Armour Residential REIT, Inc. — Q2 2017 Form 10-Q
Business context and period. Armour is an externally managed mortgage REIT investing primarily in agency mortgage-backed securities (MBS), financed mainly with short-term repurchase agreements. The unaudited report covers the quarter and six months ended June 30, 2017; balance-sheet comparisons are with December 31, 2016. Amounts below are in millions unless otherwise stated.
Financial performance and position
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Interest income | $60.0 | $65.4 | $118.6 | $144.4 |
| Net interest income | $39.5 | $47.1 | $80.0 | $106.9 |
| Net income (loss) | $29.7 | $21.2 | $82.4 | $(258.3) |
| Net income (loss) attributable to common stockholders | $25.8 | $17.3 | $74.6 | $(266.1) |
| EPS attributable to common stockholders | $0.70 | $0.47 | $2.03 | $(7.25) |
| Common dividends declared per share | $0.57 | $0.71 | $1.14 | $1.70 |
- Margins and portfolio: Management reported a 1.67% net interest rate spread at June 30, versus 1.32% at June 30, 2016. The average MBS portfolio (including TBAs) was $8.92 billion for the six-month period, down 14.3% from $10.41 billion. Asset yield and repo borrowing cost each rose 0.27 percentage points year over year for the six-month period.
- Balance sheet: Total assets were $8.45 billion, stockholders’ equity $1.29 billion and repurchase-agreement borrowings $6.30 billion at June 30. Agency securities were $6.91 billion and non-agency securities $998 million. Cash was $412 million; reported liquidity was $760 million, including $348 million of unpledged Agency securities.
- Leverage and funding: Reported leverage was 4.90:1, or 6.80:1 including forward-purchased TBAs and excluding debt for forward-settling sales. Repo borrowings had a 1.45% weighted-average contractual rate and 37-day weighted-average maturity. The weighted-average haircut was 7.26%.
- Cash flow, six months: Operating activities provided $59.5 million, investing activities provided $536.5 million, and financing activities used $455.7 million. Cash increased $140.4 million to $412.1 million. These cash flows include substantial securities purchases and sales and repo financing turnover.
Material changes versus comparable periods
- Quarterly and six-month net interest income declined, principally because interest income on Agency securities fell as the average MBS portfolio contracted. Higher reported spreads did not offset the smaller portfolio.
- Net income improved sharply from the six-month 2016 loss, when derivative losses were $381.5 million; the six-month 2017 derivative loss was $9.6 million. Q2 derivative loss was $21.1 million, compared with $46.4 million in Q2 2016. Derivative fair-value movements can make GAAP earnings volatile and do not necessarily reflect the intended hedge economics.
- Non-agency securities generated gains of $54.5 million for the first half, compared with $14.3 million a year earlier. The portfolio’s fair value declined to $998 million from $1.05 billion at year-end, while its share of the MBS portfolio fell to 12.6% from 13.9%.
- Agency securities increased to $6.91 billion from $6.51 billion, but the portfolio mix shifted materially: 30-year fixed-rate holdings rose to 47.3% of Agency securities from 16.2%, while 15-year fixed-rate holdings declined to 17.8% from 42.8%.
- Equity increased to $1.29 billion from $1.09 billion, partly reflecting a June 30 offering of 4.5 million common shares that raised $116.7 million net. Shares outstanding rose to 41.24 million from 36.72 million at year-end. The company also authorized an at-the-market program for up to 5.0 million shares; none had been sold under it by June 30.
Outlook, commentary, risks and unusual items
- Management said it believed available liquidity and capital resources were sufficient for anticipated short-term needs, including investment activity, financing obligations, expenses and REIT distributions. No numerical earnings or dividend guidance was provided.
- The Federal Reserve raised its target federal funds rate to 1.00%–1.25% in June 2017. Management cautioned that rising short-term rates can increase repo funding costs faster than asset yields, potentially compressing net interest income and reducing MBS values.
- Interest-rate sensitivity estimates at June 30 showed that an immediate 100-basis-point rate increase would raise projected net interest income 7.67% but reduce projected shareholder equity, including hedges, 11.37%. A 100-basis-point decrease was estimated to reduce projected net interest income 9.09% and increase equity 1.67%. These are model-based estimates and exclude other changes that may materially affect results.
- Mortgage-spread widening of 25 basis points was estimated to reduce portfolio book value 10.26%; actual results may differ. The company does not hedge mortgage-spread risk specifically and does not use cash-flow hedge accounting.
- Armour recorded a $10.3 million other-than-temporary impairment on low-yielding Agency securities it planned to replace, establishing a new cost basis for securities with $1.11 billion aggregate fair value. Agency securities are generally government-sponsored or agency guaranteed, but that guarantee does not eliminate market-value, funding or liquidity risk.
- Repurchase financing creates daily margin-call and refinancing exposure. At June 30, eight counterparties accounted for about 61% of repo borrowings; one counterparty represented 11%. A decline in collateral values, increased haircuts or lender withdrawal could pressure liquidity or force asset sales.
- The company committed up to $105 million in subordinated loans to BUCKLER Securities, a broker-dealer controlled by ACM and certain Armour executives, to support regulatory capital. $25 million was funded by June 30, with the remaining $80 million expected to be funded in Q3. Armour also held a 10% interest in BUCKLER. The related-party arrangement and expected financing benefits warrant attention.
- Eight consolidated Maryland putative class-action cases relating to the JAVELIN acquisition remained pending; the court had reserved ruling on the motion to dismiss. Armour said it could not estimate the outcome. The company reported no material changes to the risk factors in its 2016 Form 10-K.
- Subsequent to quarter-end, common dividends of $0.19 per share were declared for July and August 2017. Preferred dividends were also declared. Dividend declarations do not establish future payment levels.
Important facts for investors to verify
- Whether the reported spread improvement and lower leverage can offset the smaller portfolio and higher short-term funding costs.
- The drivers and sensitivity of derivative gains and losses, hedge effectiveness, and the assumptions behind interest-rate and mortgage-spread sensitivity estimates.
- Available unpledged collateral and cash relative to repo margin calls, counterparty concentration, refinancing terms and unsettled securities purchases of $828.6 million.
- Non-agency valuation assumptions and credit exposure: all $998 million of non-agency securities were classified as Level 3, with most rated below investment grade or unrated.
- The funding, governance safeguards, related-party economics and potential risks of the BUCKLER investment and subordinated-loan commitment.
- Common-share issuance and any use of the authorized ATM program, as well as whether dividends remain supported by REIT taxable income and available liquidity.
- Developments in the JAVELIN shareholder litigation and any resulting financial or governance consequences.