Armour Residential REIT, Inc. annual report, FY2018

ARMOUR Residential REIT, Inc. — 2018 Form 10-K

Reporting period: Fiscal year ended December 31, 2018; the filing also presents quarterly results. Financial amounts below are in U.S. dollars unless otherwise noted. The audited statements received an unqualified opinion.

Business context

ARMOUR is an externally managed mortgage REIT investing primarily in agency mortgage-backed securities (MBS), funded largely through short-term repurchase agreements. It also holds non-agency and credit-risk securities, interest-only securities, and, at year-end, U.S. Treasury securities. ACM manages the company. ARMOUR intends to maintain REIT status and an exclusion from regulation under the Investment Company Act.

Financial performance and position

Metric	2018	2017
Total interest income	$283.1 million	$254.4 million
Interest expense on repos	$154.2 million	$94.6 million
Net interest income	$128.9 million	$159.9 million
Total other income (loss)	$(197.9) million	$57.1 million
Net income (loss)	$(106.0) million	$181.2 million
Net income (loss) per common share, diluted	$(2.92)	$4.17
Common dividend declared per share	$2.28	$2.28

• Net interest spread was 1.60% in 2018 versus 1.63% in 2017. Average portfolio yield rose 0.27 percentage points, but average cost of funds rose 0.30 points. Repo interest expense increased substantially.
• Return on equity was negative 9.42%, compared with positive 13.66% in 2017. Quarterly net income was positive in the first three quarters, followed by a fourth-quarter net loss of $212.0 million.
• At year-end, total assets were $8.46 billion, including $7.05 billion of Agency Securities and $819.9 million of Credit Risk and Non-Agency Securities. Stockholders’ equity was $1.13 billion, down from $1.33 billion.
• Repurchase borrowings were $7.04 billion, down from $7.56 billion; period-end debt-to-equity leverage rose to 6.25:1 from 5.70:1. Repo weighted-average maturity shortened to 14 days from 51 days.
• Reported liquidity was $584.3 million: $221.7 million cash and $362.7 million of unpledged Agency Securities, including securities received as collateral. Operating activities provided $75.2 million of cash and cash collateral, compared with $110.1 million in 2017.

Material changes and unusual items

• The shift from 2017 profit to 2018 loss mainly reflected lower net interest income and a deterioration in other income (loss). Realized losses on Agency Securities were $153.0 million, compared with $8.5 million in 2017; the company also recorded $12.1 million of impairment losses on previously identified low-yielding Agency Securities.
• Credit Risk and Non-Agency Securities generated a $27.3 million loss in 2018, versus a $65.7 million gain in 2017, including a $44.2 million unrealized loss in 2018. Derivatives produced a net gain of $1.8 million, compared with $16.6 million in 2017.
• Unrealized losses on available-for-sale Agency Securities were $188.8 million in 2018 and were recorded in other comprehensive income, not current-period earnings. The filing notes that derivative fair-value changes flow through earnings while Agency Securities’ unrealized changes generally flow through equity, contributing to GAAP volatility.
• Agency Securities were 88.2% of the securities portfolio at year-end. Non-agency holdings declined to 10.3% of the portfolio from 11.5%; ARMOUR sold $97.8 million of these securities during 2018.

Dividends, outlook, risks and contingencies

• ARMOUR paid $97.0 million in common dividends and $17.0 million in preferred dividends in 2018. Estimated REIT taxable income available for dividends was $33.2 million; approximately 83.2% of common dividends were characterized as nontaxable return of capital. The Board determines future dividends; no minimum dividend is guaranteed.
• The filing provides no formal earnings or dividend guidance. Management stated it believed available liquidity and capital resources were sufficient for anticipated short-term needs, including financing obligations and distributions, while noting that future capital raising depends on market conditions.
• Interest-rate, mortgage-spread and prepayment risks are central. The Federal Reserve raised its target range to 2.25%–2.50% in December 2018. ARMOUR warns that rising short-term rates can increase funding costs faster than asset yields, while spread widening can reduce MBS values and book value. Its sensitivity estimates are model-based and actual outcomes may differ.
• Funding and collateral risks are significant: 49.8% of repo borrowings were with BUCKLER, an affiliated broker-dealer in which ARMOUR holds a 10% interest and to which it provided $105 million in subordinated loans. BUCKLER’s financing access, regulatory compliance, and concentration are material considerations.
• Nine putative class-action suits relating to the 2016 JAVELIN tender offer and merger remained in litigation; the court had not ruled on the motion to dismiss, and ARMOUR could not estimate the outcome. The company intends to defend the claims.
• Other disclosed risks include REIT qualification and Investment Company Act exclusion, counterparty and liquidity exposure, GSE reform, cybersecurity, and conflicts arising from external management and affiliated transactions. Management and the auditor reported effective internal control over financial reporting at year-end.
• Subsequent to year-end, ARMOUR reported a January common-stock offering of 6.9 million shares for net proceeds of approximately $138.2 million, in addition to ATM issuance. The filing also noted the planned introduction of Uniform MBS in June 2019, with its market impact uncertain.

Important facts for investors to verify

• Whether operating spreads and net interest income can withstand higher repo rates and very short financing maturities.
• The composition and availability of reported liquidity, collateral requirements, and the company’s dependence on BUCKLER for nearly half its repo financing.
• Drivers of the 2018 Agency Securities sale losses, non-agency valuation losses, and fourth-quarter GAAP loss; distinguish realized losses from unrealized equity changes.
• The sustainability and tax character of dividends relative to taxable income, cash generation, and capital levels.
• Developments in the JAVELIN-related litigation, GSE policy, and the transition to Uniform MBS.
• Potential conflicts and fee incentives under ACM’s management agreement, whose fees are based on gross equity raised rather than investment performance.