,348 4,806,826 4,891,341 45
-------------------------------------------------------------------------------- For our repurchase agreement borrowings, we are required to post and maintain margin to the lender (i.e., collateral in excess of the repurchase agreement financing) in order to support the amount of the financing. This excess collateral is often referred to as a "haircut" and is intended to provide the lender some protection against fluctuations in fair value of the collateral and/or the failure by us to repay the borrowing at maturity. Lenders have the right to change haircut requirements at maturity of the repurchase agreement (if the term is renewed) and may change their haircuts based on market conditions and the perceived riskiness of the collateral pledged. If the fair value of the collateral falls below the haircut required by the lender, the lender has the right to demand additional margin, or collateral, to increase the haircut back to the initial amount. These demands are typically referred to as "margin calls", and if we fail to meet any margin call, our lenders have the right to terminate the repurchase agreement and sell any collateral pledged. Declines in the fair value of investments occur for any number of reasons including but not limited to changes in interest rates, changes in ratings on an investment, changes in actual or perceived liquidity of the investment, or changes in overall market risk perceptions. Additionally, Fannie Mae and Freddie Mac announce principal payments on Agency MBS in advance of their actual remittance of principal payments, and repurchase agreement lenders generally make margin calls for an amount equal to the product of their advance rate on the repurchase agreement and the announced principal payments on the Agency RMBS. A margin call made by a lender reduces our liquidity until we receive the principal payments from Fannie Mae and Freddie Mac. The weighted average haircut for our borrowings collateralized with Agency RMBS and Agency CMBS typically averages less than 5% while CMBS IO averages between 13-16%. The collateral we post in excess of our repurchase agreement borrowing with any counterparty is also typically referred to by us as "equity at risk", which represents the potential loss to the Company if the counterparty is unable or unwilling to return collateral securing the repurchase agreement borrowing at its maturity. The counterparties with whom we have the greatest amounts of equity at risk may vary significantly during any given period due to the short-term and generally uncommitted nature of the repurchase agreement borrowings. As ofSeptember 30, 2021 , the Company had repurchase agreement amounts outstanding with 23 of its 37 available repurchase agreement counterparties and did not have more than 5% of equity at risk with any counterparty or group of related counterparties. We have various financial and operating covenants in certain of our repurchase agreements including, among other things, requirements that we maintain minimum shareholders' equity (usually a set minimum, or a percentage of the highest amount of shareholders' equity since the date of the agreement), limits on maximum decline in shareholders' equity (expressed as a percentage decline in any given period), limits on maximum leverage (as a multiple of shareholders' equity), and requirements to maintain our status as a REIT under the Internal Revenue Code of 1986 and the corresponding provisions of state law and to maintain our listing on theNew York Stock Exchange . Violations of one or more of these covenants could result in the lender declaring an event of default which would result in the termination of the repurchase agreement and immediate acceleration of amounts due thereunder. In addition, some of the agreements contain cross default features, whereby default with one lender simultaneously causes default under agreements with other lenders. Violations could also restrict us from paying dividends or engaging in other transactions that are necessary for us to maintain our REIT status. We monitor and evaluate on an ongoing basis the impact these customary financial covenants may have on our operating and financing flexibility. Currently, we do not believe we are subject to any covenants that materially restrict our financing flexibility. We were in full compliance with our debt covenants as ofSeptember 30, 2021 , and we are not aware of any circumstances which could potentially result in our non-compliance in the foreseeable future. Derivative Instruments We use certain types of financial instruments that are accounted for as derivative instruments, including interest rate swaps, futures, options, and long and short positions in TBA securities. Certain of these derivative instruments may require us to post initial margin at inception and daily variation margin based on subsequent changes in their fair value. The collateral posted as margin by us is typically in the form of cash or Agency MBS. Counterparties may have to post variation margin to us. Generally, as interest rates decline, we will be required to post collateral with counterparties on our interest rate derivatives and vice versa as interest rates increase. As ofSeptember 30, 2021 , we had received cash collateral of$22.6 million from our counterparties under these agreements. Our TBA contracts are subject to master securities forward transaction agreements published by theSecurities Industry and Financial Markets Association as well as supplemental terms and conditions with each counterparty. Under the 46 -------------------------------------------------------------------------------- terms of these agreements, we may be required to pledge collateral to, or have the right to receive collateral from, our counterparties when initiated or in the event the fair value of our TBA contracts declines. As ofSeptember 30, 2021 , we had cash of$16.6 million posted as collateral under these agreements. Declines in the fair value of TBA contracts are generally related to such factors as rising interest rates, increases in expected prepayment speeds, or widening spreads. Our TBA contracts generally provide that valuations for our TBA contracts and any pledged collateral are to be obtained from a generally recognized source agreed to by both parties. However, in certain circumstances, our counterparties have the sole discretion to determine the value of the TBA contract and any pledged collateral. In such instances, our counterparties are required to act in good faith in making determinations of value. In the event of a margin call, we must generally provide additional collateral on the same business day.
Dividends
As a REIT, we are required to distribute to our shareholders amounts equal to at least 90% of our REIT taxable income for each taxable year after certain deductions. When declaring dividends, the Board of Directors considers the requirements for maintaining our REIT status and maintaining compliance with dividend requirements of the Series C Preferred Stock. In addition, the Board considers, among other things, our total economic return, EAD to common shareholders, taxable income, gains and losses including carryforwards for tax purposes, the Company's long-term outlook for future performance, and trends in the investment and financing markets. We generally fund our dividend distributions through our cash flows from operations. If we make dividend distributions in excess of our operating cash flows during the period, whether for purposes of meeting our REIT distribution requirements or other strategic reasons, those distributions are generally funded either through our existing cash balances or through the return of principal from our investments (either through repayment or sale). Please refer to "Federal Income Tax Considerations" within Part I, Item 1, "Business" as well as Part I, Item 1A, "Risk Factors" of our 2020 Form 10-K for additional important information regarding dividends declared on our taxable income. Contractual Obligations and Other Matters As ofSeptember 30, 2021 , we do not have any material contractual obligations other than the short-term repurchase agreement amounts discussed above, nor do we believe that any off-balance sheet arrangements exist that are reasonably likely to have a material effect on our current or future financial condition, results of operations, or liquidity. In addition, we do not have any material commitments for capital expenditures and have not obtained any commitments for funds to fulfill any capital obligations. RECENT ACCOUNTING PRONOUNCEMENTS There were no accounting pronouncements issued during the nine months endedSeptember 30, 2021 that are expected to have a material impact on the Company's financial condition or results of operations. Please refer to Note 1 of the Notes to the Consolidated Financial Statements contained within Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information. CRITICAL ACCOUNTING ESTIMATES The discussion and analysis of our financial condition and results of operations are based in large part upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of our consolidated financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. We base these estimates and judgments on historical experience and assumptions believed to be reasonable under current facts and circumstances. Actual results, however, may differ from the estimated amounts we have recorded. Critical accounting estimates are defined as those that require management's most difficult, subjective or complex judgments, and which may result in materially different results under different assumptions and conditions. Our critical accounting estimates are discussed in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and 47 --------------------------------------------------------------------------------
Results of Operations" of our 2020 Form 10-K under "Critical Accounting
Estimates." There have been no significant changes in our critical accounting
estimates during the three months ended
FORWARD-LOOKING STATEMENTS Certain written statements in this Quarterly Report on Form 10-Q that are not historical facts constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Statements in this report addressing expectations, assumptions, beliefs, projections, future plans and strategies, future events, developments that we expect or anticipate will occur in the future, and future operating results, capital management, and dividend policy are forward-looking statements. Forward-looking statements are based upon management's beliefs, assumptions, and expectations as of the date of this report regarding future events and operating performance, taking into account all information currently available to us, and are applicable only as of the date of this report. Forward-looking statements generally can be identified by use of words such as "believe", "expect", "anticipate", "estimate", "plan", "may", "will", "intend", "should", "could" or similar expressions. We caution readers not to place undue reliance on our forward-looking statements, which are not historical facts and may be based on projections, assumptions, expectations, and anticipated events that do not materialize. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statement whether as a result of new information, future events, or otherwise. Forward-looking statements in this Quarterly Report on Form 10-Q may include, but are not limited to statements about: •Our business and investment strategy including our ability to generate acceptable risk-adjusted returns and our target investment allocations, and our views on the future performance of MBS and other investments; •Our views on the macroeconomic environment, monetary and fiscal policy, and conditions in the investment, credit, and derivatives markets; •Our views on the effect of actual or proposed actions of theFederal Reserve , theFOMC , or other central banks with respect to monetary policy (including the targeted Federal Funds Rate), and the potential impact of these actions on interest rates, inflation or unemployment; •The effect of regulatory initiatives of theFederal Reserve (including theFOMC ), theFederal Housing Finance Agency , other financial regulators, and other central banks; •Our financing strategy including our target leverage ratios, our use of TBA dollar roll transactions, and anticipated trends in financing costs including TBA dollar roll transaction costs, and our hedging strategy including changes to the derivative instruments to which we are a party, and changes to government regulation of hedging instruments and our use of these instruments; •Our investment portfolio composition and target investments; •Our investment portfolio performance, including the fair value, yields, and forecasted prepayment speeds of our investments; •The impact of the COVID-19 pandemic on the economy, as well as certain actions taken by federal, state and local governments in response to the pandemic, and on delinquencies in loans underlying our investments; •Our liquidity and ability to access financing, and the anticipated availability and cost of financing; •Our capital stock activity including the impact of stock issuances and repurchases; •The amount, timing, and funding of future dividends; •Our use of our tax NOL carryforward and other tax loss carryforwards;; •The status of pending litigation; •The competitive environment in the future, including competition for investments and the availability of financing; •Estimates of future interest expenses, including related to the Company's repurchase agreements and derivative instruments; •The status and effect of legislative reforms and regulatory rule-making or review processes, and the status of reform efforts and other business developments in the repurchase agreement financing market; •Market, industry and economic trends, and how these trends and related economic data may impact the behavior of market participants and financial regulators; •The financial position and credit worthiness of the depository institutions in which the Company's MBS and cash deposits are held; 48 -------------------------------------------------------------------------------- •The impact of applicable tax and accounting requirements on the us including our tax treatment of derivative instruments such as TBAs, interest rate swaps, options and futures; •Our future compliance with covenants in our master repurchase agreements, ISDA agreements, and debt covenants in our other contractual agreements; •Market interest rates and market spreads; and •Possible future effects of the COVID-19 pandemic. Forward-looking statements are inherently subject to risks, uncertainties and other factors that could cause our actual results to differ materially from historical results or from any results expressed or implied by such forward-looking statements. Not all of these risks and other factors are known to us. New risks and uncertainties arise over time, and it is not possible to predict those events or how they may affect us. The projections, assumptions, expectations or beliefs upon which the forward-looking statements are based can also change as a result of these risks or other factors. If such a risk or other factor materializes in future periods, our business, financial condition, liquidity and results of operations may vary materially from those expressed or implied in our forward-looking statements. While it is not possible to identify all factors that may cause actual results to differ from historical results or from any results expressed or implied by forward-looking statements, or that may cause our projections, assumptions, expectations or beliefs to change, some of those factors include the following: •the risks and uncertainties referenced in this Quarterly Report on Form 10-Q, especially those incorporated by reference into Part II, Item 1A, "Risk Factors," and in particular, adverse effects of the ongoing COVID-19 pandemic and any governmental or societal responses thereto, including the efficacy, distribution, availability and adoption rates of vaccines for COVID-19 and variants thereof; •our ability to find suitable reinvestment opportunities; •changes in domestic economic conditions; •changes in interest rates and interest rate spreads, including the repricing of interest-earning assets and interest-bearing liabilities; •our investment portfolio performance particularly as it relates to cash flow, prepayment rates and credit performance; •the impact on markets and asset prices from changes in theFederal Reserve's policies regarding the purchases of Agency RMBS, Agency CMBS, andU.S. Treasuries; •actual or anticipated changes inFederal Reserve monetary policy or the monetary policy of other central banks; •adverse reactions inU.S. financial markets related to actions of foreign central banks or the economic performance of foreign economies including in particularChina ,Japan , theEuropean Union , and theUnited Kingdom ; •uncertainty concerning the long-term fiscal health and stability ofthe United States ; •the cost and availability of financing, including the future availability of financing due to changes to regulation of, and capital requirements imposed upon, financial institutions; •the cost and availability of new equity capital; •changes in our leverage and use of leverage; •changes to our investment strategy, operating policies, dividend policy or asset allocations; •the quality of performance of third-party servicer providers of our loans and loans underlying our securities; •the level of defaults by borrowers on loans underlying MBS that we have purchased, or on loans which we have securitized; •changes in our industry; •increased competition; •changes in government regulations affecting our business; •changes or volatility in the repurchase agreement financing markets and other credit markets; •changes to the market for interest rate swaps and other derivative instruments, including changes to margin requirements on derivative instruments; •uncertainty regarding continued government support of theU.S. financial system andU.S. housing and real estate markets, or to reform theU.S. housing finance system including the resolution of the conservatorship of Fannie Mae and Freddie Mac; •the composition of theBoard of Governors of theFederal Reserve ; •systems failures or cybersecurity incidents; and •exposure to current and future claims and litigation. 49
--------------------------------------------------------------------------------
© Edgar Online, source