Item 7A. Quantitative and Qualitative Disclosures About Market Risk
ITEM 7A.
QUANTITATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the exposure to loss resulting from changes in market factors such as
interest rates, foreign currency exchange
rates, commodity prices and equity prices. The primary market risks that we
are exposed to are interest rate risk, prepayment risk,
spread risk, liquidity risk, extension risk and counterparty credit risk.
Interest Rate Risk
Interest rate risk is highly sensitive to many factors, including governmental
monetary and tax policies, domestic and international
economic and political considerations and other factors beyond our control.
Changes in the general level of interest rates can affect our net interest income, which is the
difference between the interest
income earned on interest-earning assets and the interest expense incurred in
connection with our interest-bearing liabilities, by
affecting the spread between our interest-earning assets and interest-bearing liabilities. Changes
in the level of interest rates can also
affect the rate of prepayments of our securities and the value of the RMBS that constitute our
investment portfolio, which affects our net
income, ability to realize gains from the sale of these assets and ability to borrow, and the amount that we can
borrow against, these
securities.
We may utilize a variety of financial instruments in order to limit the effects of changes in interest rates on
our operations. The
principal instruments that we use are futures contracts, interest rate swaps and
swaptions. These instruments are intended to serve as
an economic hedge against future interest rate increases on our repurchase agreement
borrowings.
Hedging techniques are partly
based on assumed levels of prepayments of our Agency RMBS.
If prepayments are slower or faster than assumed, the life of the
Agency RMBS will be longer or shorter, which would reduce the effectiveness of any hedging strategies we may use and
may cause
losses on such transactions.
Hedging strategies involving the use of derivative securities are highly
complex and may produce volatile
returns.
Hedging techniques are also limited by the rules relating to REIT
qualification.
In order to preserve our REIT status, we may
be forced to terminate a hedging transaction at a time when the transaction is
most needed.
Our profitability and the value of our investment portfolio (including derivatives used
for hedging purposes) may be adversely
affected during any period as a result of changing interest rates, including changes in
the forward yield curve.
Our portfolio of PT RMBS is typically comprised of adjustable-rate RMBS (“ARMs”),
fixed-rate RMBS and hybrid adjustable-rate
RMBS. We generally seek to acquire low duration assets that offer high levels of protection from mortgage
prepayments provided they
are reasonably priced by the market.
Although the duration of an individual asset can change as a result of
changes in interest rates,
we strive to maintain a hedged PT RMBS portfolio with an effective duration of less than
2.0. The stated contractual final maturity of the
mortgage loans underlying our portfolio of PT RMBS generally ranges up to
30 years. However, the effect of prepayments of the
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underlying mortgage loans tends to shorten the resulting cash flows from
our investments substantially. Prepayments occur for various
reasons, including refinancing of underlying mortgages, loan payoffs in connection with home
sales, and borrowers paying more than
their scheduled loan payments, which accelerates the amortization of the loans.
The duration of our IO and IIO portfolios will vary greatly depending on the
structural features of the securities.
While prepayment
activity will always affect the cash flows associated with the securities, the interest only
nature of IOs may cause their durations to
become extremely negative when prepayments are high, and less negative when prepayments
are low.
Prepayments affect the
durations of IIOs similarly, but the floating rate nature of the coupon of IIOs (which is inversely related to the level of one
month LIBOR)
causes their price movements, and model duration, to be affected by changes in both prepayments
and one month LIBOR, both
current and anticipated levels.
As a result, the duration of IIO securities will also vary greatly.
Prepayments on the loans underlying our RMBS can alter the timing of the cash flows
from the underlying loans to us. As a result,
we gauge the interest rate sensitivity of our assets by measuring their effective duration.
While modified duration measures the price
sensitivity of a bond to movements in interest rates, effective duration captures both the
movement in interest rates and the fact that
cash flows to a mortgage related security are altered when interest rates
move. Accordingly, when the contract interest rate on a
mortgage loan is substantially above prevailing interest rates in the market,
the effective duration of securities collateralized by such
loans can be quite low because of expected prepayments.
We face the risk that the market value of our PT RMBS assets will increase or decrease
at different rates than that of our
structured RMBS or liabilities, including our hedging instruments. Accordingly, we assess our interest rate risk by estimating the
duration of our assets and the duration of our liabilities. We generally calculate duration
using various third party models.
However,
empirical results and various third party models may produce different duration numbers
for the same securities.
The following sensitivity analysis shows the estimated impact on the fair value of
our interest rate-sensitive investments and hedge
positions as of December 31, 2021 and December 31, 2020, assuming rates instantaneously
fall 200 bps, fall 100 bps, fall 50 bps, rise
50 bps, rise 100 bps and rise 200 bps, adjusted to reflect the impact of
convexity, which is the measure of the sensitivity of our hedge
positions and Agency RMBS’ effective duration to movements in interest rates.
We have a negatively convex asset profile and a linear
to slightly positively convex hedge portfolio (short positions).
It is not at all uncommon for us to have losses in both directions.
All changes in value in the table below are measured as percentage changes from
the investment portfolio value and net asset
value at the base interest rate scenario. The base interest rate scenario assumes
interest rates and prepayment projections as of
December 31, 2021 and 2020.
Actual results could differ materially from
estimates
, especially in the current market environment. To the extent that these
estimates or other assumptions do not hold true, which is likely in a period of
high price volatility, actual results will likely differ
materially from projections and could be larger or smaller than the estimates in the
table below. Moreover, if different models were
employed in the analysis, materially different projections could result. Lastly, while the table below reflects the estimated impact of
interest rate increases and decreases on a static portfolio, we may from time to
time sell any of our agency securities as a part of our
overall management of our investment portfolio.
Interest Rate Sensitivity
(1)
Portfolio
Market
Book
Change in Interest Rate
Value
(2)(3)
Value
(2)(4)
As of December 31, 2021
-200 Basis Points
(2.01)%
(17.00)%
-100 Basis Points
(0.33)%
(2.76)%
-50 Basis Points
0.19%
1.59%
+50 Basis Points
(0.48)%
(4.04)%
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+100 Basis Points
(1.64)%
(13.91)%
+200 Basis Points
(4.79)%
(40.64)%
As of December 31, 2020
-200 Basis Points
2.43%
21.85%
-100 Basis Points
1.35%
12.08%
-50 Basis Points
0.69%
6.18%
+50 Basis Points
(0.90)%
(8.03)%
+100 Basis Points
(2.39)%
(21.42)%
+200 Basis Points
(4.95)%
(44.44)%
(1)
Interest rate sensitivity is derived from models that are dependent on
inputs and assumptions provided by third parties as well as by our
Manager, and assumes there are no changes
in mortgage spreads and assumes a static portfolio. Actual results could differ
materially from
these estimates.
(2)
Includes the effect of derivatives and other securities used for hedging
purposes.
(3)
Estimated dollar change in investment portfolio value expressed as a percent
of the total fair value of our investment portfolio as of such date.
(4)
Estimated dollar change in portfolio value expressed as a percent of stockholders' equity as
of such date.
In addition to changes in interest rates, other factors impact the fair value of our
interest rate-sensitive investments, such as the
shape of the yield curve, market expectations as to future interest rate changes
and other market conditions. Accordingly, in the event
of changes in actual interest rates, the change in the fair value of our assets would
likely differ from that shown above and such
difference might be material and adverse to our stockholders.
Prepayment Risk
Because residential borrowers have the option to prepay their mortgage loans at
par at any time, we face the risk that we will
experience a return of principal on our investments faster than anticipated. Various factors affect the rate at which mortgage
prepayments occur, including changes in the level of and directional trends in housing prices, interest rates, general economic
conditions, loan age and size, loan-to-value ratio, the location of the property and
social and demographic conditions. Additionally,
changes to GSE underwriting practices or other governmental programs could
also significantly impact prepayment rates or
expectations. Generally, prepayments on Agency RMBS increase during periods of falling mortgage interest rates and decrease
during
periods of rising mortgage interest rates. However, this may not always be the case.
We may reinvest principal repayments at a yield
that is lower or higher than the yield on the repaid investment, thus affecting our net interest
income by altering the average yield on
our assets.
Spread Risk
When the market spread widens between the yield on our Agency RMBS and benchmark
interest rates, our net book value could
decline if the value of our Agency RMBS falls by more than the offsetting fair value increases
on our hedging instruments tied to the
underlying benchmark interest rates. We refer to this as "spread risk" or "basis risk." The
spread risk associated with our mortgage
assets and the resulting fluctuations in fair value of these securities can occur independent
of changes in benchmark interest rates and
may relate to other factors impacting the mortgage and fixed income markets,
such as actual or anticipated monetary policy actions by
the Fed, market liquidity, or changes in required rates of return on different assets. Consequently, while we use futures contracts and
interest rate swaps and swaptions to attempt to protect against moves in interest rates,
such instruments typically will not protect our
net book value against spread risk.
Liquidity Risk
The primary liquidity risk for us arises from financing long-term assets with
shorter-term borrowings through repurchase
agreements. Our assets that are pledged to secure repurchase agreements
are Agency RMBS and cash. As of December 31, 2021,
we had unrestricted cash and cash equivalents of $385.1 million and unpledged
securities of approximately $4.7 million (not including
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unsettled securities purchases or securities pledged to us) available to
meet margin calls on our repurchase agreements and derivative
contracts, and for other corporate purposes. However, should the value of our Agency RMBS pledged as collateral
or the value of our
derivative instruments suddenly decrease, margin calls relating to our repurchase
and derivative agreements could increase, causing
an adverse change in our liquidity position. Further, there is no assurance that we will always be able to renew
(or roll) our repurchase
agreements. In addition, our counterparties have the option to increase our haircuts
(margin requirements) on the assets we pledge
against repurchase agreements, thereby reducing the amount that can be borrowed against
an asset even if they agree to renew or roll
the repurchase agreement. Significantly higher haircuts can reduce our
ability to leverage our portfolio or even force us to sell assets,
especially if correlated with asset price declines or faster prepayment rates on our
assets.
Extension Risk
The projected weighted average life and the duration (or interest rate
sensitivity) of our investments is based on our Manager's
assumptions regarding the rate at which the borrowers will prepay the underlying mortgage
loans. In general, we use futures contracts
and interest rate swaps and swaptions to help manage our funding cost
on our investments in the event that interest rates rise. These
hedging instruments allow us to reduce our funding exposure on the notional amount
of the instrument for a specified period of time.
However, if prepayment rates decrease in a rising interest rate environment, the average life or duration of
our fixed-rate assets or
the fixed-rate portion of the ARMs or other assets generally extends. This could have
a negative impact on our results from operations,
as our hedging instrument expirations are fixed and will, therefore, cover a
smaller percentage of our funding exposure on our
mortgage assets to the extent that their average lives increase due to slower prepayments.
This situation
may
also cause the market
value of our Agency RMBS and CMOs collateralized by fixed rate mortgages
or hybrid ARMs to decline by more than otherwise would
be the case, while most of our hedging instruments would not receive any incremental
offsetting gains. In extreme situations, we may
be forced to sell assets to maintain adequate liquidity, which could cause us to incur realized losses.
Counterparty Credit Risk
We are exposed to counterparty credit risk relating to potential losses that could be recognized
in the event that the counterparties
to our repurchase agreements and derivative contracts fail to perform their obligations
under such agreements. The amount of assets
we pledge as collateral in accordance with our agreements varies over time based
on the market value and notional amount of such
assets as well as the value of our derivative contracts. In the event of a default
by a counterparty, we may not receive payments
provided for under the terms of our agreements and may have difficulty obtaining our assets
pledged as collateral under such
agreements. Our credit risk related to certain derivative transactions is largely
mitigated through daily adjustments to collateral pledged
based on changes in market value, and we limit our counterparties to registered
central clearing exchanges and major financial
institutions with acceptable credit ratings, monitoring positions with individual counterparties
and adjusting collateral posted as required.
However, there is no guarantee our efforts to manage counterparty credit risk will be successful and we could suffer significant losses if
unsuccessful.
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