DYNEX CAPITAL, INC. 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 OVERVIEW
Dynex 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
Economic conditions during the second quarter of 2021 reversed direction from
the first quarter's recovery as the yield curve flattened and credit spreads
widened for Agency RMBS. Markets began to price the impact of potentially
tighter monetary conditions after commentary made by Federal Reserve officials
at the conclusion of its Federal Open Market Committee ("FOMC") meeting in June
indicated they were discussing the possibility of tapering its purchases of
assets including Agency RMBS. In addition, the concern over the impact of
variants of COVID-19 on real economic activity, along with technicals in the UST
market, drove yields lower during the second quarter, and the curve has
continued to flatten further so far into the third quarter of 2021. The 2-year
U.S. Treasury ("UST") rate rose 9 basis points while the 10-year fell 27 basis
points during the second quarter of 2021 and has dropped further since June 30,
2021 .
The table below shows changes in market spreads in basis points for certain
investment types in our MBS portfolio during the three months ended June 30,
2021 :
Second Quarter 2021 As of As of
Investment Type: Change in Spreads June 30, 2021 March 31, 2021
Agency RMBS: (1)
2.0% coupon 14 (6) (20)
2.5% coupon 17 1 (16)
3.0% coupon 25 27 2
3.5% coupon 32 40 8
4.0% coupon 43 54 11
Agency DUS (Agency CMBS) (2) (4) 18 22
Freddie K AAA IO (Agency CMBS IO) (2) (30) 65 95
AAA CMBS IO (Non-Agency CMBS IO) (2) (25) 105 130
(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.
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The charts below show the highest and lowest U.S. Treasury and swap rates during
the three months ended June 30, 2021 as well as the rates as of June 30, 2021
and March 31, 2021 :
[[Image Removed: dx-20210630_g1.jpg]]
[[Image Removed: dx-20210630_g2.jpg]]
We stated our expectations last quarter for a range-bound interest rate
environment with bouts of volatility and a potential for wider MBS spreads,
which largely played out during the second quarter of 2021. In response to this
volatility, we continued to focus on our leverage position and management of our
capital. Early in the second quarter, we reduced our investment portfolio when
spreads were tighter, reducing our leverage a full turn. Later in the second
quarter, we partially re-leveraged our balance sheet, using a portion of the
$68.3 million in capital we raised through ATM issuances to re-invest in lower
coupon Agency RMBS as spreads were widening. As discussed further below in
"Current Outlook", we believe market fundamentals and technicals remain positive
toward a steepening yield curve with longer-term interest rates moving higher as
the economy continues recovery in the medium term.
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--------------------------------------------------------------------------------Second Quarter 2021 Performance
The decline in our book value of$(1.32) per common share during the second quarter was the result of a comprehensive loss to common shareholders of$(31.4) million , which was primarily comprised of hedge losses of$(93.8) million due to the yield curve flattening. Partially offsetting the hedge losses, the fair value of the Company's investments including TBA securities increased$58.2 million as a result of the decline in longer-term interest rates. The majority of this increase is from our investment in TBA securities, which are highly liquid and continue to provide substantial returns at a lower implied cost of financing. In addition to the flattening yield curve, Agency RMBS credit spreads widened versus benchmarks. Though the widening offset a portion of the gains in fair value of MBS from declining longer-term rates, it also provided opportunities for us to purchase approximately$1.0 billion in specified pools and increase our average TBA investments by approximately$0.5 billion in the latter half of the second quarter. In addition to benefiting from an increase in fair value when spreads tighten, the premiums paid for securities are generally lower when spreads are wider, which results in lower premium amortization expense and higher yields on these securities. Net interest income of$12.1 million for the second quarter of 2021 was relatively unchanged from the first quarter of 2021, and net interest spread was flat at 1.87% versus the prior quarter. Interest income declined by$0.5 million due primarily to a smaller average balance of MBS at lower effective yields and a decline of$0.3 million in net prepayment penalty income from CMBS IO from the prior quarter. Though we purchased Agency RMBS of$0.8 million , net of sales, in the latter half of the second quarter, interest income for the period includes one month or less of interest earnings as these purchases settled either in June or were pending settlement as ofJune 30, 2021 . The decline in interest income was mostly offset by the decline of$0.4 million in interest expense from repurchase agreement financing costs. Our overall effective yield on investments declined to 2.10%, but was offset by a corresponding decline in the cost of financing on our repurchase agreements used to finance our investments. Core net operating income to common shareholders, a non-GAAP measure, increased$3.9 million to$16.3 million due to higher drop income from TBA securities and lower preferred stock dividends as a result of our redemption of the remaining shares of our Series B Preferred Stock in the first quarter of 2021. Our implied funding cost for TBA dollar roll transactions was approximately 49 basis points lower than our repurchase agreement financing rate for Agency RMBS during the second quarter of 2021, an increase of 10 basis points in specialness relative to the prior quarter. As a result, TBA dollar roll transactions contributed an 8 basis point increase to adjusted net interest spread, a non-GAAP measure, which was 1.95% for the second quarter of 2021. Current Outlook Our outlook for market conditions and the Company has not changed from the prior quarter. We believe that the global economy is still evolving through varied consequences of the pandemic coupled with the impact of massive fiscal and monetary stimulus. For the next few quarters, we believe rates will remain relatively range-bound near current levels. Over the next six-to-twelve months, we believe that the 10-year UST rate will most likely move higher in the range as we anticipate a global transition to a more fully reopened economy, a higher percentage of vaccinated populations, stable or rising inflation, and a rising supply of global sovereign bonds from central bank purchase tapering, continued deficit spending, and fiscal stimulus. In the intermediate term, we believe tapering of asset purchases by theFederal Reserve will cause spreads to widen across all asset classes, but especially spreads on lower quality assets. This is because asset tapering, while still growing the size of theFederal Reserve's balance sheet, represents a reduction of monetary stimulus. From a borrowing cost perspective, theFederal Reserve has indicated that theU.S. Federal Funds Target Rate will remain near zero until at least 2023, which means our financing costs should remain at current low levels until then. An environment where borrowing costs are anchored and the yield curve is reasonably steep with rates range-bound supports our ability to generate solid total economic returns to our shareholders. While there are risks that the 10-year UST rate moves outside the range or there is a sudden change inFederal Reserve policy, we believe the probability of either occurring in the near-term is relatively low. We have planned for other potential scenarios that may unfold, including the risk of an exogenous event, which we believe remains high. As a result, we are maintaining a lower leveraged capital structure, a highly liquid position, and are investing in highly liquid Agency RMBS and TBAs. We believe that we are entering a period where there will be opportunity 27 -------------------------------------------------------------------------------- to invest capital at wider spreads, and we are positioned with relatively low leverage on our capital with ample liquidity to add assets at attractive return profiles. Longer term, we maintain our belief that the demographics behind the housing sector continue to support our investment thesis of investing in high quality, highly liquidU.S. -based housing assets, and we maintain our focus on capital preservation while generating returns over the long term. 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: 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 core net operating income to common shareholders and adjusted net interest income to the related GAAP financial measures are provided below and within "Results of Operations". Management views core net operating income to common shareholders as an estimate of the Company's financial performance based on the effective yield of its investments, net of financing costs and other normal recurring operating income/expense, net. In addition to the non-GAAP reconciliation set forth below, which derives core net operating income to common shareholders from GAAP comprehensive income (loss) to common shareholders, core net operating income 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, and preferred dividends. 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 core net operating income 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 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: June 30, 2021 March 31, 2021 ($s in thousands except per share data) Comprehensive (loss) income to common shareholders$ (31,412) $ 47,227 Less: Change in fair value of investments (1) (17,362) 61,439 Change in fair value of derivative instruments, net (2) 65,117 (99,233) Preferred stock redemption charge - 2,987 Core net operating income to common shareholders$ 16,343 $ 12,420 Average common shares outstanding 31,973,587 26,788,693 Comprehensive income per common share $
(0.98) $ 1.76
28
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Core net operating income per common share $ 0.51 $ 0.46
Net interest income $ 12,118 $ 12,259
TBA drop income (3) 12,177 8,568
Adjusted net interest income $ 24,295 $ 20,827
Other operating expense, net (323)
(380)
General and administrative expenses (5,706)
(5,468)
Preferred stock dividends (1,923)
(2,559)
Core net operating income to common shareholders
(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.
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-20210630_g3.jpg]]
(1) Includes TBA positions at their implied market value, as if settled, of $2.4
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 of June 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 or U.S.
Government agency guarantee and servicer fees. Mortgage pass-through
certificates generally
29
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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 of June 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:
June 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% $ 907,767 $ 925,875 $ 919,889 10 13.2 % 7.60
2.5% 1,244,081 1,298,263 1,295,851 9 16.0 % 6.78
4.0% 208,875 215,146 225,168 39 44.8 % 3.24
TBA 2.0% 915,000 922,078 923,683 n/a n/a 7.51
TBA 2.5% 820,000 845,214 847,390 n/a n/a 5.63
15-year fixed-rate:
TBA 1.5% 375,000 377,864 378,267 n/a n/a 5.07
TBA 2.0% 200,000 205,609 206,086 n/a n/a 4.48
Total $ 4,670,723 $ 4,790,049 $ 4,796,334 12 19.0 % 6.47
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.
30
--------------------------------------------------------------------------------(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 of June 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.
The following table presents information about our CMBS investments by year of
origination as of the dates indicated:
June 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) $ 6,457 $ 6,273 18 5.76 % $ 9,132 $ 8,964 36 5.69 %
2009 to 2012 11,281 11,851 41 5.56 % 11,424 12,085 65 5.56 %
2013 to 2014 9,759 9,904 42 3.61 % 9,865 10,033 44 3.61 %
2015 118,870 120,126 62 2.88 % 155,760 157,137 69 2.85 %
2017 30,858 31,215 86 3.18 % 30,907 31,294 91 3.18 %
2019 19,702 19,976 146 3.13 % 19,702 19,988 151 3.12 %
$ 196,927 $ 199,345 70 3.24 % $ 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 $1.0 million as of June 30, 2021 and
December 31, 2020 .
CMBS IO. CMBS IO are interest-only securities issued as part of a CMBS
securitization and represent the right to receive a portion of the monthly
interest payments (but not principal cash flows) on the unpaid principal balance
of the underlying pool of commercial mortgage loans. We invest in both
Agency-issued and non-Agency issued CMBS IO. Agency-issued CMBS IO pools are
backed by multifamily housing loans, and our non-Agency issued CMBS IO are
backed by loans secured by a number of different property types including office
buildings, hospitality, and retail, among others. Since CMBS IO securities have
no principal associated with them, the interest payments received are based on
the unpaid principal balance of the underlying pool of mortgage loans, which is
often referred to as the notional amount. Yields on CMBS IO securities are
dependent upon the performance of the underlying loans. Similar to CMBS
described above, the Company receives prepayment compensation as most loans in
these securities have some form of prepayment protection from early repayment;
however, there are no prepayment protections if the loan defaults and is
partially or wholly repaid earlier because of loss mitigation actions taken by
the underlying loan servicer. Because Agency CMBS IO generally contain higher
credit quality loans, they have a lower risk of default than non-Agency CMBS IO.
The majority of our CMBS IO investments are investment grade-rated with the
majority rated 'AAA ' by at least one of the nationally recognized statistical
rating
31
--------------------------------------------------------------------------------organizations.
The following tables present our CMBS IO investments by year of origination as of the dates indicated:
June 30, 2021
Agency Non-Agency
($s in thousands) Amortized Cost Fair Value Remaining WAL (1) Amortized Cost Fair Value Remaining WAL (1)
Year of Origination:
2010-2012 $ 6,241 $ 6,106 5 $ 1,486 $ 1,505 5
2013 16,070 18,210 9 8,213 8,291 10
2014 20,567 21,495 18 41,931 43,169 16
2015 27,246 28,623 22 46,599 48,430 22
2016 20,647 21,667 27 14,975 15,163 16
2017 24,590 25,977 38 7,000 7,260 30
2018 3,589 3,922 57 - - -
2019 84,391 89,018 56 - - -
2020 3,028 3,105 48 - - -
2021 526 542 78 - - -
$ 206,895 $ 218,665 37 $ 120,204 $ 123,818 20
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 0.64% as of
June 30, 2021 and 0.56% as of December 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.
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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 since December 31, 2020 , are shown in the table below as of
June 30, 2021 :
June 30, 2021
($s in thousands) Fair Value Percentage of Portfolio
Property Type:
Retail $ 34,811 28.1 %
Office 26,907 21.7 %
Multifamily 20,834 16.8 %
Hotel 16,641 13.4 %
Mixed use 8,561 6.9 %
Other (1) 16,064 13.1 %
Total non-Agency CMBS IO $ 123,818 100.0 %
(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 ofJune 30, 2021 , approximately 86% of our MBS portfolio including TBA securities were hedged using short positions inU.S. Treasury futures, put options onU.S. Treasury futures, and interest rate swaptions compared to approximately 62% as ofDecember 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. 33 -------------------------------------------------------------------------------- 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 June 30, 2021 March 31, 2021
Net interest income $ 12,118 $ 12,259
Realized gain on sale of investments, net 2,008 4,697
Unrealized gain (loss) on investments, net 1,084 (980)
(Loss) gain on derivative instruments, net (52,940) 107,801
General and administrative expenses (5,706) (5,468)
Other operating expenses, net (323) (380)
Preferred stock dividends (1,923) (2,559)
Preferred stock redemption charges - (2,987)
Net (loss) income to common shareholders (45,682) 112,383
Other comprehensive income (loss) 14,270 (65,156)
Comprehensive (loss) income to common shareholders $
(31,412)
Net Interest Income Net interest income was relatively stable for the three months endedJune 30, 2021 compared to the three months endedMarch 31, 2021 , and net interest spread was flat at 1.87% versus the prior quarter. Interest income declined$(0.5) million for the second quarter of 2021 compared to the prior quarter due to a smaller average balance of assets at lower effective yields and a decline of$0.3 million in net prepayment penalty income from CMBS IO. Though we purchased Agency RMBS of$0.8 million , net of sales, in the latter half of the second quarter, interest income for the period includes one month or less of interest earnings as these purchases settled either in June or were pending settlement as ofJune 30, 2021 . The decline in interest income was mostly offset by the decline of$0.4 million in interest expense from repurchase agreement financing costs. The following table presents certain information about our interest-earning assets and interest-bearing liabilities and their performance for the periods indicated: 34 -------------------------------------------------------------------------------- Three Months Ended June 30, 2021 March 31, 2021 Effective Yield/ Effective Yield/ Interest Average Balance Cost of Interest Average Balance Cost of ($s in thousands) Income/Expense (1)(2) Funds (3)(4) Income/Expense (1)(2) Funds (3)(4) Interest-earning assets: Agency RMBS $ 7,373$ 1,863,420 1.58 % $ 7,381$ 1,821,920 1.62 % Agency CMBS 1,959 233,815 2.97 % 1,832 238,158 2.91 % CMBS IO (5) 3,918 339,288 4.24 % 4,516 365,891 4.33 % Non-Agency MBS and other investments 143 6,617 6.94 % 163 7,304 7.15 % Total: $ 13,393$ 2,443,140 2.10 % $ 13,892$ 2,433,273 2.17 % Interest-bearing liabilities: (6) (1,275) 2,155,200 (0.23) % (1,633) 2,158,121 (0.30) % Net interest income/net interest spread $ 12,118 1.87 % $ 12,259 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
June 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 $ (176) $ 168 $ - $ (8)
Agency CMBS (4) (14) 145 127
CMBS IO (2) (12) (278) (308) (598)
Non-Agency MBS and other investments (7) (9) (4) (20)
Change in interest income (199) (133) (167) (499)
Change in interest expense (349) (9) - (358)
Total net change in net interest income
$ (167) $ (141) (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. 35 -------------------------------------------------------------------------------- As mentioned previously, CMBS and CMBS IO 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. We earned$1.2 million in gross prepayment compensation for the three months endedJune 30, 2021 compared to$0.8 million for the three months endedMarch 31, 2021 . These amounts were offset by additional premium amortization adjustments of$(0.5) million and$0.1 million , respectively, resulting in net prepayment penalty income of$0.7 million for the three months endedJune 30, 2021 and$0.9 million for the three months endedMarch 31, 2021 . Adjusted Net Interest Income Please refer to "Non-GAAP Financial Measures" at the end of the "Executive Overview" section of this Quarterly Report on Form 10-Q for additional information about this financial measure used by management to evaluate results of operations. Three Months Ended June 30, 2021 March 31, 2021 ($s in thousands) Amount Rate Amount Rate Net interest income$ 12,118 1.87 %$ 12,259 1.87 % Add: TBA drop income (1) (2) 12,177 0.08 % 8,568 - % Adjusted net interest income$ 24,295 1.95 %$ 20,827 1.87 % (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. Adjusted net interest income increased for the three months endedJune 30, 2021 compared to the three months endedMarch 31, 2021 because we increased our average investment in TBA securities by approximately 29% during the second quarter, resulting in higher TBA drop income. The financing cost imputed in TBA dollar roll transactions continues to be lower than the average repurchase agreement financing rate, which 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 an implied financing costs dropping below 0%. The implied financing rate for our TBA long positions was (0.36)% compared to our repurchase agreement financing cost for specified pools of Agency RMBS of 0.13% for the three months endedJune 30, 2021 , an increase of 10 basis points in dollar roll specialness versus the prior quarter. As a result, TBA dollar roll transactions contributed 8 basis points to adjusted net interest spread of 1.95% for the second quarter of 2021. 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 recorded within "unrealized gain (loss) on investments, net" and "other comprehensive income (loss)" for the periods indicated: 36 -------------------------------------------------------------------------------- Three Months Ended ($s in thousands) June 30, 2021 March 31,
2021
MBS purchased after
86 (35)
Other 1
15
Unrealized gain (loss) on investments, net 1,084 (980) Agency RMBS 12,429 (60,175) Agency CMBS (259) (7,046) CMBS IO 2,148 2,121 Non-Agency other (48) (56) Other comprehensive income (loss) 14,270
(65,156)
Total unrealized gains (losses)$ 15,354 $
(66,136)
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. The following table provides information related to our
"realized gains (losses) on sales of investments, net" for the periods
indicated:
Three Months Ended
June 30, 2021 March 31, 2021
Amortized Realized Amortized Realized
($s in thousands) cost sold Gain cost sold Gain
Agency RMBS-designated as AFS $ 213,339 $ (759) $ 70,132 $ 4,697
Agency CMBS-designated as AFS 35,106 2,767 - -
Total $ 248,445 $ 2,008 $ 70,132 $ 4,697
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 second quarter of 2021 as longer-term
interest rates declined. However, we maintained our hedge position for a steeper
yield curve given management's macroeconomic view that market fundamentals
remain positive and point toward continued economic recovery in the medium term.
The following table provides information on our financial instruments accounted
for as derivative instruments for the periods indicated:
37
--------------------------------------------------------------------------------
Three Months Ended
($s in thousands) June 30, 2021 March 31, 2021 Change in fair value of interest rate hedges: Interest rate swaptions$ (19,062) $
57,763
U.S. Treasury futures (63,184)
95,647
Options onU.S. Treasury futures (11,531)
12,617
Total (loss) gain on interest rate hedges (93,777) 166,027 TBA dollar roll positions: Change in fair value (1) 28,660 (66,794) TBA drop income (2) 12,177 8,568 Total TBA dollar roll gain (loss), net 40,837
(58,226)
Total (loss) gain on derivative instruments, net
107,801
(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) June 30, 2021 March 31, 2021
Interest rate swaptions $ - $ 31,173
U.S. Treasury futures 36,679 21,397
Options on U.S. Treasury futures (3,633) 1,872
TBA long positions 16,309 (29,471)
Total realized gains (losses) on derivative instruments
General and Administrative Expenses General and administrative expenses increased$0.2 million for the three months endedJune 30, 2021 compared to the three months endedMarch 31, 2021 . This increase is attributable to a$0.1 million increase in compensation and benefits due to an increase in the accrual for annual bonuses based on company performance during the first six months of 2021 and a$0.1 million increase in other general and administrative expenses due to an increase in consulting expenses related to planning for implementation of new investment software, partially offset by a decline in accounting and legal fee expenses. Six Months EndedJune 30, 2021 Compared to the Six Months EndedJune 30, 2020 Net Interest Income Net interest income declined$(8.3) million for the six months endedJune 30, 2021 compared to the six months endedJune 30, 2020 because we held a smaller average balance of lower yielding investments during the first half of 2021 compared to the first half of 2020. Net interest spread increased 34 basis points for the six months endedJune 30, 2021 compared to the six months endedJune 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: 38 -------------------------------------------------------------------------------- Six Months Ended June 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 $ 14,754$ 1,842,785 1.60 % $ 28,895$ 2,073,379 2.79 % Agency CMBS 3,792 235,974 3.03 % 19,922 1,309,637 3.00 % CMBS IO (5) 8,434 352,516 4.45 % 9,968 461,988 4.03 % Non-Agency MBS and other investments (6) 305 6,959 7.44 % 891 9,944 7.83 % Total: $ 27,285$ 2,438,234 2.17 % $ 59,676$ 3,854,948 3.02 % Interest-bearing liabilities: (7) (2,908) 2,156,652 (0.27) % (26,952) 3,642,871 (1.46) % Net interest income/net interest spread $ 24,377 1.90 % $ 32,724 1.56 % (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 six months endedJune 30, 2020 includes$0.5 million of interest income from cash and cash equivalents. Average balance and effective yield for non-Agency MBS and other investments excludes cash and cash equivalents. (7) Interest-bearing liabilities consist primarily of repurchase agreement borrowings.
The following table presents the estimated impact on our net interest income due to changes in rate (effective yield/cost of funds) and changes in volume (average balance) of our interest-earning assets and interest-bearing liabilities for the periods indicated:
39
--------------------------------------------------------------------------------Six Months Ended
June 30 ,
2021 Compared to
Increase (Decrease) Due to Change In Total Change in
Prepayment Interest
($s in thousands) Rate Volume Adjustments (1) Income/Expense
Interest-earning assets:
Agency RMBS $ (10,933) $ (3,208) $ - $ (14,141)
Agency CMBS (166) (16,277) 313 (16,130)
CMBS IO (2) 658 (2,045) (147) (1,534)
Non-Agency MBS and other investments (59) (501) (26) (586)
Change in interest income $ (10,500) $ (22,031) $ 140 $ (32,391)
Change in interest expense (12,959) (11,085) - (24,044)
Total net change in net interest income
140 $ (8,347)
(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 financial measure used by management to evaluate results
of operations.
Six Months Ended
June 30,
2021 2020
($s in thousands) Amount Rate Amount Rate
Net interest income $ 24,377 1.90 % $ 32,724 1.56 %
Add: TBA drop income (1) (2) 20,745 0.03 % 2,535 - %
Add: net periodic interest benefit (3) - - % 1,957 0.10 %
Adjusted net interest income $ 45,122 1.93 % $ 37,216 1.66 %
(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 $7.9 million in adjusted net interest income for the six months
ended June 30, 2021 compared to the six months ended June 30, 2020 is due to our
increased investment in TBA securities at lower implied funding costs relative
to the six months ended June 30, 2020 , which resulted in an increase in TBA drop
income of $18.2 million . This increase in TBA drop income offset the decline of
$(8.3) million in net interest income and $(2.0) million in net periodic
interest benefit from interest rate swaps. As discussed previously, we have
increased our investment in TBA securities relative to prior periods due to
dollar roll specialness, and also given the current market environment. TBA
securities allow us more flexibility should we decide or find it necessary to
reduce leverage. The decline in net periodic interest benefit from interest rate
swaps is because we are not currently using interest rate swaps to hedge our
interest rate risk.
The following table discloses net premium amortization by MBS type for the
periods indicated:
40
--------------------------------------------------------------------------------
Six Months Ended
($s in thousands) June 30, 2021 June 30, 2020
Agency RMBS $ (7,450) $ (6,540)
Agency CMBS (419) (974)
CMBS IO (52,310) (56,372)
Non-Agency MBS 134 180
Total net premium amortization
Prepayment compensation from CMBS and CMBS IO was$2.0 million for the six months endedJune 30, 2021 compared to$0.9 million for the six months endedMarch 31, 2021 . Changes in Fair Value of Investments The following table provides details on unrealized gains or losses on our investments recorded within "unrealized gain (loss) on investments, net" and "other comprehensive income (loss)" for the periods indicated: Six Months Ended ($s in thousands) June 30, 2021 June 30,
2020
MBS purchased after December 31, 2020 $ 37 $
-
Mortgage loans held for investment 50
(20)
Other 17
(20)
Unrealized gain (loss) on investments, net 104 (40) Agency RMBS (47,746) (28,154) Agency CMBS (7,305) (54,251) CMBS IO 4,270 (9,495) Non-Agency other (105) (175) Other comprehensive loss (50,886) (92,075) Total unrealized losses$ (50,782) $ (92,115)
The following table provides information related to our "realized gains (losses) on sales of investments, net" for the periods indicated:
Six Months Ended
June 30, 2021 June 30, 2020
Amortized Realized Amortized Realized
($s in thousands) cost sold Gain cost sold Gain
Agency RMBS-designated as AFS
$ 75,823 Agency CMBS-designated as AFS 35,106 2,767 1,991,853 202,059 Total$ 318,577 $ 6,705 $ 4,104,486 $ 277,882 Gain (Loss) on Derivative Instruments, Net The following table provides information on our financial instruments accounted for as derivative instruments for the periods indicated: 41 -------------------------------------------------------------------------------- Six Months
Ended
($s in thousands) June 30, 2021 June 30, 2020 Change in fair value of interest rate hedges: Interest rate swaps (1) $ -$ (183,852) Interest rate swaptions 38,701 (573) U.S. Treasury futures 32,464 (19,377) Options on U.S. Treasury futures 1,086
(17,406)
Total gain (loss) on interest rate hedges 72,251 (221,208) TBA dollar roll positions: Change in fair value (2) (38,135) 14,543 TBA drop income (3) 20,745 2,535 Total TBA dollar roll (loss) gain, net (17,390)
17,078
Total gain (loss) on derivative instruments, net
(204,130)
(1) Amount for interest rate swaps for six months endedJune 30, 2020 is net of periodic interest benefit of$2.0 million . (2) Changes in fair value for TBA dollar roll positions include unrealized gains (losses) from open TBA contracts and realized gains (losses) on paired off or terminated positions. (3) TBA drop income represents a portion of the change in fair value and is calculated by multiplying the notional amount of the net TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates.
The following table provides information regarding realized gains (losses) on derivative instruments for the periods indicated:
Six Months Ended
($s in thousands) June 30, 2021 June 30, 2020
Interest rate swaps $ - $ (183,773)
Interest rate swaptions - (1,934)
U.S. Treasury futures 58,076 (15,168)
Options on U.S. Treasury futures (1,761) (13,234)
TBA long positions (13,162) 23,196
TBA short positions - (11,016)
Total realized gains (losses) on derivative instruments
General and Administrative Expenses General and administrative expenses increased$1.7 million for the six months endedJune 30, 2021 compared to the six months endedJune 30, 2020 due primarily to higher bonus accruals based on the Company's year-to-date performance and consulting fees related to planning for implementation of new investment software. 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 42 -------------------------------------------------------------------------------- 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$517.9 million as ofJune 30, 2021 compared to$415.3 million as ofDecember 31, 2020 . 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 6.7x shareholders' equity as ofJune 30, 2021 compared to 6.3x as ofDecember 31, 2020 . The increase in leverage during the first six months of 2021 resulted from a 50% increase in the cost basis of our investment in TBA securities as ofJune 30, 2021 compared toDecember 31, 2020 . This increase was partially offset by a 19% increase in our equity, which increased primarily as a result of capital raises during the first half of 2021. We include our TBA long positions 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. Management expects leverage to increase modestly over the next 6 months given current expectations of market conditions. In general, our leverage will increase if we are able to purchase investments with higher expected returns than currently exist today. Our repurchase agreement borrowings are principally uncommitted with terms renewable at the discretion of our lenders and have short-term maturities. 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 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 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 43 -------------------------------------------------------------------------------- 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 ofJune 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 ofJune 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 ofJune 30, 2021 , we had received cash collateral of$9.3 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 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 ofJune 30, 2021 , we had cash of$85.3 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 44 --------------------------------------------------------------------------------
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. 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 ofJune 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 other than as discussed above. 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 six months endedJune 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 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 endedJune 30, 2021 . 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 45 -------------------------------------------------------------------------------- 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 ), the FHFA, 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; •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. 46
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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 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 System ; •systems failures or cybersecurity incidents; and •exposure to current and future claims and litigation.
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