ARMOUR Residential REIT, Inc. — Q1 2018 Form 10-Q
Business context and reporting period. This externally managed mortgage REIT invests primarily in residential mortgage-backed securities (MBS), financed largely through short-term repurchase agreements, and uses derivatives to manage interest-rate risk. The filing covers the three months ended March 31, 2018; financial statement amounts below are in millions of dollars unless stated otherwise.
Financial results and position
| Metric | Q1 2018 / March 31, 2018 | Comparable period / prior year-end |
|---|---|---|
| Interest income | $68.2 | $58.6 in Q1 2017 |
| Interest expense on repurchase agreements | $32.0 | $18.1 in Q1 2017 |
| Net interest income | $36.2 | $40.5 in Q1 2017 |
| Net interest rate spread | 1.52% | 1.61% in Q1 2017 |
| Net income | $44.7 | $52.7 in Q1 2017 |
| Net income available to common stockholders | $40.5; diluted EPS $0.96 | $48.8; diluted EPS $1.33 in Q1 2017 |
| Common dividend declared | $0.57 per share | $0.57 per share in Q1 2017 |
| Cash from operating activities | $(0.6) | $(5.0) in Q1 2017 |
| Total assets | $8,471 | $8,929 at December 31, 2017 |
| Repurchase agreement borrowings | $6,854 | $7,556 at December 31, 2017 |
| Stockholders’ equity | $1,245 | $1,326 at December 31, 2017 |
| Cash / reported liquidity | $216 / $687 | Liquidity comprised cash and $470 of unpledged Agency Securities |
| Leverage | 5.51:1; 7.61:1 including forward-purchased TBAs under the company’s stated measure | 5.70:1 and 6.96:1, respectively, at December 31, 2017 |
Material changes and notable items
- Interest income rose year over year, supported by a larger average securities portfolio and higher asset yields, but higher borrowing costs more than offset the increase. Management reported average asset yield up 0.12 percentage points and repurchase-agreement expense up 0.7 percentage points year over year.
- Net income declined year over year. Derivatives generated a $58.6 million net gain, including a $97.2 million unrealized gain, while Agency securities sales generated a $32.6 million realized loss and the company recorded $12.1 million of other-than-temporary impairment on previously identified low-yielding Agency securities.
- Comprehensive loss was $56.0 million, mainly reflecting a $145.4 million unrealized loss on available-for-sale Agency securities, partly offset by reclassification adjustments. Agency securities’ fair value was $6.245 billion, down from $7.479 billion at year-end; U.S. Treasury securities of $671 million were newly held at quarter-end.
- The company sold $1.138 billion of Agency securities, citing portfolio repositioning and liquidity needs. It reported $681.8 million fair value of remaining identified low-yielding Agency securities and no other-than-temporary impairment on the remaining Agency portfolio.
- TBA Agency securities notional rose to $4.3 billion from $1.6 billion at year-end; interest-rate swap notional rose to $6.8 billion from $5.25 billion.
- Cash decreased by $48.7 million during the quarter. Investing activities provided $679.8 million, while financing activities used $728.0 million, including $24.1 million of common dividends paid. The company issued $2.6 million of Series B preferred stock.
Outlook, risks, and contingencies
- No earnings or dividend guidance was provided. Management stated it believes available liquidity, operating cash flows, and portfolio-adjustment capacity are sufficient for anticipated short-term needs, including financing obligations and distributions; future capital raising is not assured.
- The Federal Reserve raised its target rate twice during the quarter, to 1.50%–1.75% in March. Management warned that rising short-term funding costs, if not matched by asset yields, can reduce net interest income. Mortgage spreads, prepayments, and asset/liability repricing mismatches also affect results and book value.
- Repurchase funding is short-term and collateralized. Falling collateral values or higher haircuts can prompt margin calls or forced asset sales. At quarter-end, average repo maturity was 22 days, average haircut 5.84%, and Buckler Securities accounted for 53.9% of borrowings.
- Modeled interest-rate sensitivity at March 31 estimated that an immediate 100-basis-point increase would raise projected net interest income 10.95% but reduce portfolio value including derivatives 0.95% and shareholder equity including hedges 8.22%. A 25-basis-point widening in MBS spreads was estimated to reduce portfolio book value 9.78%. These are model estimates, not forecasts.
- Credit Risk and Non-Agency securities expose the company to defaults and losses; most were rated below investment grade or unrated. The company also depends on GSE guarantees for Agency securities and noted uncertainty around potential GSE reform and the planned Uniform MBS transition.
- Eight consolidated Maryland shareholder lawsuits concerning the JAVELIN tender offer and merger remained pending; the court had not ruled on defendants’ motion to dismiss. The company could not estimate the outcome or potential loss. The related Florida suit was dismissed.
- Management reported disclosure controls were effective at quarter-end and no material change in internal control over financial reporting. It reported no material changes to the risk factors in its 2017 Form 10-K.
Key investor verification points
- Assess whether the $687 million reported liquidity, collateral availability, and short-term repo maturities can withstand adverse market moves and margin calls.
- Review the deterioration in Agency securities’ unrealized losses and the assumptions supporting the $681.8 million remaining low-yielding portfolio assessment.
- Verify how sustainable net interest income and the 1.52% spread are under further rate increases, higher repo costs, changing prepayments, and wider mortgage spreads.
- Examine derivative positions, collateral terms, and the concentration of repo financing with Buckler, including the related-party relationship and $105 million of subordinated loans to Buckler.
- Track the pending JAVELIN litigation, preferred and common dividend coverage, and the company’s continued ability to satisfy REIT distribution and qualification requirements.