ARR

Business Context and Reporting Period

Company: Armour Residential REIT, Inc. (ARMOUR)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2010
Business Overview: ARMOUR is an externally-managed Maryland corporation investing primarily in hybrid adjustable rate, adjustable rate, and fixed rate residential mortgage-backed securities (Agency Securities) issued or guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae. The company operates as a Real Estate Investment Trust (REIT) and utilizes leverage through repurchase agreements to finance its portfolio.

Key Financial Metrics

Liquidity & Leverage: The company maintained a leverage ratio of approximately 6.2:1 (Debt to Equity) as of June 30, 2010. Cash provided by operating activities was $1.9 million for the six-month period, while investing activities used $302.6 million primarily for the purchase of Agency Securities.

Material Changes vs. Prior Period

• Portfolio Expansion: Agency Securities increased from $118.6 million at December 31, 2009, to $477.6 million at June 30, 2010. This growth was funded by a follow-on equity offering and increased borrowings.
• Debt Financing: Repurchase agreements surged from $46.4 million to $334.7 million to support the expanded portfolio. The weighted average cost of funds was 0.30%.
• Equity Capital: On June 21, 2010, the company completed an underwritten public offering of 5,110,000 shares at $6.75 per share, raising net proceeds of approximately $32.1 million. Total shares outstanding increased from 2.3 million to 7.4 million.
• Hedging Activity: The company significantly increased its hedging position, entering into Eurodollar futures contracts with a notional amount of $165.0 million (up from $21.0 million). This resulted in a non-cash unrealized loss of $2.1 million for the six-month period, which materially impacted GAAP net income.
• Prepayment Rates: The average quarterly principal repayment rate (CPR) was 15.4% for the quarter ended June 30, 2010, an increase from 14.5% in the prior quarter, driven largely by agency repurchases of delinquent loans.

Guidance, Outlook, and Risks

Management Commentary: Management notes that GAAP net loss differs significantly from REIT taxable income due to the unrealized losses on interest rate contracts, which are non-taxable. Estimated REIT taxable income for the six months ended June 30, 2010, was approximately $1.9 million, supporting the dividend payments made.

Outlook: The company intends to continue deploying capital into Agency Securities and managing interest rate risk through derivatives. Management expects prepayment rates to remain elevated due to ongoing agency repurchase programs for delinquent loans.

Risks and Contingencies:

• Interest Rate Risk: The company faces mismatch risk where borrowing costs (short-term LIBOR-based) may rise faster than asset yields (longer-term adjustable rates with caps). Sensitivity analysis indicates a 100 basis point rate decrease could reduce projected net interest income by 27.05% due to accelerated premium amortization.
• Liquidity and Margin Calls: Declines in the value of Agency Securities could trigger margin calls from lenders. The company maintains liquidity to meet these calls but notes that severe market deterioration could force asset liquidation.
• Counterparty Risk: The company relies on seven major counterparties for repurchase agreements. Concentration exists with MF Global (25.0%) and Goldman Sachs (24.3%).
• Regulatory Risk: Changes in the status of Fannie Mae and Freddie Mac or government intervention in the mortgage market could impact asset values and prepayment speeds.

Investor Verification Checklist

• REIT Taxable Income vs. GAAP Loss: Verify the reconciliation between the reported GAAP net loss and the estimated REIT taxable income to understand the sustainability of dividends.
• Hedging Effectiveness: Assess the correlation between the $165 million in Eurodollar futures and the portfolio's interest rate exposure to determine if the hedging strategy is effectively mitigating risk or introducing volatility.
• Counterparty Concentration: Review the exposure to specific lenders (MF Global, Goldman Sachs) and the potential impact of counterparty insolvency or credit tightening.
• Prepayment Sensitivity: Evaluate the impact of the 15.4% CPR on the amortization of the $19.8 million unamortized premium in the portfolio.
• Liquidity Buffer: Confirm the adequacy of the $25.7 million in cash and restricted cash relative to the $334.7 million in debt and potential margin call requirements.