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Item 7A. Quantitative and Qualitative Disclosures About Market Risk

2021-02-26 compared with 2020-02-28 · 74 added, 51 removed, 71 unchanged (64% of the section changed)

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We seek to manage risks that we believe will impact our business including interest rates, liquidity, prepayments, credit quality and market value.

Many of these risks have become particularly heightened due to the COVID-19 pandemic and related economic and market conditions.

When managing these risks we consider the impact on our assets, liabilities and derivative positions.

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The following analysis includes forward-looking statements that assume that certain market conditions occur.

Actual results may differ materially from these projected results due to changes in our portfolio assets and borrowings mix and due to developments in the domestic and global financial and real estate markets.

Actual results may differ materially from these projections due to changes in our portfolio assets and borrowings mix and due to developments in the domestic and global financial, mortgage and real estate markets.

Developments in the financial markets include the likelihood of changing interest rates and the relationship of various interest rates and their impact on our portfolio yield, cost of funds and cash flows.

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Interest Rate Risk

Interest rates are sensitive to many factors, including governmental, monetary, tax policies, domestic and international economic conditions, and political or regulatory matters beyond our control.

Interest rates are sensitive to many factors, including governmental, monetary or tax policies, domestic and international economic conditions, and political or regulatory matters beyond our control.

Changes in interest rates affect the value of the assets we manage and hold in our investment portfolio and the variable-rate borrowings we use to finance our portfolio.

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As a result, our net interest income is particularly affected by changes in interest rates.

For example, we hold RMBS, some of which may have fixed rates or interest rates that adjust on various dates that are not synchronized to the adjustment dates on our repurchase agreements.

For example, we hold RMBS and loans, some of which may have fixed rates or interest rates that adjust on various dates that are not synchronized to the adjustment dates on our repurchase agreements.

In general, the re-pricing of our repurchase agreements occurs more quickly than the re-pricing of our variable-interest rate assets.

Thus, it is likely that our floating rate borrowings, such as our repurchase agreements, may react to interest rates before our RMBS because the weighted average next re-pricing dates on the related borrowings may have shorter time periods than that of the RMBS.

In addition, the interest rates on our Agency ARMs backed by hybrid ARMs may be limited to a “periodic cap,” or an increase of typically 1% or 2% per adjustment period, while our borrowings do not have comparable limitations.

Thus, it is likely that our floating rate financing, such as our repurchase agreements, may react to interest rates before our RMBS or loans because the weighted average next re-pricing dates on the related financing may have shorter time periods than that of the RMBS or loan.

Moreover, changes in interest rates can directly impact prepayment speeds, thereby affecting our net return on RMBS.

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Treasury securities with the goal of optimizing the earnings potential while seeking to maintain long term stable portfolio values.

We continually monitor the duration of our mortgage assets and have a policy to hedge the financing of those assets such that the net duration of the assets, our borrowed funds related to such assets, and related hedging instruments, is less than one year.

Given current market volatility and historically low interest rates, we do not currently have any hedges in place to mitigate the risk of rising interest rates.

We utilize a model-based risk analysis system to assist in projecting portfolio performances over a scenario of different interest rates.

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Changes in Net Interest Income

Changes in Interest Rates (basis points)

Changes in Net Interest Income

Interest rate changes may also impact our book value as our assets and related hedge derivatives are marked-to-market each quarter.

Generally, as interest rates increase, the value of our mortgage assets decreases, and conversely, as interest rates decrease, the value of such assets will increase.

Changes in Interest Rates (basis points) Changes in Net Interest Income

+200 $ (16,339)

+100 $ (3,970)

Interest rate changes may also impact our net book value as our assets and related hedge derivatives, if any are marked-to-market each quarter.

Generally, as interest rates increase, the value of our mortgage assets decreases, and conversely, as interest rates decrease, the value of such investments will increase.

In general, we expect that, over time, decreases in the value of our portfolio attributable to interest rate changes will be offset, to the degree we are hedged, by increases in the value of our interest rate swaps or other financial instruments used for hedging purposes, and vice versa.

However, the relationship between spreads on our assets and spreads on our hedging instruments may vary from time to time, resulting in an aggregate book value increase or decline.

However, the relationship between spreads on our assets and spreads on our hedging instruments may vary from time to time, resulting in a net aggregate book value increase or decline.

The interest rates for certain of our investments and a majority of our financing transactions are either explicitly or indirectly based on LIBOR.

On July 27, 2017, the United Kingdom Financial Conduct Authority announced that it intends to stop persuading or compelling banks to submit LIBOR rates after 2021.

At this time, it is not possible to predict the effect of such change, including the establishment of potential alternative reference rates, on the economy or markets we are active in either currently or in the future, or on any of our assets or liabilities whose interest rates are based on LIBOR.

We are in the process of evaluating the potential impact of a discontinuation of LIBOR after 2021 on our portfolio, as well as the related accounting impact.

However, we expect that throughout 2021, we will work closely with the entities that are involved in calculating the interest rates for our RMBS, our loan servicers for our floating rate loans, and with the various counterparties to our financing transactions in order to determine what changes, if any, are required to be made to existing agreements for these transactions.

Our net interest income, the fair value of our assets and our financing activities could be negatively affected by volatility in interest rates caused by uncertainties stemming from COVID-19.

A prolonged period of extremely volatile and unstable market conditions would likely increase our funding costs and negatively affect market risk mitigation strategies.

Higher income volatility from changes in interest rates could cause a loss of future net interest income and a decrease in current fair market values of our assets.

Fluctuations in interest rates will impact both the level of income and expense recorded on most of our assets and liabilities and the market value of all or substantially all of our interest-earning assets and interest-bearing liabilities, which in turn could have a material adverse effect on our net income, operating results, or financial condition.

Liquidity Risk

Liquidity is a measure of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain investments, pay dividends to our stockholders and other general business needs.

The primary liquidity risk we face arises from financing long-maturity assets with shorter-term borrowings primarily in the form of repurchase agreement financings.

The primary liquidity risk we face arises from financing long-maturity assets with shorter-term financings.

We recognize the need to have funds available to operate our business.

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We plan to meet liquidity through normal operations with the goal of avoiding unplanned sales of assets or emergency borrowing of funds.

We are subject to “margin call” risk under our repurchase agreements.

We are subject to “margin call” risk under nearly all of our repurchase agreements.

In the event the value of our assets pledged as collateral suddenly decreases, margin calls relating to our repurchase agreements could increase, causing an adverse change in our liquidity position.

Additionally, if one or more of our repurchase agreement counterparties chooses not to provide ongoing funding, we may be unable to replace the financing through other lenders on favorable terms or at all.

As such, we provide no assurance that we will be able to roll over or replace our repurchase agreements as they mature from time to time in the future.

See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” in this Annual Report on Form 10-K for further information about our liquidity and capital resource management.

As discussed throughout this Annual Report on Form 10-K, in March 2020, we observed unprecedented illiquidity in repurchase agreement financing and MBS markets which resulted in our receiving margin calls under our repurchase agreements that were well beyond historical norms.

We took a number of decisive actions in response to these conditions, including the sale of assets and termination of our interest rate swaps.

Because of this, we intend to place a greater emphasis on procuring longer-termed and/or more committed financing arrangements, such as securitizations and other term financings, which may involve greater expense relative to repurchase agreement funding.

We provide no assurance that we will be able in the future to access sources of capital that are attractive to us, that we will be able to roll over or replace our repurchase agreements or other financing instruments as they mature from time to time in the future or that we otherwise will not need to resort to unplanned sales of assets to provide liquidity in the future.

See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" and the other information in this Annual Report on Form 10-K for further information about our liquidity and capital resource management.

Derivative financial instruments are also subject to “margin call” risk.

For example, under our interest rate swaps, typically we pay a fixed rate to the counterparties while they pay us a floating rate.

If interest rates drop below the fixed rate we are paying on an interest rate swap, we may be required to post cash margin.

For example, under the interest rate swaps we have utilized, typically we would pay a fixed rate to the counterparties while they would pay us a floating rate.

If interest rates drop below the fixed rate we pay on an interest rate swap, we may be required to post cash margin.

Given current market volatility and historically low interest rates, we do not currently have any interest rate swaps in place.

Prepayment Risk

When borrowers repay the principal on their residential mortgage loans before maturity or faster than their scheduled amortization, the effect generally is to shorten the period over which interest is earned, and therefore, reduce the yield for residential mortgage assets purchased at a premium to their then current balance, as with our portfolio of Agency RMBS.

Conversely, residential mortgage assets purchased for less than their then current balance, such as our distressed residential mortgage loans, exhibit higher yields due to faster prepayments.

Furthermore, actual prepayment speeds may differ from our modeled prepayment speed projections impacting the effectiveness of any hedges we have in place to mitigate financing and/or fair value risk.

When borrowers repay the principal on their residential loans before maturity or faster than their scheduled amortization, the effect is to shorten the period over which interest is earned, and therefore, reduce the yield for residential mortgage assets purchased at a premium to their then current balance.

Conversely, residential mortgage assets purchased for less than their then current balance, such as many of our residential loans, exhibit higher yields due to faster prepayments.

Furthermore, actual prepayment speeds may differ from our modeled prepayment speed projections impacting the effectiveness of any hedges we may have in place to mitigate financing and/or fair value risk.

Generally, when market interest rates decline, borrowers have a tendency to refinance their mortgages, thereby increasing prepayments.

Our modeled prepayments will help determine the amount of hedging we use to offset changes in interest rates.

Our modeled prepayments will help determine the amount of hedging we use to off-set changes in interest rates.

If actual prepayment rates are higher than modeled, the yield will be less than modeled in cases where we paid a premium for the particular residential mortgage asset.

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Historically, we have not hedged 100% of our liability costs due to prepayment risk.

Credit risk is the risk that we will not fully collect the principal we have invested in our credit sensitive assets, including distressed residential and other residential mortgage loans, non-Agency RMBS, ABS, multi-family CMBS, preferred equity and mezzanine loan and joint venture equity investments, due to borrower defaults.

In selecting the credit sensitive assets in our portfolio, we seek to identify and invest in assets with characteristics that we believe offset or limit our exposure to borrower defaults.

Given the combination of low interest rates, government stimulus, high unemployment and other disruptions related to COVID-19, it has become more difficult to predict prepayment levels for the securities in our portfolio.

Credit risk is the risk that we will not fully collect the principal we have invested in our credit sensitive assets, including residential loans, non-Agency RMBS, ABS, multi-family CMBS, preferred equity and mezzanine loan and joint venture equity investments, due to borrower defaults or defaults by our operating partners in their payment obligations to us.

In selecting the credit sensitive assets in our portfolio, we seek to identify and invest in assets with characteristics that we believe offset or limit our exposure to defaults.

We seek to manage credit risk through our pre-acquisition or pre-funding due diligence process, and by factoring projected credit losses into the purchase price we pay or loan terms we negotiate for all of our credit sensitive assets.

In general, we evaluate relative valuation, supply and demand trends, prepayment rates, delinquency and default rates, vintage of collateral and macroeconomic factors as part of this process.

Nevertheless, these procedures do not guarantee unanticipated credit losses which would materially affect our operating results.

With respect to the $158.7 million of distressed residential mortgage loans at carrying value and $940.1 million of distressed residential mortgage loans at fair value owned by the Company at December 31, 2019 , we purchased the majority of these mortgage loans at a discount to par reflecting their distressed state or perceived higher risk of default.

Nevertheless, these procedures provide no assurance that we will not experience unanticipated credit losses which would materially affect our operating results.

Concern surrounding the ongoing COVID-19 pandemic and certain of the actions taken to reduce its spread has caused and may continue to cause business shutdowns, limitations on commercial activity and financial transactions, labor shortages, supply chain interruptions, increased unemployment and multi-family property vacancy and lease default rates, reduced profitability and ability for property owners to make loan, mortgage and other payments, and overall economic and financial market instability, all of which may cause an increase in the credit risk of our credit sensitive assets.

Although we did not see a significant increase in forbearance and delinquency rates in our portfolio during the year ended December 31, 2020, we expect delinquencies, defaults and requests for forbearance arrangements to rise as savings, incomes and revenues of borrowers, operating partners and other businesses become increasingly constrained from the resulting slow-down in economic activity and/or the reduction or elimination of current unemployment benefits or other policies intended to help keep borrowers and renters in their residences.

Any future period of payment deferrals, forbearance, delinquencies, defaults, foreclosures or losses will likely adversely affect our net interest income from preferred equity investments, residential loans, mezzanine loans and our RMBS, CMBS and ABS investments, the fair value of these assets, our ability to liquidate the collateral that may underlie these investments and obtain additional financing and the future profitability of our investments.

Further, in the event of delinquencies, defaults and foreclosure, regulatory changes and policies designed to protect borrowers and renters may slow or prevent us from taking remediation actions.

See Item 1A, "Risk Factors" and Item 7,“Management's Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources” in this Annual Report on Form 10-K and for more information on how COVID-19 may impact the credit quality of our credit sensitive assets and the credit quality of the underlying borrowers or operating partners.

With respect to our residential loans, we purchased the majority of these mortgage loans at a discount to par reflecting their distressed state or perceived higher risk of default.

In connection with our loan acquisitions, we or a third-party due diligence firm perform an independent review of the mortgage file to assess the state of mortgage loan files, the servicing of the mortgage loan, compliance with existing guidelines, as well as our ability to enforce the contractual rights in the mortgage.

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A seller who breaches these representations and warranties may be obligated to repurchase the loan from us.

In addition, as part of our process, we focus on selecting a servicer with the appropriate expertise to mitigate losses and maximize our overall return on these residential mortgage loans.

In addition, as part of our process, we focus on selecting a servicer with the appropriate expertise to mitigate losses and maximize our overall return on these residential loans.

This involves, among other things, performing due diligence on the servicer prior to their engagement, assigning the appropriate servicer on each loan based on certain characteristics and monitoring each servicer's performance on an ongoing basis.

We are exposed to credit risk in our investments in non-Agency RMBS, which includes first loss subordinated securities and certain IOs included in Consolidated SLST, totaling $965.9 million as of December 31, 2019 .

The non-Agency RMBS in our investment portfolio consist of either the senior, mezzanine, subordinated, and IO tranches in non-Agency securitizations.

The underlying collateral of these securitizations are predominantly residential credit assets, which may be exposed to various macroeconomic and asset-specific credit risks.

These securities have varying levels of credit enhancement which provides some structural protection from losses within the portfolio.

We are exposed to credit risk in our investments in CMBS, non-Agency RMBS and ABS.

These investments typically consist of either the senior, mezzanine or subordinate tranches in securitizations.

The underlying collateral of these securitizations may be exposed to various macroeconomic and asset-specific credit risks.

These securities have varying levels of credit enhancement which provide some structural protection from losses within the portfolio.

We undertake an in-depth assessment of the underlying collateral and securitization structure when investing in these assets, which may include modeling defaults, prepayments and loss across different scenarios.

As of December 31, 2019 , we own $824.5 million of multi-family CMBS comprised solely of first loss POs that are backed by commercial mortgage loans on multi-family properties at a weighted average amortized purchase price of approximately 47.6% of current par.

Prior to the acquisition of each of our multi-family CMBS comprised of first loss POs, the Company completed an extensive review of the underlying loan collateral, including loan level cash flow re-underwriting, site inspections on selected properties, property specific cash flow and loss modeling, review of appraisals, property condition and environmental reports, and other credit risk analysis.

We continue to monitor credit quality on an ongoing basis using updated property level financial reports provided by borrowers and periodic site inspection of selected properties.

We also reconcile on a monthly basis the actual bond distributions received against projected distributions to assure proper allocation of cash flow generated by the underlying loan pool.

As of December 31, 2019 , we own approximately $316.2 million of preferred equity, mezzanine loan and equity investments in owners of residential and multi-family properties.

In addition, we are exposed to credit risk in our preferred equity, mezzanine loan and equity investments in owners of residential and multi-family properties.

The performance and value of these investments depend upon the applicable operating partner’s or borrower’s ability to effectively operate the multi-family and residential properties, that serve as the underlying collateral, to produce cash flows adequate to pay distributions, interest or principal due to us.

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Additionally, the Company's preferred equity and equity investments typically provide us with various rights and remedies to protect our investment.

In March 2017, the Company exercised such rights and remedies with respect to Riverchase Landing and The Clusters and effectively assumed control of both entities.

In March 2018, the Company successfully resolved its investment in Riverchase Landing with the sale of the entity’s multi-family apartment community and full redemption of the Company’s preferred equity investment.

In February 2019, the Company successfully resolved its investment in The Clusters with the sale of the entity’s multi-family apartment community and full redemption of the Company’s preferred equity investment.

Fair Value Risk

Changes in interest rates also expose us to market value (fair value) fluctuation on our assets, liabilities and hedges.

While a significant amount of our assets (when excluding all Consolidated K-Series and Consolidated SLST assets other than the securities we actually own) that are measured on a recurring basis are determined using Level 2 fair values, we own certain assets, such as our multi-family CMBS first loss POs and residential mortgage loans, for which fair values may not be readily available if there are no active trading markets for the instruments.

In such cases, fair values would only be derived or estimated for these investments using various valuation techniques, such as computing the present value of estimated future cash flows using discount rates commensurate with the risks involved.

Changes in interest rates, market liquidity, credit quality and other factors also expose us to market value (fair value) fluctuation on our assets, liabilities and hedges.

For certain of our credit sensitive assets, fair values may only be derived or estimated for these investments using various valuation techniques, such as computing the present value of estimated future cash flows using discount rates commensurate with the risks involved.

However, the determination of estimated future cash flows is inherently subjective and imprecise.

Moreover, the uncertainty over the ultimate impact that the COVID-19 pandemic will have on the global economy generally, and on our business in particular, makes any estimates and assumptions inherently less certain than they would be absent the current and potential impacts of the COVID-19 pandemic.

The uncertainties stemming from the pandemic created unprecedented illiquidity and volatility in the financial markets.

As a result, our market value (fair value) risk has significantly increased.

Minor changes in assumptions or estimation methodologies can have a material effect on these derived or estimated fair values.

Our fair value estimates and assumptions are indicative of the interest rate environments as of December 31, 2019 and do not take into consideration the effects of subsequent interest rate fluctuations.

We note that the fair values of our investments in derivative instruments will be sensitive to changes in market interest rates, interest rate spreads, credit spreads and other market factors.

The value of these investments can vary and has varied materially from period to period.

Our fair value estimates and assumptions are indicative of the interest rate and business environments as of December 31, 2020 and do not take into consideration the effects of subsequent changes.

The following describes the methods and assumptions we use in estimating fair values of our financial instruments:

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The table below presents the sensitivity of the fair value and net duration changes of our portfolio as of December 31, 2020, using a discounted cash flow simulation model assuming an instantaneous interest rate shift.

Application of this method results in an estimation of the fair market value change of our assets, liabilities and hedging instruments per 100 basis point (“bp”) shift in interest rates.

The use of hedging instruments is a critical part of our interest rate risk management strategies, and the effects of these hedging instruments on the market value of the portfolio are reflected in the model’s output.

Application of this method results in an estimation of the fair market value change of our assets, liabilities and hedging instruments per 100 basis point shift in interest rates.

The use of hedging instruments has historically been a critical part of our interest rate risk management strategies.

This analysis also takes into consideration the value of options embedded in our mortgage assets including constraints on the re-pricing of the interest rate of assets resulting from periodic and lifetime cap features, as well as prepayment options.

Assets and liabilities that are not interest rate-sensitive such as cash, payment receivables, prepaid expenses, payables and accrued expenses are excluded.

Changes in assumptions including, but not limited to, volatility, mortgage and financing spreads, prepayment behavior, defaults, as well as the timing and level of interest rate changes will affect the results of the model.

Changes in assumptions including, but not limited to, volatility, mortgage and financing spreads, prepayment behavior, credit conditions, defaults, as well as the timing and level of interest rate changes will affect the results of the model.

Therefore, actual results are likely to vary from modeled results.

Fair Value Changes

Changes in Interest Rates

Changes in Fair Value

(basis points)

(dollar amounts in thousands)

Changes in Interest Rates Changes in Fair Value Net Duration

(basis points) (dollar amounts in thousands)

+200 $ (63,808) 2.66

+100 $ (40,842) 2.37

-100 $ 63,651 2.62

It should be noted that the model is used as a tool to identify potential risk in a changing interest rate environment but does not include any changes in portfolio composition, financing strategies, market spreads or changes in overall market liquidity.

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Accordingly, we make extensive use of an earnings simulation model to further analyze our level of interest rate risk.

Capital Market Risk

We are exposed to risks related to the equity capital markets, and our related ability to raise capital through the issuance of our common stock, preferred stock or other equity instruments.

We are also exposed to risks related to the debt capital markets, and our related ability to finance our business through credit facilities or other debt instruments.

As a REIT, we are required to distribute a significant portion of our taxable income annually, which constrains our ability to accumulate operating cash flow and therefore may require us to utilize debt or equity capital to finance our business.

We seek to mitigate these risks by monitoring the debt and equity capital markets to inform our decisions on the amount, timing, and terms of capital we raise.

The ongoing COVID-19 pandemic has resulted in volatility that has been extreme at times in a variety of global markets, including the U.S.

financial, mortgage and real estate markets.

In reaction to these tumultuous market conditions, various banks and other financing participants restricted or limited lending activity and requested margin posting or repayments where applicable.

Although these conditions have subsided somewhat during the year ended December 31, 2020, we expect these conditions to remain volatile and uncertain at varying levels for the near future and this may adversely affect our ability to access capital to fund our operations, meet our obligations and make distributions to our stockholders.

Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-K

Item 7A. Quantitative and Qualitative Disclosures About Market Risk