Item 7. Management’s Discussion and Analysis
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Executive Summary
We are a Maryland real estate investment trust, or "REIT," formed in August 2012 that specializes in acquiring, investing in, and managing residential mortgage- and real estate-related assets. Our primary objective is to generate attractive current yields and risk-adjusted total returns for our shareholders by making investments that we believe compensate us appropriately
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for the risks associated with them. We seek to attain this objective by constructing and actively managing a portfolio consisting primarily of residential mortgage-backed securities, or "RMBS," for which the principal and interest payments are guaranteed by a U.S. government agency or a U.S. government-sponsored entity, or "Agency RMBS," and, to a lesser extent, RMBS that do not carry such guarantees, or "non-Agency RMBS," such as RMBS backed by prime jumbo, Alternative A-paper, manufactured housing, and subprime residential mortgage loans. We also may opportunistically acquire other types of mortgage- and real estate-related asset classes, such as commercial mortgage-backed securities, or "CMBS," residential mortgage loans, mortgage servicing rights, or "MSRs," and credit risk transfer securities, or "CRTs." We believe that being able to combine Agency RMBS with non-Agency RMBS and other mortgage- and real estate-related asset classes enables us to balance a range of mortgage-related risks.
We were formed through an initial strategic venture among affiliates of Ellington Management Group, L.L.C., an investment management firm and registered investment adviser with a 25-year history of investing in a broad spectrum of residential and commercial mortgage-backed securities, or "MBS," and related derivatives, with an emphasis on the RMBS market, and the Blackstone Tactical Opportunity Funds, or the "Blackstone Funds." As of December 31, 2019 , the Blackstone Funds owned approximately 25% of our outstanding common shares. We are externally managed and advised by our Manager, an affiliate of Ellington.
We use leverage in our Agency RMBS strategy and, while we have not done so meaningfully to date, we may use leverage in our non-Agency RMBS strategy as well, although we expect such leverage to be lower. We have financed our purchases of Agency RMBS exclusively through repurchase agreements, which we account for as collateralized borrowings. As of December 31, 2019 , we had outstanding borrowings under repurchase agreements in the amount of $1.3 billion with 15 counterparties.
We have elected to be taxed as a REIT for U.S. federal income tax purposes. Accordingly, we generally will not be subject to U.S. federal income taxes on our taxable income that we distribute currently to our shareholders as long as we maintain our qualification as a REIT. We intend to conduct our operations so that neither we nor any of our subsidiaries is required to register as an investment company under the Investment Company Act of 1940, as amended, or the "Investment Company Act."
As of December 31, 2019 , our book value per share was $12.91, as compared to $12.30 as of December 31, 2018.
Trends and Recent Market Developments
Market Overview
•
After raising the target range for the federal funds rate four times in 2018, the U.S. Federal Reserve, or "Federal Reserve," elected to maintain the range of 2.25%–2.50% during the first half of 2019, before lowering the range by 25 basis points at each of its July, September, and October meetings, to the current range of 1.50%–1.75%. These were the first reductions since 2008 and were in response to uncertainties around global growth and trade negotiations. At its final meeting of the year, in December 2019, the Federal Reserve elected to leave the target range unchanged.
•
In March 2019, the Federal Reserve announced that over the following six months it would gradually end the tapering of its U.S. Treasury security reinvestments. According to the plan, beginning in May, the monthly tapering of U.S. Treasury security reinvestments would decrease to $15 billion, from $30 billion, and the tapering would end altogether at the end of September. Additionally, the tapering of Agency RMBS would continue at $20 billion per month, but beginning in October, monthly paydowns from Agency RMBS up to the $20 billion monthly cap would be reinvested in U.S. Treasury securities. Then, in July, the Federal Reserve announced that it would end the tapering of its U.S. Treasury security reinvestments on August 1, 2019, two months earlier than previously planned. It also announced that it would reinvest principal payments from Agency RMBS into U.S. Treasury securities, up to $20 billion per month, and that it would reinvest principal payments in excess of $20 billion into Agency RMBS. The Federal Reserve confirmed this plan at its December meeting.
•
During the week of September 16, 2019, interest rates on overnight repo spiked to unusually high levels. In response, the Federal Reserve conducted overnight and term repo operations to provide liquidity to the repo market, and repo rates normalized as a result. To help prevent future spikes in overnight repo rates, the Federal Reserve began buying short-term U.S. Treasury bills in October, and committed to continue purchasing them at least into the second quarter of 2020. The Federal Reserve also committed to continue these repo operations through January 2020 to address any year-end liquidity issues. Repo markets remained relatively stable in the fourth quarter of 2019, allaying fears of year-end volatility.
•
LIBOR rates, which drive many of our financing costs, steadily declined during 2019 before increasing modestly in December. For the year, one-month LIBOR decreased 74 basis points to 1.76% at year end, and three-month LIBOR fell 90 basis points to 1.91%, a 15 basis point positive spread, as compared to a 30 basis point positive spread at the
45
end of 2018. However, at several points during 2019, in anticipation of near-term interest rate cuts by the Federal Reserve, the spread between one- and three-month LIBOR inverted.
•
Over the course of 2019, interest rates declined across the U.S. Treasury yield curve, with the two-year U.S. Treasury yield decreasing 92 basis points to finish the year at 1.57%, and the ten-year U.S. Treasury yield declining 76 basis points to 1.92%. During one week in the third quarter, the spread between the two-year U.S. Treasury yield and ten-year U.S. Treasury yield inverted, which had not happened since June 2007. As of the end of the third quarter, the entire two-month through five-year segment of the U.S. Treasury yield curve was inverted. During the fourth quarter, the yield curve normalized, and the spread between the two-year and ten-year U.S. Treasury yields was 35 basis points at year end, its steepest level in more than 18 months.
•
Mortgage rates declined sharply during the first eight months of the year, before increasing moderately going into year end. The Freddie Mac survey 30-year mortgage rate declined 106 basis points between December 31, 2018 and September 5, 2019, before increasing 25 basis points to end the year at 3.74%. With falling mortgage rates, Agency RMBS prepayment rates surged, increasing from 6.6% in January to 21.2% in October, before retracing to 17.0% in December.
•
U.S. real GDP increased at an estimated annualized rate of 3.1% in the first quarter, 2.0% in the second quarter, 2.1% in the third quarter, and 2.1% in the fourth quarter. Total unemployment declined throughout the year, falling to 3.5% as of year-end 2019, as compared to 3.9% as of year-end 2018.
•
Each of the Bloomberg Barclays US MBS Index ("BB MBS Index"), Bloomberg Barclays US Corporate Bond Index ("BB IG Index"), and Bloomberg Barclays US Corporate High Yield Bond Index ("BB HY Index") generated positive returns for each quarter of 2019; and for the full year, each generated excess returns (on a duration-adjusted basis) over the Bloomberg Barclays US Treasury Index ("BB UST Index"). During 2019, the BB MBS Index generated a positive return of 6.35% and an excess return of 0.61%; the BB IG Index generated a positive return of 14.5% and an excess return of 6.76%; and the BB HY Index generated a positive return of 14.3% and an excess return of 9.3%.
Changing market sentiment around central bank policies, trade negotiations, global growth prospects, and geopolitical tensions drove market fluctuations during 2019, but over the course of the year most asset classes performed well, as interest rates ratcheted tighter and the yield curve remained flat, and at times, inverted.
During the first quarter of the year, the market weakness of December 2018 reversed course, and most fixed income and equity assets performed well. Dovish messaging from the Federal Reserve soothed the stock and bond markets and sparked a market rally; domestic equity indexes rose, yield spreads on most credit assets and many Agency assets tightened, and market volatility declined. Interest rates were range-bound for the first two months of the year before dropping considerably in March. At March 31, 2019 the yield on the ten-year U.S. Treasury note had declined to 2.41%, down 83 basis points from early November 2018. Meanwhile, the yield curve continued to flatten, with a portion of the curve even inverting for a week in March, again stoking fears of a full yield curve inversion, and whether that might signal a looming recession. The Federal Reserve appeared to end its rate hiking cycle and also announced a slowdown of its balance sheet runoff in March; in Europe, the European Central Bank ("ECB") introduced new stimulus measures in response to slowing growth, including a recession in Italy.
Moving into the second quarter, volatility remained low, and equities and many credit assets continued to perform well in April. Meanwhile, declining interest rates continued to drive increases in actual and projected prepayments, which in turn led to modest widening of Agency RMBS yield spreads and increases in pay-ups on specified pools, trends that would continue through most of 2019. Volatility returned to the markets in May, however, as global trade tensions escalated. By the end of May, the Merrill Lynch Option Volatility Estimate Index, or "MOVE Index," which had just reached an all-time low in March, spiked to its highest level in more than two years. Meanwhile, domestic equities sold off, yield spreads on most fixed income assets widened, and interest rates plummeted. Over the course of the month, the S&P 500 declined 6% while the yield on the ten-year U.S. Treasury fell 38 basis points. Both the BB IG Index and BB HY Index underperformed relative to the BB UST Index, while the BB MBS Index had its worst performance relative to U.S. Treasuries since November 2016. In June, interest rate futures markets implied a near-certain probability of a rate cut in July, which spurred a broad rally across most asset classes. Long-term U.S. Treasury yields continued their precipitous decline, with the ten-year yield dropping below 2% for the first time since November 2016. In Europe, the ECB signaled that it was ready to launch another round of stimulus, and the total amount of negative-yielding sovereign bonds reached $13 trillion globally.
In July, the market was optimistic about U.S./China trade negotiations, and anticipating an interest rate cut by the Federal Reserve, domestic equities hit record highs. On July 31, the Federal Reserve indeed cut short term rates by 25 basis points, and announced an end to its U.S. Treasury security portfolio runoff two months early. Sentiment flipped in August, however, and significant market volatility returned, as messaging from the Federal Reserve shifted hawkish, concerns over global growth intensified, and U.S. trade negotiations with China grew tense following China's devaluation of its currency. During the month,
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the MOVE Index hit a 3.5-year high, and the VIX volatility index spiked to its highest level since the beginning of the year. Meanwhile, domestic equities fell, interest rates plummeted, various parts of the yield curve inverted, and yield spreads on many fixed income assets fluctuated. Over the course of the month, the S&P 500 declined by 1.8% while the yield on the ten-year U.S. Treasury fell by 52 basis points, finishing the month below the yield on the two-year U.S. Treasury.
The Federal Reserve responded to the increased volatility by pledging more monetary stimulus should the global slowdown damage the U.S. economy, while several central banks around the globe also responded by cutting interest rates. Moving into September, volatility subsided; the VIX and MOVE indexes declined, domestic equities recovered, and U.S. Treasury yields rose. The ECB cut its short-term rate in September, its first cut since 2016, and announced a quantitative easing program. Later in the month, the Federal Reserve cut its short term rate again, though the decision was not unanimous, clouding the outlook for future reductions. Domestic equity indexes posted positive returns for the month, and medium-term and long-term U.S. Treasury yields rose.
Markets remained steady in the fourth quarter. Trade concerns eased with the announcement that the U.S. and China had reached agreement on "Phase One" of a trade deal in principle, and with the signing of the U.S.–Mexico–Canada Agreement. Meanwhile, accommodative monetary policy continued globally with a third rate cut from the Federal Reserve, the ECB restarting asset purchases, and additional policy support in China. Domestic equity indexes set new record highs and volatility was low as the VIX hit its low point for the year in November, and the ten-year traded in a 41-basis point range for the quarter, as compared to a range of 133 basis points during the year's first three quarters. Interest rates drifted up modestly, slowing prepayments in November and December and supporting agency yield spreads, and the yield curve steepened moderately going into year end.
Over the course of 2019, market optimism over global stimulus, including three interest rate cuts by the Federal Reserve, and progress on trade negotiations seemed to prevail over various macroeconomic concerns including slowing global growth, the Federal Reserve signaling an end to interest rate cuts, geopolitical tensions, and an upcoming U.S. presidential election. Coming off of a weak December in 2018, virtually all investment classes performed well over 2019. Domestic equities had one of the best years of the decade, with the NASDAQ up 35%, the S&P up 29%, and the Dow Jones Industrial Average up 22%. The BB IG Index and BB HY Index each generated returns over 14% and significant excess returns to the BB UST Index. Safer assets rallied as well, with the BB MBS Index generating positive absolute and excess returns to the BB UST Index, despite falling mortgage rates and significant increases in prepayments; gold prices appreciating 18%; and the yield on the ten-year U.S. Treasury note reaching a 3-year low in September, before finishing the year below 2%.
Portfolio Overview and Outlook
As of December 31, 2019 , our mortgage-backed securities portfolio consisted of $1.241 billion of fixed-rate Agency "specified pools," $33.3 million of Agency RMBS backed by adjustable rate mortgages, or "Agency ARMs," $99.9 million of Agency reverse mortgage pools, $18.2 million of Agency interest only securities, or "Agency IOs," and $8.9 million of non-Agency RMBS. Specified pools are fixed-rate Agency pools consisting of mortgages with special characteristics, such as mortgages with low loan balances, mortgages backed by investor properties, mortgages originated through the government-sponsored "Making Homes Affordable" refinancing programs, and mortgages with various other characteristics.
Our overall RMBS portfolio decreased by 9% to $1.402 billion as of December 31, 2019 , as compared to $1.540 billion as of December 31, 2018. Our overall debt-to-equity ratio, adjusted for unsettled purchases and sales, decreased to 8.1:1 as of December 31, 2019 from 9.2:1 as of December 31, 2018. Our debt-to-equity ratio may fluctuate period over period based on portfolio management decisions, market conditions, capital markets activities, and the timing of security purchase and sale transactions.
Despite fluctuations in interest rates and yield spreads, increasing prepayment rates, and at times an inverted yield curve, our Agency RMBS portfolio had excellent performance in 2019. Pay-ups on our specified pools steadily increased during the year, and along with declining interest rates, helped generate net realized and unrealized gains on our portfolio. Pay-ups are price premiums for specified pools relative to their TBA counterparts, and reflect the prepayment protection that specified pools provide. TBAs are forward-settling Agency RMBS where the mortgage pass-through certificates to be delivered are "To-Be-Announced." The decline in mortgage rates and associated increase in actual and projected prepayments during the year drove the expansion of pay-ups. Average pay-ups on our specified pools increased to 2.05% as of December 31, 2019 , as compared to 1.86% as of September 30, 2019, 1.56% as of June 30, 2019, 0.99% as of March 31, 2019, and 0.58% as of December 31, 2018.
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At different points in 2019, in response to market opportunities, we either increased or decreased our net mortgage assets-to-equity ratio—which we define as the net aggregate market value of our mortgage-backed securities (including the underlying market values of our long and short TBA positions) divided by total shareholders' equity—by varying the sizes of our net short TBA position and/or our long RMBS portfolio. The following table summarizes our net mortgage assets-to-equity ratio and provides additional details, for each of the following period ends, to illustrate these fluctuations.
Notional Amount of Long TBAs
Notional Amount of Short TBAs
Fair Value of Mortgage-backed Securities
Net Short TBA Underlying Market Value (1)
Net Mortgage Assets-to-Equity Ratio
($ In thousands)
December 31, 2019
$
70,447
$
(246,955
)
$
1,401,778
$
(183,369
)
7.6:1
September 30, 2019
106,465
(301,223
)
1,394,568
(202,014
)
7.7:1
June 30, 2019
259,155
(332,583
)
1,459,452
(74,780
)
9.0:1
March 31, 2019
216,234
(367,422
)
1,492,261
(152,342
)
8.5:1
December 31, 2018
95,054
(289,012
)
1,540,296
(197,213
)
8.7:1
(1)
Market value represents the current market value of the underlying Agency RMBS (on a forward delivery basis) as of period end.
During the year we continued to hedge interest rate risk, primarily through the use of interest rate swaps, short positions in TBAs, U.S. Treasury securities, and futures. The decline in interest rates during the year generated net realized and unrealized losses on our interest rate hedges.
We expect to continue to target specified pools that, taking into account their particular composition and based on our prepayment projections, should: (1) generate attractive yields relative to other Agency RMBS and U.S. Treasury securities, (2) have less prepayment sensitivity to government policy shocks, and/or (3) create opportunities for trading gains once the market recognizes their value, which for newer pools may come only after several months, when actual prepayment experience can be observed. We believe that our research team, proprietary prepayment models, and extensive databases remain essential tools in our implementation of this strategy.
Our non-Agency RMBS performed well during the year, driven by strong net interest income and net realized and unrealized gains. Fundamentals underlying non-Agency RMBS remain strong, led by a stable housing market. Our total investment in non-Agency RMBS was $8.9 million and $11.2 million as of December 31, 2019 and 2018, respectively. To the extent that more attractive entry points develop in non-Agency RMBS, we may increase our capital allocation to this sector.
The following table summarizes prepayment rates for our portfolio of fixed-rate specified pools (excluding those backed by reverse mortgages) for the three-month periods ended December 31, 2019, September 30, 2019, June 30, 2019, March 31, 2019, and December 31, 2018.
Three-Month Period Ended
December 31, 2019
September 30, 2019
June 30,
2019
March 31, 2019
December 31, 2018
Three-Month Constant Prepayment Rates
14.9%
14.5%
9.6%
6.0%
6.6%
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The following table provides details about the composition of our portfolio of fixed-rate specified pools (excluding those backed by reverse mortgages) as of December 31, 2019 and 2018.
December 31, 2019
December 31, 2018
Coupon
Current Principal
Fair Value
Weighted Average Loan Age (Months)
Current Principal
Fair Value
Weighted
Average Loan
Age (Months)
(In thousands)
(In thousands)
Fixed-rate Agency RMBS:
15-year fixed-rate mortgages:
2.50
$
4,900
$
4,953
64
$
—
$
—
—
3.00
33,474
34,537
62
6,905
6,905
47
3.50
110,637
115,902
31
106,128
107,564
22
4.00
23,480
24,944
28
22,504
23,062
16
4.50
859
895
123
—
—
—
Total 15-year fixed-rate mortgages
173,350
181,231
38
135,537
137,531
22
20-year fixed-rate mortgages:
4.00
—
—
—
7,267
7,505
42
5.00
1,276
1,385
16
—
—
—
Total 20-year fixed-rate mortgages
1,276
1,385
16
7,267
7,505
42
30-year fixed-rate mortgages:
3.00
34,052
34,858
42
25,703
25,158
38
3.03
312
323
90
440
433
78
3.25
849
884
36
976
984
24
3.28
101
104
90
222
217
78
3.50
213,367
224,427
45
241,264
242,232
33
3.75
3,054
3,179
29
3,251
3,289
17
4.00
335,843
356,323
36
435,855
446,919
26
4.50
230,635
246,829
32
329,446
342,813
19
5.00
124,558
134,235
27
111,267
117,328
20
5.50
45,374
48,674
19
68,454
72,477
8
6.00
8,306
9,042
15
20,169
21,664
4
Total 30-year fixed-rate mortgages
996,451
1,058,878
35
1,237,047
1,273,514
24
Total fixed-rate Agency RMBS
$
1,171,077
$
1,241,494
35
$
1,379,851
$
1,418,550
24
Prices on our Agency RMBS portfolio generally rose during the year ended December 31, 2019 and we had total net realized and unrealized gains on our Agency RMBS of $51.9 million, or $4.16 per share. Our Agency RMBS portfolio turnover was 52% for the year.
During the year ended December 31, 2019 , we continued to hedge interest rate risk, primarily through the use of interest rate swaps and short positions in TBAs, U.S. Treasury securities, and futures. For the year, we had total net realized and unrealized losses of $(33.0) million, or $(2.65) per share, on our interest rate hedging portfolio, as interest rates declined. In our hedging portfolio, the relative proportion, based on 10-year equivalents, of net short positions in TBAs decreased year over year relative to our other interest rate hedges. 10-year equivalents for a group of positions represent the amount of 10-year U.S. Treasury securities that would be expected to experience a similar change in market value under a standard parallel move in interest rates. The relative makeup of our interest rate hedging portfolio can change materially from period to period.
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After giving effect to aggregate dividends during the year of $1.18 per share, our book value per share increased to $12.91 as of December 31, 2019 , from $12.30 as of December 31, 2018, and we had an economic return of 14.6% for the year ended December 31, 2019 . Economic return is computed by adding back dividends declared to ending book value per share, and comparing that amount to book value per share as of the beginning of the quarter.
Our net Agency premium as a percentage of the fair value of our specified pool holdings is one metric that we use to measure the overall prepayment risk of our specified pool portfolio. Net Agency premium represents the total premium (excess of market value over outstanding principal balance) on our specified pool holdings less the total premium on related net short TBA positions. The lower our net Agency premium, the less we believe that our specified pool portfolio is exposed to market-wide increases in Agency RMBS prepayments. As of December 31, 2019 and 2018, our net Agency premium as a percentage of fair value of our specified pool holdings was approximately 5.3% and 2.7%, respectively. Excluding TBA positions used to hedge our specified pool holdings, our Agency premium as a percentage of fair value was approximately 5.8% and 2.9% as of December 31, 2019 and 2018, respectively. Our Agency premium percentage and net Agency premium percentage may fluctuate from period to period based on a variety of factors, including market factors such as interest rates and mortgage rates, and, in the case of our net Agency premium percentage, based on the degree to which we hedge prepayment risk with short TBAs. We believe that our focus on purchasing pools with specific prepayment characteristics provides a measure of protection against prepayments.
We believe that our adaptive and active style of portfolio management is well suited to the current MBS market environment, which continues to be shaped by interest rate risk, prepayment risk, shifting central bank and government policies, regulatory changes, and developing technologies.
Financing
As of December 31, 2019, the weighted average borrowing rate on our repurchase agreements declined to 2.00% from 2.56% as of December 31, 2018. For the year ended December 31, 2019 , however, our average borrowing cost on repo increased to 2.52% as compared to 2.06% for the year ended December 31, 2018.
While large banks still dominate the repo market, non-bank firms, not subject to the same regulations as banks, are active in providing repo financing. Most of our outstanding repo financing is still provided by banks and bank affiliates; however, we have also entered into repo agreements with non-bank dealers. In general, we continue to see strong appetite and competitive terms from both types of lenders.
Our debt-to-equity ratio was 8.1:1 as of December 31, 2019 , as compared to 9.6:1 as of December 31, 2018. Adjusted for unsettled security purchases and sales, our debt-to-equity ratio was 8.1:1 as of December 31, 2019 , as compared to 9.2:1 as of December 31, 2018. Our debt-to-equity ratio may fluctuate period over period based on portfolio management decisions, market conditions, capital markets activities, and the timing of security purchase and sale transactions.
Critical Accounting Policies
Our consolidated financial statements have been prepared in conformity with generally accepted accounting principles in the United States of America, or "U.S. GAAP." Entities in which we have a controlling financial interest, through ownership of the majority of the entities' voting equity interests, or through other contractual rights that give us control, are consolidated by us. All inter-company balances and transactions have been eliminated.
Certain of our critical accounting policies require management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We believe that all of the decisions and assessments upon which our consolidated financial statements are based were reasonable at the time made based upon information available to us at that time. We rely on our Manager and Ellington's experience and analysis of historical and current market data in order to arrive at what we believe to be reasonable estimates. See Note 2 of the notes to our consolidated financial statements included in this Annual Report on Form 10-K for a complete discussion of our significant accounting policies. We have identified our most critical accounting policies to be the following:
Valuation : For financial instruments that are traded in an "active market," the best measure of fair value is the quoted market price. However, many of our financial instruments are not traded in an active market. Therefore, management generally uses third-party valuations when available. If third-party valuations are not available, management uses other valuation techniques, such as the discounted cash flow methodology. Summary descriptions, for the various categories of financial instruments, of the valuation methodologies management uses in determining fair value of our financial instruments are detailed in Note 2 of the notes to our consolidated financial statements. Management utilizes such methodologies to assign a good faith
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fair value (the estimated price that, in an orderly transaction at the valuation date, would be received to sell an asset, or paid to transfer a liability, as the case may be) to each such financial instrument.
See the notes to our consolidated financial statements for more information on valuation techniques used by management in the valuation of our assets and liabilities.
Accounting for Securities : Investments in mortgage-backed securities are recorded on trade date. We have chosen to make a fair value election pursuant to ASC 825-10, Financial Instruments , for our mortgage-backed securities portfolio. Electing the fair value option allows us to record changes in fair value in our Consolidated Statement of Operations, which, in our view, more appropriately reflects the results of our operations for a particular reporting period as all securities activities will be recorded in a similar manner. As such, the mortgage-backed securities are recorded at fair value on our Consolidated Balance Sheet and the period change in fair value is recorded in current period earnings on our Consolidated Statement of Operations as a component of Change in net unrealized gains (losses) on securities.
Realized gains or losses on sales of mortgage-backed securities are included in Net realized gains (losses) on securities on the Consolidated Statement of Operations, and are recorded at the time of disposition. The cost of positions sold is calculated based on identified cost. Principal write-offs are generally treated as realized losses.
Interest Income : Coupon interest income on investment securities is accrued based on the outstanding principal balance and the current coupon rate on each security. We amortize purchase premiums and accrete purchase discounts on our fixed income investments using the effective interest method.
Our accretion of discounts and amortization of premiums on securities for U.S. federal and other tax purposes is likely to differ from the accounting treatment under U.S. GAAP of these items as described above.
See the Note 2 of the notes to our consolidated financial statements for more information on the assumptions and methods that we use to amortize purchase premiums and accrete purchase discounts.
Income Taxes : We made an election to be taxed as a REIT for U.S. federal income tax purposes. As a REIT, we generally are not subject to corporate-level federal and state income tax on net income we distribute to our shareholders within the prescribed timeframes. To qualify as a REIT, we must meet a number of organizational and operational requirements, including a requirement to distribute at least 90% of our taxable income to our shareholders. Even if we qualify as a REIT, we may be subject to certain federal, state, local and foreign taxes on our income and property, and to federal income and excise taxes on our undistributed taxable income. If we fail to qualify as a REIT, and do not qualify for certain statutory relief provisions, we will be subject to U.S. federal, state, and local income taxes and may be precluded from qualifying as a REIT for the four taxable years following the year in which we fail to qualify as a REIT.
We follow the authoritative guidance on accounting for and disclosure of uncertainty on tax positions, which requires management to determine whether a tax position is more likely than not to be sustained upon examination by the applicable taxing authority, including resolution of any related appeals or litigation processes, based on the technical merits of the position. For uncertain tax positions, the tax benefit to be recognized is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. We did not have any unrecognized tax benefits resulting from tax positions related to the current period or our open tax years. In the normal course of business, we may be subject to examination by federal, state, local, and foreign jurisdictions, where applicable, for the current period and our open tax years. We may take positions with respect to certain tax issues which depend on legal interpretation of facts or applicable tax regulations. Should the relevant tax regulators successfully challenge any such positions; we might be found to have a tax liability that has not been recorded in the accompanying consolidated financial statements. Also, management's conclusions regarding the authoritative guidance may be subject to review and adjustment at a later date based on changing tax laws, regulations, and interpretations thereof. There were no amounts accrued for penalties or interest as of or during the periods presented in the consolidated financial statements included in this Annual Report on Form 10-K.
Recent Accounting Pronouncements
Refer to the notes to our consolidated financial statements for a description of relevant recent accounting pronouncements.
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Financial Condition
Investment portfolio
The following tables summarize our securities portfolio as of December 31, 2019 and 2018:
December 31, 2019
December 31, 2018
(In thousands)
Current Principal
Fair Value
Average Price (1)
Cost
Average Cost (1)
Current Principal
Fair Value
Average Price (1)
Cost
Average Cost (1)
Agency RMBS (2)
15-year fixed-rate mortgages
$
173,350
$
181,231
$
104.55
$
176,848
$
102.02
$
135,537
$
137,531
$
101.47
$
138,844
$
102.44
20-year fixed-rate mortgages
1,276
1,385
108.54
1,356
106.27
7,267
7,505
103.28
7,842
107.91
30-year fixed-rate mortgages
996,451
1,058,878
106.26
1,041,550
104.53
1,237,047
1,273,514
102.95
1,294,517
104.65
ARMs
32,122
33,255
103.53
33,049
102.89
17,752
18,243
102.77
18,969
106.86
Reverse mortgages
91,560
99,934
109.15
98,407
107.48
70,991
75,904
106.92
77,322
108.92
Total Agency RMBS
1,294,759
1,374,683
106.17
1,351,210
104.36
1,468,594
1,512,697
103.00
1,537,494
104.69
Non-Agency RMBS
10,947
8,851
80.85
6,924
63.25
13,755
11,233
81.66
9,431
68.56
Total RMBS (2)
1,305,706
1,383,534
105.96
1,358,134
104.02
1,482,349
1,523,930
102.81
1,546,925
104.36
Agency IOs
n/a
18,244
n/a
17,795
n/a
n/a
16,366
n/a
16,740
n/a
Total mortgage-backed securities
1,401,778
1,375,929
1,540,296
1,563,665
U.S. Treasury securities sold short
(2,100
)
(2,070
)
98.57
(2,070
)
98.57
(360
)
(374
)
103.89
(362
)
100.56
Reverse repurchase agreements
2,084
2,084
100.00
2,084
100.00
379
379
100.00
379
100.00
Total
$
1,401,792
$
1,375,943
$
1,540,301
$
1,563,682
(1)
Represents the dollar amount (not shown in thousands) per $100 of current principal of the price or cost for the security.
(2)
Excludes Agency IOs.
The vast majority of our capital is allocated to our Agency RMBS strategy, which includes investments in Agency pools and Agency collateralized mortgage obligations, or "CMOs." As of both December 31, 2019 and 2018, investments in non-Agency RMBS constituted a relatively small portion of our total investments.
Our most prevalent method of financing RMBS is through short-term repos, which generally have maturities of 180 days or less. The weighted average lives of the RMBS that we own are generally much longer. Consequently, the weighted average term of our repurchase agreement financings will almost always be substantially shorter than the expected average maturity of our RMBS. This mismatch in maturities, together with the uncertainty of RMBS prepayments, and other potential changes in timing and/or amount of cash flows on our RMBS assets, creates the risk that changes in interest rates will cause our financing costs with respect to our RMBS to increase relative to the income on our RMBS over the term of our investments.
52
Financial Derivatives
The following table summarizes our portfolio of financial derivative holdings as of December 31, 2019 and 2018:
(In thousands)
December 31, 2019
December 31, 2018
Financial derivatives–assets, at fair value:
TBA securities purchase contracts
$
48
$
794
TBA securities sale contracts
74
—
Fixed payer interest rate swaps
3,543
10,201
Fixed receiver interest rate swaps
81
844
Futures
434
—
Total financial derivatives–assets, at fair value
4,180
11,839
Financial derivatives–liabilities, at fair value:
TBA securities purchase contracts
(71
)
—
TBA securities sale contracts
(233
)
(2,536
)
Fixed payer interest rate swaps
(1,632
)
(6,190
)
Fixed receiver interest rate swaps
(15
)
(3
)
Futures
(96
)
(7,830
)
Total financial derivatives–liabilities, at fair value
(2,047
)
(16,559
)
Total
$
2,133
$
(4,720
)
Pursuant to our hedging program, we engage in a variety of interest rate hedging activities that are designed to reduce the interest rate risk with respect to the liabilities incurred to acquire or hold RMBS. These interest rate hedges generally seek to reduce the interest rate sensitivity of our liabilities or, in other words, reduce the volatility of our financing cost over time attributable to interest rate changes. Our interest rate hedging transactions may include:
•
Interest rate swaps (a contract exchanging a variable rate for a fixed rate, or vice versa);
•
Interest rate swaptions (options to enter into interest rate swaps at a future date);
•
TBA forward contracts on Agency pass-through certificates;
•
Short sales of U.S. Treasury securities;
•
Eurodollar and U.S. Treasury futures; and
•
Other derivatives.
We generally enter into these transactions to offset the potential adverse effects of rising interest rates on short-term repurchase agreements. Our repurchase agreements generally have maturities of up to 180 days and carry interest rates that are determined by reference to LIBOR or correlated benchmark rates for those same periods. As each then-existing fixed-rate repo borrowing matures, it will generally be replaced with a new fixed-rate repo borrowing based on market interest rates established at that future date.
In the case of interest rate swaps, most of our agreements are structured such that we receive payments based on a variable interest rate and make payments based on a fixed interest rate. The variable interest rate on which payments are received is generally calculated based on various reset mechanisms for LIBOR. To the extent that our future repo borrowing costs continue to be highly correlated with LIBOR, our LIBOR-based interest rate swap agreements help to reduce the variability of our overall repo borrowing costs, thus reducing risk to the extent we hold fixed-rate assets that are financed with repo borrowings. While for the time being we are continuing to enter into LIBOR-based interest rate swap agreements, we are currently considering entering into SOFR-based interest rate swap agreements as well.
In the case of TBAs, most of our positions are short TBA positions with a negative duration, meaning that as interest rates rise, the value of the short position increases, so these positions serve as a hedge against increases in interest rates. In the event that interest rates rise, the increase in value of the short TBA position serves to offset corollary increases in our current and/or future borrowing costs under our repurchase agreements. While we use TBAs to hedge interest rate risk, we also hold net long positions in certain TBA securities as a means of acquiring exposure to Agency RMBS.
53
As of December 31, 2019 , as part of our interest rate hedging program, we also held short positions in U.S. Treasury securities, with a total principal amount of $2.1 million and a fair value of $2.1 million . As of December 31, 2018, we also held short positions in U.S. Treasury securities, with a total principal amount of $0.4 million and a fair value of $0.4 million .
The composition and relative mix of our hedging instruments may vary from period to period given the amount of our liabilities outstanding or anticipated to be entered into, the overall market environment and our view as to which instruments best enable us to execute our hedging goals.
Leverage
The following table summarizes our outstanding liabilities under repurchase agreements as of December 31, 2019 and 2018. We had no other borrowings outstanding.
December 31, 2019
December 31, 2018
Weighted Average
Weighted Average
Remaining Days to Maturity
Borrowings Outstanding
Interest Rate
Remaining Days to Maturity
Borrowings Outstanding
Interest Rate
Remaining Days to Maturity
(In thousands)
30 days or less
$
513,092
2.10
%
15
$
512,505
2.45
%
16
31-60 days
549,541
1.91
45
594,199
2.56
46
61-90 days
233,639
1.97
74
359,861
2.71
75
91-120 days
—
—
—
—
—
—
121-150 days
—
—
—
—
—
—
151-180 days
—
—
—
14,996
2.72
177
Total
$
1,296,272
2.00
%
39
$
1,481,561
2.56
%
44
We finance our assets with what we believe to be a prudent amount of leverage, which will vary from time to time based upon the particular characteristics of our portfolio, availability of financing, and market conditions. As of December 31, 2019 and 2018, our total debt-to-equity ratio was 8.1:1 and 9.6:1, respectively. Collateral transferred with respect to our outstanding repo borrowings as of December 31, 2019 and 2018 had an aggregate fair value of $1.3 billion and $1.6 billion, respectively. Adjusted for unsettled security purchases and sales, our debt-to-equity ratio was 8.1:1 and 9.2:1 as of December 31, 2019 and 2018, respectively. Our debt-to-equity ratio may fluctuate period over period based on portfolio management decisions, market conditions, capital markets conditions, and the timing of security purchase and sale transactions.
Shareholders' Equity
As of December 31, 2019 , our shareholders' equity increased to $160.8 million from $153.8 million as of December 31, 2018. This increase principally consisted of net income of $22.3 million, partially offset by dividends declared of $(14.7) million, and common shares repurchased of $(0.7) million. As of December 31, 2019 , our book value per share was $12.91, as compared to $12.30 as of December 31, 2018.
54
Results of Operations for the Years Ended December 31, 2019 and 2018
The following table summarizes our results of operations for the years ended December 31, 2019 and 2018:
Year Ended December 31,
(In thousands except for per share amounts)
2019
2018
Interest Income (Expense)
Interest income
$
43,846
$
54,553
Interest expense
(35,276
)
(32,519
)
Net interest income
8,570
22,034
Expenses
Management fees to affiliate
2,365
2,547
Other operating expenses
2,923
2,961
Total expenses
5,288
5,508
Other Income (Loss)
Net realized and change in net unrealized gains (losses) on securities
51,511
(35,768
)
Net realized and change in net unrealized gains (losses) on financial derivatives
(32,537
)
7,947
Total Other Income (Loss)
18,974
(27,821
)
Net Income (Loss)
$
22,256
$
(11,295
)
Net Income (Loss) Per Common Share
$
1.79
$
(0.88
)
Core Earnings
Core Earnings consists of net income (loss), excluding realized and change in net unrealized gains and (losses) on securities and financial derivatives, and excluding, if applicable, any non-recurring items of income or loss. Core Earnings also excludes the effect of the Catch-up Premium Amortization Adjustment on interest income. The Catch-up Premium Amortization Adjustment is a quarterly adjustment to premium amortization triggered by changes in actual and projected prepayments on our Agency RMBS (accompanied by a corresponding offsetting adjustment to realized and unrealized gains and losses). The adjustment is calculated as of the beginning of each quarter based on our then-current assumptions about cashflows and prepayments, and can vary significantly from quarter to quarter. Core Earnings includes net realized and change in net unrealized gains (losses) associated with periodic settlements on interest rate swaps.
Core Earnings is a supplemental non-GAAP financial measure. We believe that Core Earnings provides information useful to investors because it is a metric that we use to assess our performance and to evaluate the effective net yield provided by the portfolio. Moreover, one of our objectives is to generate income from the net interest margin on the portfolio, and Core Earnings is used to help measure the extent to which this objective is being achieved. In addition, we believe that presenting Core Earnings enables our investors to measure, evaluate and compare our operating performance to that of our peer companies. However, because Core Earnings is an incomplete measure of our financial results and differs from net income (loss) computed in accordance with GAAP, it should be considered as supplementary to, and not as a substitute for, net income (loss) computed in accordance with GAAP.
In previous periods, we presented two related supplemental non-GAAP financial measures, which we referred to as "Core Earnings" and "Adjusted Core Earnings." Subsequent to September 30, 2019, we modified our definition of Core Earnings to exclude the effect of the Catch-up Premium Amortization Adjustment. This new definition of Core Earnings now matches the definition of what we previously presented as Adjusted Core Earnings, and so we will no longer present a supplemental non-GAAP financial measure called "Adjusted Core Earnings." As a result, when comparing Core Earnings for periods ending on or after December 31, 2019 against periods ending on or before September 30, 2019, "Core Earnings" as presented in those later periods should be compared against "Adjusted Core Earnings" as presented in those earlier periods. These changes are intended to help investors focus on what we believe is the more useful supplemental non-GAAP financial measure when measuring and evaluating our operating performance, and when comparing our operating performance to that of our peer companies. Similarly, net interest margin for the year ended December 31, 2019 (and future periods) should be compared against adjusted net interest margin as presented in earlier periods.
55
The following table reconciles, for the years ended December 31, 2019 and 2018, Core Earnings (based on the newly modified definition of "Core Earnings" described above) to the line on the Consolidated Statement of Operations entitled Net Income (Loss), which we believe is the most directly comparable GAAP measure:
Year Ended December 31,
(In thousands except for share amounts)
2019
2018 (1)
Net Income (Loss)
$
22,256
$
(11,295
)
Adjustments:
Net realized (gains) losses on securities
(2,280
)
23,377
Change in net unrealized (gains) losses on securities
(49,231
)
12,391
Net realized (gains) losses on financial derivatives
38,975
(19,378
)
Change in net unrealized (gains) losses on financial derivatives
(6,438
)
11,431
Net realized gains (losses) on periodic settlements of interest rate swaps
1,262
1,037
Change in net unrealized gains (losses) on accrued periodic settlements of interest rate swaps
850
(432
)
Negative (positive) component of interest income represented by Catch-up Premium Amortization Adjustment
5,903
38
Subtotal
(10,959
)
28,464
Core Earnings
$
11,297
$
17,169
Weighted Average Shares Outstanding
12,461,054
12,811,366
Core Earnings Per Share
$
0.91
$
1.34
(1)
Conformed to current period presentation.
Net Income (Loss)
Net income (loss) for the year ended December 31, 2019 was $22.3 million , as compared to $(11.3) million for the year ended December 31, 2018 . The year-over-year reversal in net income (loss) was primarily due to a reversal from Total Other (Loss) for the year ended December 31, 2018 , to Total Other Income for the year ended December 31, 2019 , partially offset by a decline in net interest income.
Interest Income
Our portfolio as of both December 31, 2019 and 2018 consisted primarily of Agency RMBS, and to a lesser extent, non-Agency RMBS. Before interest expense, we earned approximately $42.4 million and $53.4 million in interest income on these securities for the years ended December 31, 2019 and 2018, respectively. The year-over-year decrease in interest income primarily resulted from lower average holdings on our Agency RMBS portfolio, combined with a larger negative Catch-up Premium Amortization Adjustment, both of which decreased interest income. The Catch-up Premium Amortization Adjustment causes variability in our interest income and portfolio yields. For the years ended December 31, 2019 and 2018, we had a negative Catch-up Premium Amortization Adjustment of approximately $(5.9) million and $(38) thousand, respectively, which decreased interest income. Excluding the Catch-up Premium Amortization Adjustments, the weighted average yield of our overall portfolio was 3.29% and 3.30% for the years ended December 31, 2019 and 2018, respectively.
The following table details our interest income, average holdings of yield-bearing assets, and weighted average yield based on amortized cost for the years ended December 31, 2019 and 2018:
Agency (1)
Non-Agency (1)
Total (1)
(In thousands)
Interest Income
Average Holdings
Yield
Interest Income
Average Holdings
Yield
Interest Income
Average Holdings
Yield
Year ended December 31, 2019
$
41,487
$
1,461,487
2.84
%
$
892
$
7,763
11.49
%
$
42,379
$
1,469,250
2.88
%
Year ended December 31, 2018
$
52,123
$
1,608,210
3.24
%
$
1,261
$
8,980
14.04
%
$
53,384
$
1,617,190
3.30
%
(1)
Amounts exclude interest income on cash and cash equivalents (including when posted as margin) and long U.S. Treasury securities.
56
Interest Expense
For the years ended December 31, 2019 and 2018, the majority of interest expense that we incurred was related to our repo borrowings, which we use to finance our assets. We also incur interest expense in connection with our short positions in U.S. Treasury securities as well as on our counterparties' cash collateral held by us. Our total interest expense for the year ended December 31, 2019 was $35.3 million , of which $34.6 million represented interest expense on our repo borrowings and $0.6 million represented interest expense related primarily to our short positions in U.S. Treasury securities. Our total interest expense for the year ended December 31, 2018 was $32.5 million , of which $31.3 million represented interest expense on our repo borrowings and $1.2 million represented interest expense related primarily to our short positions in U.S. Treasury securities. The year-over-year increase in our total interest expense resulted mainly from higher rates on our repo borrowings stemming from the increase in short-term interest rates and wider spreads, partially offset by lower average outstanding borrowings. Our average outstanding repo borrowings for the year ended December 31, 2019 was $1.38 billion , and we had an average cost of funds on repo borrowings of 2.52% . Our average outstanding repo borrowings for the year ended December 31, 2018 was $1.52 billion , and we had an average cost of funds on repo borrowings of 2.06% .
The following table shows information related to our average cost of funds (1) for the years ended December 31, 2019 and 2018.
Repurchase
Agreements
Interest Rate
Swaps (2)
Short U.S. Treasury Securities (2)
Total (2)
Average Borrowed Funds
Interest Expense
Average
Cost of
Funds
Net periodic expense paid or payable
Average
Cost of
Funds
Interest expense
Average
Cost of
Funds
Interest and net periodic expense paid or payable
Average
Cost of
Funds
(In thousands)
Year ended December 31, 2019
$
1,376,089
$
34,640
2.52
%
$
(2,103
)
(0.15
)%
$
621
0.04
%
$
33,158
2.41
%
Year ended December 31, 2018
$
1,520,354
$
31,291
2.06
%
$
(580
)
(0.04
)%
$
1,170
0.08
%
$
31,881
2.10
%
(1)
This metric does not take into account other instruments that we use to hedge interest rate risk, such as TBAs, swaptions, and futures.
(2)
As an alternative cost of funds measure, we add to our repo borrowing cost the net periodic amounts paid or payable by us on our interest rate swaps and the interest expense we incur on our short positions in U.S. Treasury securities, and express the total as a percentage of our average outstanding repurchase agreement borrowings.
For the years ended December 31, 2019 and 2018, average one-month LIBOR was 2.22% and 2.02%, respectively. For the years ended December 31, 2019 and 2018, average six-month LIBOR was 2.32% and 2.49%, respectively. For the year ended December 31, 2019 , the weighted average yield of our portfolio of Agency and non-Agency RMBS excluding the impact of the Catch-up Premium Amortization Adjustment was 3.29%, while our total average cost of funds, including interest rate swaps and short U.S. Treasury securities, was 2.41% , resulting in a net interest margin of 0.88%. By comparison, for the year ended December 31, 2018 , the weighted average yield of our Agency and non-Agency RMBS excluding the impact of the Catch-up Premium Amortization Adjustment was 3.30%, while our average cost of funds, including interest rate swaps and short U.S. Treasury securities, was 2.10% , resulting in a net interest margin of 1.20%.
Management Fees
For years ended December 31, 2019 and 2018, our management fee expense was approximately $2.4 million and $2.5 million , respectively. The decrease in management fee was primarily due to a smaller capital base year over year. Management fees are calculated based on our shareholders' equity at the end of each quarter.
Other Operating Expenses
Other operating expenses, as presented above, include professional fees, compensation expense, insurance expense, and various other expenses incurred in connection with the operation of our business. For the years ended December 31, 2019 and 2018, our other operating expenses were approximately $2.9 million and $3.0 million, respectively.
Other Income (Loss)
Other income (loss) consists of net realized and net change in unrealized gains (losses) on securities and financial derivatives. For the year ended December 31, 2019 , Other income (loss) was $19.0 million , consisting of net realized and change in net unrealized gains of $51.5 million on our securities, primarily our Agency RMBS, partially offset by net realized
57
and change in net unrealized losses of $(32.5) million on our financial derivatives. The increase in prices on our Agency RMBS holdings, primarily as a result of the decrease in interest rates during the year ended December 31, 2019 , led to significant gains on our securities portfolio. The decrease in interest rates also led to losses on our interest rate hedges, including net realized and unrealized losses of $(21.5) million on our interest rate swaps, $(5.8) million on our futures, and $(5.1) million on our TBAs. For the year ended December 31, 2019 , as measured by sales and excluding paydowns, we turned over approximately 52% of our Agency RMBS portfolio and, as a result of these sales, we generated net realized gains of $2.8 million on our Agency RMBS portfolio.
Other income (loss) for the year ended December 31, 2018 was $(27.8) million and consisted of net realized and change in net unrealized losses of $(35.8) million on our securities, primarily our Agency RMBS, partially offset by net realized and change in net unrealized gains of $7.9 million on our financial derivatives. During the year ended December 31, 2018, the increase in interest rates and overall decline in RMBS prices led to significant realized and unrealized losses on our securities portfolio, as well as significant realized and unrealized net gains on our interest rate hedges. The net realized and unrealized losses on securities primarily consisted of $(40.2) million of net losses on our Agency RMBS, partially offset by net gains of $4.0 million on our net short U.S. Treasury securities; while the net realized and unrealized gains on our financial derivatives primarily included net gains of $14.4 million from our net TBA short positions and interest rate swaps, partially offset by net losses on our futures of $(6.3) million. For the year ended December 31, 2018, as measured by sales and excluding paydowns, we turned over approximately 72% of our Agency RMBS portfolio and, as a result of these sales, we generated net realized losses of $(29.3) million on our Agency RMBS portfolio.
Liquidity and Capital Resources
Liquidity refers to our ability to meet our cash needs, including repaying our borrowings, funding and maintaining RMBS and other assets, paying dividends, and other general business needs. Our short-term (one year or less) and long-term liquidity requirements include acquisition costs for assets we acquire, payment of our management fee, compliance with margin requirements under our repurchase agreements, TBA and other financial derivative contracts, repayment of repurchase agreement borrowings to the extent we are unable or unwilling to extend our repurchase agreements, the payment of dividends, and payment of our general operating expenses. Our capital resources primarily include cash on hand, cash flow from our investments (including monthly principal and interest payments received on our RMBS and proceeds from the sale of RMBS), borrowings under repurchase agreements, and proceeds from equity offerings. We expect that these sources of funds will be sufficient to meet our short-term and long-term liquidity needs.
We borrow funds in the form of repurchase agreements. The terms of our repo borrowings are predominantly governed by Master Repurchase Agreements, or "MRAs," which generally conform to the terms in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association as to repayment and margin requirements. In addition, each lender may require that we include supplemental terms and conditions to the standard master repurchase agreement. Typical supplemental terms and conditions include the addition of or changes to provisions relating to margin calls, net asset value requirements, cross default provisions, certain key person events, changes in corporate structure, and requirements that all controversies related to the repurchase agreement be litigated in a particular jurisdiction. These provisions may differ for each of our lenders.
As of December 31, 2019 and 2018, we had $1.3 billion and $1.5 billion outstanding under our repurchase agreements, respectively. As of December 31, 2019 , our outstanding repurchase agreements were with 15 counterparties.
The amounts borrowed under our repurchase agreements are generally subject to the application of "haircuts." A haircut is the percentage discount that a repo lender applies to the market value of an asset serving as collateral for a repo borrowing, for the purpose of determining whether such repo borrowing is adequately collateralized. As of December 31, 2019 and 2018, the weighted average contractual haircut applicable to the assets that serve as collateral for our outstanding repo borrowings was 4.9% and 5.1%, respectively.
58
The following table details total outstanding borrowings, average outstanding borrowings, and the maximum outstanding borrowings at any month end for each quarter under repurchase agreements for the past twelve quarters.
Quarter Ended
Borrowings
Outstanding at
Quarter End
Average
Borrowings Outstanding
Maximum Borrowings Outstanding at Any Month End
(In thousands)
December 31, 2019
$
1,296,272
$
1,301,270
$
1,319,839
September 30, 2019
1,337,984
1,369,722
1,374,080
June 30, 2019
1,442,043
1,412,434
1,442,043
March 31, 2019
1,427,147
1,422,333
1,427,147
December 31, 2018
1,481,561
1,456,905
1,481,561
September 30, 2018
1,500,632
1,506,855
1,515,617
June 30, 2018
1,537,216
1,530,734
1,537,216
March 31, 2018
1,589,319
1,588,515
1,590,790
December 31, 2017
1,597,206
1,614,096
1,643,683
September 30, 2017
1,642,313
1,633,746
1,650,729
June 30, 2017 (1)
1,628,450
1,339,806
1,628,450
March 31, 2017
1,178,285
1,194,321
1,199,860
(1)
For the quarter ended June 30, 2017, the significant increase between average borrowings outstanding and total borrowings as of June 30, 2017 was the result of our deployment of the proceeds from our follow-on offering of common shares during the quarter. Based on our higher equity base, we increased our repo borrowings so as to maintain our desired debt-to-equity ratio.
As of December 31, 2019 , we had an aggregate amount at risk under our repurchase agreements with 15 counterparties of $62.9 million. As of December 31, 2018, we had an aggregate amount at risk under our repurchase agreements with 12 counterparties of $89.6 million. Amounts at risk represent the excess, if any, for each counterparty of the fair value of collateral held by such counterparty over the amounts outstanding under repurchase agreements. If the amounts outstanding under repurchase agreements with a particular counterparty are greater than the collateral held by the counterparty, there is no amount at risk for the particular counterparty. Amounts at risk under our repurchase agreements as of December 31, 2019 and 2018 does not include $0.9 million and $0.2 million, respectively, of net accrued interest receivable, which is defined as accrued interest on securities held as collateral less interest payable on cash borrowed.
Our derivatives are predominantly subject to bilateral collateral arrangements or clearing in accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the "Dodd-Frank Act." We may be required to deliver or receive cash or securities as collateral upon entering into derivative transactions. Changes in the relative value of derivative transactions may require us or the counterparty to post or receive additional collateral. Entering into derivative contracts involves market risk in excess of amounts recorded on our balance sheet. In the case of cleared derivatives, the clearinghouse becomes our counterparty and the future commission merchant acts as an intermediary between us and the clearinghouse with respect to all facets of the related transaction, including the posting and receipt of required collateral.
As of December 31, 2019 , we had an aggregate amount at risk under our derivative contracts, excluding TBAs, with two counterparties of approximately $10.4 million. We also had $9.0 million of initial margin for cleared over-the-counter, or "OTC," derivatives posted to central clearinghouses as of that date. As of December 31, 2018, we had an aggregate amount at risk under our derivatives contracts, excluding TBAs, with three counterparties of approximately $11.6 million. We also had $9.8 million of initial margin for cleared OTC derivatives posted to central clearinghouses as of that date. Amounts at risk under our derivatives contracts represent the excess, if any, for each counterparty of the fair value of our derivative contracts plus our collateral held directly by the counterparty less the counterparty's collateral held by us. If a particular counterparty's collateral held by us is greater than the aggregate fair value of the financial derivatives plus our collateral held directly by the counterparty, there is no amount at risk for the particular counterparty.
We purchase and sell TBAs and Agency pass-through certificates on a when-issued or delayed delivery basis. The delayed delivery for these securities means that these transactions are more prone to market fluctuations between the trade date and the ultimate settlement date, and therefore are more vulnerable, especially in the absence of margining arrangements with respect to these transactions, to increasing amounts at risk with the applicable counterparties. As of December 31, 2019 , in connection with our forward settling TBA and Agency pass-through certificates, we had an aggregate amount at risk with five counterparties of approximately $1.2 million. As of December 31, 2018, in connection with our forward settling TBA and Agency pass-through certificates, we had an aggregate amount at risk with eight counterparties of approximately $2.5 million.
59
Amounts at risk in connection with our forward settling TBA and Agency pass-through certificates represent the excess, if any, for each counterparty of the net fair value of the forward settling securities plus our collateral held directly by the counterparty less the counterparty's collateral held by us. If a particular counterparty's collateral held by us is greater than the aggregate fair value of the forward settling securities plus our collateral held directly by the counterparty, there is no amount at risk for the particular counterparty.
We held cash and cash equivalents of approximately $35.4 million and $18.6 million as of December 31, 2019 and 2018, respectively.
We may declare dividends based on, among other things, our earnings, our financial condition, the REIT qualification requirements of the Internal Revenue Code of 1986, as amended, our working capital needs and new opportunities. The declaration of dividends to our shareholders and the amount of such dividends are at the discretion of our Board of Trustees. The following table sets forth the dividend distributions authorized by the Board of Trustees for the periods indicated below:
Year Ended December 31, 2019
Dividend
Per Share
Dividend Amount
Declaration Date
Record Date
Payment Date
(In thousands)
First Quarter
$
0.34
$
4,239
March 4, 2019
March 29, 2019
April 25, 2019
Second Quarter
0.28
3,491
June 11, 2019
June 28, 2019
July 25, 2019
Third Quarter
0.28
3,485
September 11, 2019
September 30, 2019
October 25, 2019
Fourth Quarter
0.28
3,488
December 13, 2019
December 31, 2019
January 27, 2020
Year Ended December 31, 2018
Dividend
Per Share
Dividend Amount
Declaration Date
Record Date
Payment Date
(In thousands)
First Quarter
$
0.37
$
4,746
March 7, 2018
March 29, 2018
April 25, 2018
Second Quarter
0.37
4,704
June 13, 2018
June 29, 2018
July 25, 2018
Third Quarter
0.37
4,700
September 12, 2018
September 28, 2018
October 25, 2018
Fourth Quarter
0.34
4,252
December 11, 2018
December 31, 2018
January 25, 2019
For the year ended December 31, 2019 , our operating activities provided net cash of $17.5 million and our investing activities provided net cash of $221.9 million . Our repo activity used to finance our purchase of securities (including repayments, in conjunction with the sales of securities, of amounts borrowed under our repurchase agreements as well as collateral posted in connection with our repo activity) used net cash of $206.4 million . Thus our operating and investing activities, when combined with our net repo financing activities, provided net cash of $33.0 million . We used $15.5 million to pay dividends and $0.7 million to repurchase common shares. As a result of these activities, there was an increase in our cash holdings of $16.8 million , from $18.6 million as of December 31, 2018 to $35.4 million as of December 31, 2019 .
For the year ended December 31, 2018, our operating activities provided net cash of $28.8 million and our investing activities provided net cash of $62.8 million. Our repo activity used to finance our purchase of securities (including repayments, in conjunction with the sales of securities, of amounts borrowed under our repurchase agreements as well as collateral posted in connection with our repo activity) used net cash of $100.7 million. Thus our operating and investing activities, when combined with our net repo financing activities, used net cash of $9.1 million. We used $19.1 million to pay dividends and $9.4 million to repurchase common shares. As a result of these activities, there was a decrease in our cash holdings of $37.5 million, from $56.1 million as of December 31, 2017 to $18.6 million as of December 31, 2018.
On June 13, 2018, our Board of Trustees approved the adoption of a share repurchase program under which we are authorized to repurchase up to 1.2 million common shares. The program, which is open-ended in duration, allows us to make repurchases from time to time on the open market or in negotiated transactions, including through Rule 10b5-1 plans. Repurchases are at our discretion, subject to applicable law, share availability, price and our financial performance, among other considerations. During the year ended December 31, 2019 , we repurchased 73,816 common shares at an average price per share of $10.12 and a total cost of $0.7 million . Under the current repurchase program adopted on June 13, 2018, we have repurchased 298,029 common shares through March 6, 2020 at an average price per share of $10.46 and an aggregate cost of $3.1 million, and have authorization to repurchase an additional 901,971 common shares.
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Based on our current portfolio, amount of free cash on hand, debt-to-equity ratio and current and anticipated availability of credit, we believe that our capital resources will be sufficient to enable us to meet anticipated short-term and long-term liquidity requirements.
We are not required by our investment guidelines to maintain any specific debt-to-equity ratio, and we believe that the appropriate leverage for the particular assets we hold depends on the credit quality and risk of those assets, as well as the general availability and terms of stable and reliable financing for those assets.
Contractual Obligations and Commitments
We are a party to a management agreement with our Manager. Pursuant to that agreement, our Manager is entitled to receive a management fee based on shareholders' equity, reimbursement of certain expenses and, in certain circumstances, a termination fee. Such fees and expenses do not have fixed and determinable payments. For a description of the management agreement provisions, see Note 9 to our consolidated financial statements.
We enter into repurchase agreements with third-party broker-dealers whereby we sell securities to such broker-dealers at agreed-upon purchase prices at the initiation of the repurchase agreements and agree to repurchase such securities at predetermined repurchase prices and termination dates, thus providing the broker-dealers with an implied interest rate on the funds initially transferred to us by the broker-dealers. We may enter into reverse repurchase agreements with third-party broker-dealers whereby we purchase securities under agreements to resell at an agreed-upon price and date. In general, we most often will enter into reverse repurchase agreement transactions in order to effectively borrow securities that we can then deliver to counterparties to whom we have made short sales of the same securities. The implied interest rates on the repurchase agreements and reverse repurchase agreements we enter into are based upon competitive market rates at the time of initiation. Repurchase agreements and reverse repurchase agreements that are conducted with the same counterparty may be reported on a net basis if they meet the requirements of ASC 210-20, Balance Sheet, Offsetting . As of both December 31, 2019 and 2018, there were no repurchase agreements and reverse repurchase agreements reported on a net basis on the Consolidated Balance Sheet.
As of December 31, 2019 , we had $1.3 billion of outstanding borrowings with 15 counterparties.
Off-Balance Sheet Arrangements
As of December 31, 2019 , we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, we have not guaranteed any obligations of unconsolidated entities nor do we have any commitment or intent to provide funding to any such entities. As such, we are not materially exposed to any market, credit, liquidity, or financing risk that could arise if we had engaged in such relationships.
Inflation
Virtually all of our assets and liabilities are interest rate-sensitive in nature. As a result, interest rates and other factors influence our performance far more so than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our activities and balance sheet are measured with reference to historical cost and/or fair market value without considering inflation.