ARMOUR Residential REIT, Inc. — 2011 Form 10-K
Reporting period: Fiscal year ended December 31, 2011; filed March 6, 2012. ARMOUR is an externally managed mortgage REIT investing primarily in residential mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae. It finances investments mainly with short-term repurchase agreements and uses derivatives to manage interest-rate risk.
Financial and operating highlights
| Metric | 2011 | 2010 |
|---|---|---|
| Total assets at year-end | $6.21 billion | $1.21 billion |
| Agency securities, fair value | $5.39 billion | $1.16 billion |
| Repurchase agreements at year-end | $5.34 billion | $972 million |
| Net interest income | $105.8 million | $11.0 million |
| Net income (loss) | $(9.4) million | $6.5 million |
| Diluted earnings (loss) per share | $(0.15) | $1.12 |
| Operating cash flow | $118.1 million | $9.2 million |
| Debt-to-equity at year-end | 8.52:1 | 8.94:1 |
- 2011 average portfolio yield was 3.00%, average cost of funds including derivatives was 0.94%, and the reported interest-rate spread was 2.05%, versus 3.29%, 0.45%, and 2.85%, respectively, in 2010. In Q4 2011, asset yield was 2.60%, cost of funds 0.98%, and net interest margin 1.62%.
- Cash was $252.4 million and restricted cash was $147.2 million at year-end. Restricted cash included substantial collateral posted for derivatives. Operating cash flow was outweighed by $4.74 billion of investing cash outflow; financing provided $4.84 billion.
- Year-end book value was $6.57 per share, down from $6.61 a year earlier. Shareholders’ equity was $626.6 million. The securities portfolio was purchased at a weighted-average amortized price of 104.23% of par and included $216.7 million of unamortized premium.
Material changes versus the prior year
- Portfolio assets expanded sharply, supported by equity issuance and increased repo financing. ARMOUR issued 65.6 million shares in 2011 follow-on offerings and sold another 13.4 million shares through its dividend reinvestment and stock purchase plan; reported net common-equity proceeds were approximately $561.8 million.
- Net interest income rose with portfolio growth, but the annual result shifted from profit to loss. The principal driver was derivatives: 2011 included $25.0 million of realized derivative losses and $97.1 million of unrealized losses, versus $0.5 million and $2.6 million, respectively, in 2010. Derivatives were not eligible for cash-flow hedge accounting, so mark-to-market changes flowed through earnings.
- The portfolio’s average annual repayment rate was 13.2%, versus 13.0% in 2010; Q4 repayment rate accelerated to 19.3% from 10.8% in Q4 2010. Faster prepayments can accelerate amortization of purchase premiums and reduce asset yield.
- Year-end repo leverage decreased to 8.52:1 from 8.94:1, while repurchase debt increased to $5.34 billion from $972 million as the balance sheet grew. The weighted-average repo maturity was 18 days, versus 32 days.
- The common dividend was $1.40 per share paid for 2011, compared with $1.54 in 2010. The regular monthly amount declined from $0.12 to $0.11 late in 2011. The filing says 86.1% of the 2011 payment represented ordinary income and 13.9% capital gain, with no tax return of capital.
Outlook, risks, contingencies, and notable items
- Management stated it believed available equity, operating cash flow, and borrowing capacity were sufficient for anticipated short-term liquidity needs. This is not a quantified earnings or dividend forecast. The company depends on short-term, generally uncommitted repo financing; year-end repo maturity averaged 18 days, and lenders may demand collateral or repayment following market-value declines.
- Management’s market discussion cited exceptionally low expected short-term rates through at least late 2014, strong demand for Agency securities, and low financing costs. It also described potential spread compression and faster prepayments from Federal Reserve actions, refinancing programs, and other policy changes.
- Key risks include interest-rate and yield-curve movements, premium-amortization/prepayment risk, leverage and margin calls, short-term refinancing and counterparty risk, and the future role and guarantees of the GSEs. The SEC was reviewing whether mortgage REITs could continue to rely on the Investment Company Act Section 3(c)(5)(C) exclusion; a change could impair ARMOUR’s leveraged business model.
- At year-end, interest-rate swaps had $2.765 billion notional and a fair-value liability of $116.4 million; Eurodollar futures had $131 million notional and a $5.3 million liability. The filing’s modeled parallel-rate scenario estimated that a 100-basis-point increase would reduce projected net interest income by 9.79%; the company cautioned that model results are assumption-dependent and static.
- On December 1, 2011, shareholders approved broadening the charter’s permitted asset classes to include non-Agency securities, although management said it remained committed to Agency securities while supply and pricing were adequate. The filing reports no pending litigation and no other-than-temporary impairment losses.
- After year-end, ARMOUR completed additional common-stock offerings, including a 35.0 million-share offering in February 2012, and raised further proceeds through at-the-market sales. These issuances increase capital but dilute existing ownership. The independent auditor changed from EisnerAmper to Deloitte in September 2011; the filing reports unqualified audit opinions and effective internal control over financial reporting.
Important facts for investors to verify
- Whether the net interest spread and dividend level remain sustainable as asset yields, short-term funding costs, prepayments, and hedge results change.
- Available unencumbered liquidity, collateral requirements, repo renewals and counterparty concentration; reconcile cash with restricted cash and derivative margin obligations.
- How derivative mark-to-market losses, hedge coverage, and any mismatch between hedges and assets affect GAAP earnings, book value, and cash distributions.
- The effect of further share issuance and outstanding warrants on per-share book value, earnings, and dividends; warrants cover up to 32.5 million shares at $11 per share and expire in 2013.
- Developments in GSE guarantees, mortgage refinancing/prepayment policy, and SEC guidance on the company’s Investment Company Act exclusion.