Armour Residential REIT, Inc. quarterly report, Q2 FY2019

Armour Residential REIT, Inc. — Q2 2019 Form 10-Q

Reporting period: Three and six months ended June 30, 2019. Unaudited. Amounts below are in millions of dollars unless stated otherwise. Armour is an externally managed REIT investing primarily in residential mortgage-backed securities, funded largely with short-term repurchase agreements.

Financial performance and position

Metric	Q2 2019	Q2 2018	Six months 2019	Six months 2018
Interest income	$128.4	$65.8	$223.2	$134.0
Net interest income	$40.9	$30.1	$74.7	$66.2
Net income (loss)	($183.3)	$13.6	($297.6)	$58.3
Net income (loss) available to common	($187.5)	$9.3	($306.2)	$49.8
Basic loss per common share	($3.14)	$0.22 income	($5.40)	$1.19 income
Common dividends declared per share	$0.57	$0.57	$1.14	$1.14

Quarterly drivers: Q2 other loss was $214.1 million, including $200.3 million of derivative losses; the latter included a $104.8 million realized loss from terminating $2.35 billion notional of interest-rate swaps. Higher interest income and portfolio size lifted net interest income, but did not offset derivative and other losses.
Six-month cash flow: Operating activities used $43.5 million. Investing activities used $6.34 billion, while financing activities provided $6.50 billion, principally reflecting repurchase-agreement borrowing and repayment activity. Cash and cash collateral posted to counterparties ended at $348.8 million.
June 30 balance sheet: Total assets were $14.92 billion, liabilities $13.55 billion, and stockholders’ equity $1.38 billion. Agency securities at fair value were $13.62 billion, up from $7.05 billion at year-end 2018; credit-risk and non-agency securities were $788.6 million, down from $819.9 million.
Funding and liquidity: Repurchase agreements totaled $13.30 billion, compared with $7.04 billion at December 31, 2018. Reported leverage was 9.66:1 versus 6.25:1. The average repo rate was 2.70%, with a 16-day weighted average maturity. Management reported liquidity of $595.4 million, consisting of $211.7 million cash and $383.8 million unpledged Agency securities.
Margins and portfolio: Management reported a 1.40% net interest-rate spread at June 30, 2019, versus 1.56% at June 30, 2018. The six-month average securities portfolio grew 23.48% year over year. Agency securities represented 94.5% of the securities portfolio at quarter-end.

Changes versus comparable periods and year-end

Year-over-year net interest income rose to $40.9 million in Q2 and $74.7 million for the half-year, from $30.1 million and $66.2 million, respectively. The filing attributes the increase to a larger average securities portfolio and higher asset yields, partly offset by higher financing costs.
Net results moved from income to substantial losses: six-month derivative results were a $335.5 million loss in 2019 versus an $89.3 million gain in 2018. Changes in derivatives’ fair value are recorded in earnings; the company does not use cash-flow hedge accounting.
Agency securities’ unrealized gains recorded in other comprehensive income were $173.1 million in Q2 and $357.3 million for the first half. Consequently, comprehensive loss was $10.2 million in Q2 and comprehensive income was $62.6 million for the half-year, despite the net losses.
At June 30, Agency securities had $322.5 million of gross unrealized gains and $6.2 million of gross unrealized losses. No other-than-temporary impairment was recognized in the first half of 2019.
Common shares outstanding increased from 43.7 million at year-end to 59.2 million at June 30, following public and ATM offerings. The company also repurchased 625,000 shares for $11.3 million during the first half.
The 8.25% Series A preferred stock was called for redemption: $54.5 million was recorded as a liability at June 30 and was scheduled for redemption on July 26, 2019. The filing reports a $0.17 common dividend for July and August 2019, below the $0.19 monthly rate paid during the first half.

Outlook, commentary, risks and contingencies

Management stated it believed available liquidity and borrowing arrangements were sufficient for anticipated short-term needs, including investment activity, financing obligations, expenses and REIT distributions. It gave no specific full-year earnings or dividend guidance; future financing and capital-raising success was not assured.
Management seeks to maintain liquidity while remaining substantially invested. Repo financing is short-term and secured by securities; falling collateral values, wider spreads or higher haircuts may prompt margin calls, additional collateral demands or forced asset sales. At June 30, 26 counterparties had outstanding borrowings, and BUCKLER accounted for 41.6% of aggregate repo borrowings.
Interest-rate sensitivity estimates at June 30 indicated that an instantaneous 100-basis-point rise could reduce projected net interest income by 14.81% and shareholder equity, including derivatives, by 14.11%; a 100-basis-point decline was estimated to reduce them by 29.17% and 8.52%, respectively. A 25-basis-point widening in mortgage spreads was estimated to reduce portfolio book value by 11.80%. These are model estimates, not forecasts.
Principal risks include interest-rate and asset-liability mismatch, prepayment speeds, mortgage-spread movements, non-agency credit losses, repo and counterparty liquidity, derivative valuation and performance, and possible changes affecting Fannie Mae and Freddie Mac. The company noted that Agency MBS values and financing access could be materially affected by GSE reform or reduced government support.
Nine putative class-action suits concerning the 2016 JAVELIN tender offer and merger remained unresolved. The court had not ruled on the motion to dismiss; Armour said it could not estimate the outcome. An adverse result could involve damages and substantial defense costs.
Management fees are based on gross equity raised rather than asset performance; the filing notes fees may not decline when earnings decline. The manager and BUCKLER relationships are related-party arrangements. Armour also disclosed cybersecurity risks, while stating disclosure controls were effective and no material change in internal control over financial reporting was identified during the quarter.

Important facts for investors to verify

How much of the reported derivative loss reflects realized cash costs versus noncash fair-value changes, and how the swap portfolio is positioned after the Q2 terminations.
Whether repo leverage, short maturities, collateral haircuts and BUCKLER concentration remain manageable under adverse market and margin-call conditions.
Whether net interest income and common dividends are supportable given the reported spread compression, quarterly and half-year losses, and lower declared common dividend rate after June.
The assumptions behind the interest-rate and mortgage-spread sensitivity estimates, including prepayment and reinvestment behavior.
Developments in the JAVELIN litigation and any resulting financial exposure; the filing provides no clear estimate of potential loss.