Invesco Mortgage Capital Inc. — Q2 2014 Form 10-Q
Business context and reporting period
Quarter ended June 30, 2014; unaudited consolidated results, with comparisons to Q2 and first half 2013. The externally managed REIT invests in agency and non-agency mortgage securities, GSE credit-risk-transfer securities, commercial mortgage-backed securities, and residential and commercial loans. Its earnings and liquidity are sensitive to interest rates, prepayments, credit spreads, asset values, and short-term financing conditions.
Financial performance and position
| Metric | Q2 2014 | First half 2014 | Comparable 2013 |
|---|---|---|---|
| Interest income | $174.5 million | $345.5 million | $175.7 million / $336.2 million |
| Net interest income (GAAP) | $105.0 million | $207.5 million | $96.2 million / $189.1 million |
| Net income (loss) attributable to common shareholders | $(94.1) million | $(168.5) million | $138.8 million / $222.8 million income |
| Basic EPS | $(0.76) | $(1.37) | $1.03 / $1.69 |
| Common dividend declared per share | $0.50 | $1.00 | $0.65 / $1.30 |
GAAP net interest margin was 1.90% in Q2 and 1.91% for the first half, versus 1.59% and 1.61%. Management’s non-GAAP effective margin, which includes swap interest and excludes amortization of deferred swap losses, was 1.20% for both 2014 periods, down from 1.59% and 1.61%. Non-GAAP core earnings were $62.1 million ($0.50 per share) in Q2 and $119.0 million ($0.97 per share) for the first half, compared with $80.5 million ($0.60) and $159.8 million ($1.22). Core earnings are not GAAP income, operating cash flow, or a measure of funds available for distributions.
Total assets were $21.43 billion and total equity $2.61 billion at June 30. Debt included $14.72 billion of repurchase agreements, $625 million of secured loans, $2.02 billion of asset-backed securities, and $400 million of exchangeable notes. Period-end total debt-to-equity was 6.8x; repo debt-to-equity was 5.6x. Cash and cash equivalents were $126.1 million. First-half operating cash flow was $186.6 million, investing cash outflow $328.9 million, financing cash inflow $57.9 million, and cash declined $84.5 million.
Book value per common share, fully diluted, rose to $19.80 from $17.97 at December 31, 2013. Other comprehensive income was $315.5 million in Q2 and $518.0 million for the first half, principally reflecting changes in MBS values. These gains do not offset the reported GAAP net losses on a net-income basis.
Material changes versus prior periods
- GAAP results swung from income to loss: first-half common-shareholder loss was $168.5 million versus income of $222.8 million in 2013. Management attributed the change chiefly to interest-rate derivative losses after discontinuing cash-flow hedge accounting, losses on investment sales, and expired swaptions.
- Q2 net loss on interest-rate derivatives was $167.8 million; first-half loss was $319.1 million. Beginning January 1, 2014, swap fair-value changes and net swap interest flow through earnings rather than the prior hedge-accounting presentation, increasing reported earnings volatility.
- Net interest income increased, but effective net interest income fell to $74.3 million in Q2 and $146.6 million for the first half, versus $96.2 million and $189.1 million. The company reported effective cost of funds of 2.28% and 2.30%, respectively, versus 1.66% and 1.62%.
- Portfolio allocation shifted toward credit assets and loans: GSE CRT fair value reached $506.6 million from zero a year earlier; residential loans rose to $2.31 billion from $1.55 billion, and commercial loans to $95.6 million from $9.0 million. Agency RMBS fair value was $10.91 billion, down from $13.54 billion a year earlier.
- Repurchase agreements declined from $15.45 billion at year-end 2013 to $14.72 billion at June 2014. The company began using Federal Home Loan Bank of Indianapolis (FHLBI) secured funding in 2014.
Outlook, commentary, risks and unusual items
- Management described Q2 market conditions as supportive: Treasury yields and interest-rate volatility declined, credit spreads tightened, and the company said these conditions lifted portfolio values and book value. It cited slower prepayments as supportive of core earnings. Management expected to pursue commercial loans, subordinate interests in residential securitizations, and GSE CRT; it expected at least one additional prime-jumbo securitization in Q3 2014.
- After quarter-end, the company refinanced $625 million of short-term FHLBI advances into a 10-year loan and entered into an additional $625 million 10-year secured loan. Management estimated these transactions would extend consolidated average liability maturity from about two months to about 12 months. The advances are subject to FHLBI approval, collateral, and credit requirements.
- Management believed available cash flow and borrowing capacity could meet anticipated short-term needs, but cautioned there is no assurance it can maintain sufficient liquidity for margin calls. Repo and secured lenders can revalue collateral and demand additional collateral or repayment. Market declines, higher haircuts, counterparty issues, or difficulty refinancing could force asset sales and impair distributions.
- Other risks include interest-rate, prepayment and extension risk; credit and real-estate collateral risk; derivative and counterparty exposure; changes in regulation, Federal Reserve policy, and GSE policy; and maintaining REIT and Investment Company Act status. The company was in compliance with repo and derivative financial covenants at quarter-end. No legal proceedings were reported, and the filing noted no material risk-factor changes apart from disclosed financing risks.
- The $0.50 common dividend declared for Q2 was paid in July. The REIT generally must distribute at least 90% of taxable income; taxable income may differ from GAAP earnings, and distributions remain subject to operating and debt-service requirements.
Important facts for investors to verify
- How much of the GAAP loss and future earnings volatility reflects the hedge-accounting change and derivative marks, versus underlying portfolio economics; reconcile GAAP results with core earnings and effective-margin measures.
- Whether tighter credit spreads, portfolio valuations, prepayment assumptions, and management’s stated improvement in book value persist; review the quality and concentration of non-agency, GSE CRT, CMBS, and loan exposures.
- Repo renewal terms, collateral haircuts, margin-call capacity, counterparty concentration, and the availability and terms of FHLBI borrowing, including its uncommitted and discretionary capacity.
- Settlement and consolidation of the planned securitization, and performance and credit losses in the residential-loan trusts; California represented 49.8% of residential-loan principal balance.
- Whether dividends are supported by taxable income and cash resources, given the lower declared common dividend versus 2013 and high leverage.