Business context and reporting period
ARMOUR Residential REIT, Inc. filed this unaudited Form 10-Q for the quarter ended March 31, 2016. Unless stated otherwise, dollar amounts below are in millions; the filing reports financial statements in thousands. ARMOUR is an externally managed mortgage REIT investing primarily in mortgage-backed securities (MBS), financed largely through short-term repurchase agreements and managed with derivatives.
At quarter-end, Agency securities were 97.3% of its MBS portfolio. ARMOUR began investing in Non-Agency securities during the quarter, which were 2.7% of the portfolio. On April 6, 2016, after the reporting period, ARMOUR completed its $85.2 million cash acquisition of JAVELIN Mortgage Investment Corp.
Financial performance and position
| Metric | Q1 2016 / March 31, 2016 | Comparable period / prior date |
|---|---|---|
| Interest income | $78.5 | $99.6 in Q1 2015 |
| Net interest income | $59.3 | $85.4 in Q1 2015 |
| Other loss, including derivative losses | $(329.2) | $(201.7) in Q1 2015 |
| Net loss | $(279.5) | $(125.5) in Q1 2015 |
| Net loss attributable to common stockholders | $(283.4), or $(7.73) per share | $(129.4), or $(2.96) per share, in Q1 2015 |
| Comprehensive loss | $(89.5) | $(42.3) in Q1 2015 |
| Total assets | $11,344.0 | $13,055.3 at December 31, 2015 |
| Repurchase agreement borrowings | $9,923.9 | $11,570.5 at December 31, 2015 |
| Stockholders’ equity | $1,095.6 | $1,225.2 at December 31, 2015 |
Derivative losses included $246.1 million of realized losses and $89.1 million of unrealized losses. Agency securities generated $191.9 million of other comprehensive income from unrealized fair-value gains; these gains are reported outside net income. Total expenses were $9.6 million, up from $9.1 million, including $1.5 million of JAVELIN-related acquisition costs.
Net cash used in operating activities was $208.7 million, compared with $73.1 million provided in Q1 2015. Investing activities provided $1,849.0 million, and financing activities used $1,686.9 million. Cash ended the quarter at $243.3 million, down $46.6 million from year-end. Management reported total liquidity of $509.4 million, comprising cash and $266.1 million of unpledged Agency securities.
ARMOUR reported a 9.06:1 leverage ratio, versus 9.44:1 at year-end. Average MBS portfolio size fell 16.7% year over year to $11,455.7 million. The reported net interest spread improved to 1.37% from 1.20%, but lower portfolio size contributed to reduced net interest income. Agency asset yield was 2.73%, cost of funds 1.36%, and repurchase-agreement interest expense rate 0.68% for the quarter. Repurchase borrowings had a 0.72% weighted average contractual rate, 32-day weighted average maturity, and 5.21% average haircut.
Common dividends declared were $0.99 per share for the quarter. After quarter-end, ARMOUR paid a $0.27 common dividend for April and declared $0.22 per share for each of May and June. Preferred dividends continued at stated rates of 8.25% for Series A and 7.875% for Series B.
Material changes versus the prior comparable period
- Net loss more than doubled year over year, driven principally by substantially greater realized derivative losses; net interest income also declined 30.5%.
- Interest expense on repurchase agreements rose to $19.1 million from $14.2 million, while interest income declined as the average MBS portfolio contracted.
- The portfolio shifted from all Agency securities at year-end 2015 to include $285.7 million of Non-Agency securities at quarter-end. These securities are trading assets valued using Level 3, significant unobservable inputs.
- Agency securities fair value increased by $191.9 million through other comprehensive income, compared with $89.7 million in Q1 2015. No other-than-temporary impairment was recorded on Agency securities.
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. This is management’s assessment, not formal earnings guidance; the filing provides no numerical earnings or dividend outlook beyond declared dividends.
- The business is exposed to short-term funding and refinancing risk: most assets are financed with repurchase agreements that reprice frequently, and falling collateral values or higher haircuts may trigger margin calls. Management cautioned that adequate liquidity to meet all margin calls cannot be assured.
- Interest-rate sensitivity estimates showed that an immediate 100-basis-point increase could reduce projected net interest income by 14.56%; a 100-basis-point decrease was estimated to increase it by 23.95%. These are model-based estimates under stated assumptions, not forecasts, and results may differ materially.
- Other key risks include interest-rate and mortgage-spread movements, prepayment speeds and premium amortization, Non-Agency credit performance, counterparty and derivative risk, and potential changes to Fannie Mae and Freddie Mac. ARMOUR noted its derivatives may not fully offset portfolio risks and that GAAP derivative mark-to-market changes can create earnings volatility.
- The April JAVELIN acquisition added Agency and Non-Agency assets and repurchase liabilities. Preliminary acquisition accounting showed $91.7 million of identifiable net assets against $85.2 million of consideration; ARMOUR expected to recognize a $6.5 million bargain-purchase gain in Q2 2016. The filing also identified $1.5 million of acquisition costs in Q1 expenses.
- Nine putative shareholder class actions challenged the JAVELIN transaction, alleging fiduciary-duty breaches and inadequate disclosures, among other claims. ARMOUR said it intended to defend the cases, but could not estimate the outcome; damages, transaction rescission, and substantial defense costs were possible.
- Management fees are based on gross equity raised rather than asset performance, so they may not decline with earnings. ARMOUR also reported potential conflicts arising from its external manager’s relationships with ARMOUR, JAVELIN, and affiliated officers and directors.
Important facts for investors to verify
- Whether the acquisition’s preliminary $6.5 million bargain-purchase gain and other JAVELIN fair-value estimates changed when finalized.
- Subsequent performance of net interest income, derivative results, and book value, distinguishing GAAP derivative mark-to-market losses from portfolio fair-value changes reported in other comprehensive income.
- Liquidity, unpledged collateral, repurchase-agreement maturities and haircuts, leverage, and exposure to margin calls or lender concentration.
- Actual credit performance and valuation assumptions for the new Level 3 Non-Agency portfolio.
- Developments and potential financial or operational consequences of the JAVELIN shareholder litigation, as well as the sustainability of common dividends relative to taxable income and cash resources.