Business context and reporting period
Invesco Mortgage Capital Inc. is an externally managed mortgage REIT investing in Agency and non-Agency mortgage-backed securities, credit risk transfer securities, commercial mortgage-backed securities, and residential and commercial loans. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2015; comparative 2014 figures are restated.
Major reporting caveat: The company concluded that financial statements for 2013, 2014, and all quarters through March 31, 2015 required restatement and should no longer be relied upon. This filing should be read with the company’s amended 2014 Form 10-K.
Financial performance and condition
| Metric | Q2 2015 | Six months 2015 |
|---|---|---|
| Interest income | $160.8 million | $328.6 million |
| Interest expense | $70.4 million | $142.7 million |
| Net interest income | $90.4 million | $185.9 million |
| Net income attributable to common stockholders | $139.9 million | $122.5 million |
| Diluted earnings per common share | $1.04 | $0.96 |
| Common dividends declared per share | $0.45 | $0.90 |
| Core earnings, a non-GAAP measure | $50.0 million; $0.41 per share | $112.0 million; $0.91 per share |
Q2 net income included a $56.0 million net gain on derivatives; the six-month derivative result was a $66.7 million net loss. Results were therefore materially affected by derivative fair-value movements, including swap gains, rather than solely by recurring interest earnings. Q2 comprehensive loss attributable to common stockholders was $36.7 million, reflecting a $193.3 million unrealized loss on mortgage-backed and credit risk transfer securities during the quarter.
Average investment portfolio yield was 3.12% in Q2 and 3.20% for the first half, down from 3.41% and 3.43% in the respective 2014 periods. GAAP net interest margin was 1.58% in Q2 and 1.63% for the first half, versus 1.83% and 1.84%. Management’s non-GAAP effective interest rate margin was 1.05% and 1.13%, respectively. Core earnings are non-GAAP and should not be treated as a substitute for GAAP income or cash available for distributions.
At June 30, total assets were $21.2 billion, including $17.2 billion of mortgage-backed and credit risk transfer securities and $3.5 billion of residential loans. Cash and cash equivalents were $87.0 million. Total liabilities were $18.6 billion; borrowings included $13.2 billion of repurchase agreements, $1.55 billion of secured loans, $3.0 billion of securitization ABS and $400 million of exchangeable notes. Total debt-to-equity was 6.9x; repurchase-agreement debt-to-equity was 5.3x. Diluted book value per common share was $18.62, compared with $18.82 at December 31, 2014.
For the first half, operating activities provided $187.5 million of cash, investing activities used $55.2 million and financing activities used $209.4 million. Cash declined by $77.1 million to $87.0 million.
Material changes versus the prior comparable period
- Common-stockholder earnings rebounded from a restated Q2 2014 loss of $65.8 million to income of $139.9 million; first-half results changed from a restated loss of $132.5 million to income of $122.5 million. The principal driver was the sharply improved derivative result.
- Net interest income declined 10.7% in Q2 and 7.2% for the first half year over year. Management attributed the decline primarily to lower portfolio yields and higher average borrowings.
- Portfolio yield decreased while the average investment portfolio grew to approximately $20.6 billion in Q2, partly reflecting more consolidated residential-loan securitizations. The company had 11 such trusts versus seven a year earlier.
- Repurchase agreements declined from $13.6 billion at year-end to $13.2 billion, while secured loans increased from $1.25 billion to $1.55 billion. Weighted-average remaining borrowing maturity was 354 days.
- Book value per diluted common share decreased from $18.82 at year-end, primarily due to valuation changes recorded in other comprehensive income.
Outlook, risks and unusual items
Management provided no quantified earnings or investment guidance. It said it believed available liquidity and capital resources were sufficient for anticipated short-term needs, including investments, debt repayments, margin requirements and dividends. Long-term liquidity depends on obtaining additional debt financing; the company cautioned that inability to renew, replace or expand financing on comparable terms could adversely affect results.
Management described Q2 financial conditions as weaker, with higher longer-term rates, greater volatility and wider credit spreads. Key exposures include interest rates, prepayments and extension risk, credit losses, real-estate values, funding availability, repo refinancing, margin calls, counterparty performance and derivative effectiveness. A parallel 100-basis-point rate increase was modeled to reduce projected portfolio value by 1.17% and increase projected net interest income by 10.17%; a 100-basis-point decrease was modeled to change those measures by 0.06% and negative 50.72%, respectively. These are management estimates, not forecasts or guarantees.
Controls and restatement: Management reported disclosure controls were ineffective at June 30, 2015 because a material weakness in internal control over financial reporting remained unremediated. The weakness involved accounting for GSE CRTs and Agency MBS interest-only securities as investments rather than evaluating them as hybrid instruments with embedded derivatives. The company was engaging an accounting firm and formalizing technical-accounting review procedures, but the new controls had not operated long enough to establish remediation.
Management reported no other-than-temporary impairment losses for the periods presented and no legal proceedings as of June 30. The company reported compliance with repurchase-agreement covenants and derivative financial provisions. It had $26.3 million of remaining commitments to affiliated-manager-sponsored unconsolidated ventures and $1.1 million of unfunded commercial-loan commitments.
Important facts for investors to verify
- Review the amended 2014 Form 10-K and March 2015 Form 10-Q for the full restatement basis, effects on prior results and related disclosures.
- Track remediation and independent assessment of the material weakness, and whether subsequent filings report effective controls.
- Separate recurring portfolio economics and core earnings from volatile derivative marks; verify the assumptions and cash effects of hedges.
- Monitor repo financing terms, collateral haircuts, margin-call capacity, available FHLBI borrowing and the maturity profile of funding.
- Assess whether lower asset yields and margins, high leverage, and the $0.45 quarterly common dividend remain supportable by future earnings and taxable income.
- Evaluate portfolio credit and concentration risks, including California exposure in residential loans and the effect of changing rates, prepayments and spreads on asset values.