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Item 3. Quantitative and Qualitative Disclosures About Market Risk

2022-04-29 compared with 2021-10-29 · 351 added, 170 removed, 21 unchanged (96% of the section changed)

QUANTITATIVE AND QUALITATIVE DISCLOSURES

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

The principal instruments that we use are futures contracts, interest rate swaps and swaptions.

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.

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.

is the exposure

to loss resulting

rates, foreign

currency exchange

equity prices.

to are interest

risk, extension

to many factors,

and international

considerations

factors beyond

level of interest

income, which

is the difference

interest income

interest-earning

expense incurred

in connection

interest-bearing

spread between

our interest-earning

interest-bearing

of our securities

our investment

which affects

our net income,

realize gains

sale of these

borrow against

these securities.

We may utilize

our operations.

The principal

and swaptions.

These instruments

as an economic

hedge against

future interest

rate increases

on our repurchase

Hedging techniques

of our Agency

If prepayments

than assumed,

shorter, which

the effectiveness

of any hedging

and may cause

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 that 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 underlying mortgage loans tends to shorten the resulting

cash flows from our investments substantially.

Prepayments occur for various reasons, including refinancing of underlying

mortgages and 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.

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

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.

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 September 30, 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.

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 September 30, 2021 and December 31, 2020.

Actual results could differ materially from estimates, especially in the current market environment.

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.

different models were employed in the analysis, materially different projections could result.

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 the overall management of our investment portfolio.

and may produce

volatile returns.

qualification.

may be forced

is most needed.

Our profitability

and the value

of our investment

may be adversely

rates, including

Our portfolio

of adjustable-rate

RMBS (“ARMs”),

hybrid adjustable-rate

seek to acquire

from mortgage

are reasonably

of an individual

RMBS portfolio

with an effective

stated contractual

final maturity

loans underlying

our portfolio

generally ranges

of prepayments

the resulting

substantially.

of underlying

their scheduled

loan payments,

which accelerates

the amortization

of the loans.

and IIO portfolios

greatly depending

on the structural

of the securities.

While prepayment

activity will

always affect

flows associated

negative when

and less negative

when prepayments

similarly, but the

floating rate

of IIOs (which

LIBOR) causes

to be affected

and one month

of IIO securities

vary greatly.

the underlying

rate sensitivity

of our assets

their effective

While modified

price sensitivity

rates, effective

duration captures

related security

when interest

Accordingly, when

substantially

above prevailing

effective duration

of securities

collateralized

by such loans

expected prepayments.

Accordingly, we

by estimating

of our assets

and the duration

of our liabilities.

using various

However, empirical

different duration

The following

rate-sensitive

assuming rates

instantaneously

convexity, which

is the measure

of the sensitivity

effective duration

have a negatively

(short positions).

both directions.

as percentage

the investment

rate scenario.

rate scenario

assumes interest

Actual results

from estimates,

in the current

market environment.

To the extent that

these estimates

of high price

volatility, actual

likely differ

different projections

could result.

Lastly, while

below reflects

the estimated

rate increases

and decreases

of the overall

Interest Rate Sensitivity

Change in Interest Rate

As of September 30, 2021

As of March 31, 2022

-200 Basis Points

11 unchanged sentences

+200 Basis Points

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

Interest rate

sensitivity is

derived from models

that are dependent

on inputs and

assumptions provided

by third parties

as well as by

mortgage spreads

and assumes a

static portfolio.

Actual results

materially from

these estimates.

Includes the effect of derivatives and other securities used for hedging

Estimated dollar change in investment portfolio value expressed as a percent

of the total fair value of our investment portfolio as of such date.

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

Additionally, changes to government sponsored entity 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.

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

effect of derivatives

and other securities

used for hedging

Estimated dollar

change in investment

portfolio value

expressed as a

the total fair

investment portfolio

as of such date.

Estimated dollar

change in portfolio

value expressed

of stockholders'

factors impact

rate-sensitive

curve, market

market conditions.

Accordingly, in

likely differ

and such difference

our stockholders.

Because residential

on our investments

Various factors

affect the rate

occur, including

of and directional

housing prices,

rates, general

economic conditions,

size, loan-to-value

of the property

and demographic

Additionally, changes

to government

entity underwriting

significantly

impact prepayment

expectations.

Generally, prepayments

RMBS increase

during periods

We may reinvest

that is lower

on the repaid

thus affecting

market spread

widens between

on our Agency

of our Agency

the offsetting

on our hedging

this as "spread

risk" or "basis

and the resulting

value of these

factors impacting

income markets,

such as actual

or anticipated

policy actions

market liquidity,

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

Our assets that are pledged to secure repurchase agreements are Agency RMBS and cash.

As of September

30, 2021, we had unrestricted cash and cash equivalents of $424.1 million and unpledged securities of approximately $5.4

million (not including 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.

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

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

Consequently, while

we use futures

against moves

against spread

from financing

through repurchase

secure repurchase

had unrestricted

cash and cash

of approximately

(not including

or securities

to us) available

to meet margin

and derivative

and for other

However, should

of our Agency

as collateral

of our derivative

suddenly decrease,

to our repurchase

and derivative

could increase,

adverse change

Further, there

is no assurance

able to renew

our repurchase

counterparties

have the option

requirements)

on the assets

against repurchase

thereby reducing

if they agree

Significantly

higher haircuts

our portfolio

or even force

assets, especially

if correlated

price declines

The projected

and the duration

rate sensitivity)

of our investments

our Manager's

the borrowers

the underlying

we use futures

contracts and

and swaptions

to help manage

that interest

These hedging

on the notional

the instrument

for a specified

However, if prepayment

rates decrease

rate environment,

of our fixed-rate

have a negative

from operations,

hedging instrument

cover a smaller

of our funding

on our mortgage

average lives

This situation

of our Agency

CMOs collateralized

by fixed rate

ARMs to decline

the case while

of our hedging

extreme situations,

maintain adequate

liquidity, which

realized losses.

We are exposed

to counterparty

could be recognized

counterparties

our repurchase

and derivative

fail to perform

their obligations

in accordance

on the market

notional amount

of such assets

by a counterparty,

receive payments

of our agreements

difficulty obtaining

certain derivative

daily adjustments

to collateral

pledged based

our counterparties

to registered

central clearing

with acceptable

credit ratings,

with individual

counterparties

and adjusting

However, there

is no guarantee

will be successful

suffer significant

unsuccessful.

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-Q

Item 3. Quantitative and Qualitative Disclosures About Market Risk