Business context and reporting period
Invesco Mortgage Capital Inc. (NYSE: IVR) filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2011. The externally managed REIT invests in Agency and non-Agency residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and related investments, financing most securities with short-term repurchase agreements. Unless noted otherwise, dollar amounts below are in millions.
Financial performance and position
| Metric | Q2 2011 | Q2 2010 | Six months 2011 | Six months 2010 |
|---|---|---|---|---|
| Interest income | $109.0 | $29.2 | $177.5 | $47.2 |
| Interest expense | $34.2 | $6.4 | $49.8 | $10.0 |
| Net interest income | $74.8 | $22.8 | $127.7 | $37.2 |
| Net income | $74.4 | $22.1 | $128.1 | $35.2 |
| Net income attributable to common shareholders | $73.0 | $20.8 | $125.2 | $32.8 |
| Basic and diluted EPS | $0.99 | $0.91 | $2.00 | $1.70 |
| Dividend declared per common share | $0.97 | $0.74 | $1.97 | $1.52 |
- At June 30, total assets were $12,526.8, including mortgage-backed securities of $12,155.9. Total liabilities were $10,701.4 and total equity was $1,825.4.
- Repurchase-agreement borrowings were $9,560.8, up from $4,344.7 at year-end 2010. The weighted average repo rate was 0.52%. Reported total leverage was 5.2x; management said it would have been about 5.7x if quarter-end securities awaiting settlement had been financed.
- Portfolio fair value was $12,155.9: Agency RMBS $8,551.0, non-Agency RMBS $2,320.4, CMBS $1,205.7, and CMOs $78.8. Average portfolio yield in Q2 was 4.29%; average cost of funds was 1.54%, producing a 2.75% net interest rate margin. Annualized return on average equity was 18.99%.
- Six-month operating cash flow was $115.8; investing cash outflow was $6,172.0 and financing cash inflow was $5,992.7. Cash at June 30 was only $0.066, with restricted cash of $134.0. Management emphasized access to borrowing capacity and available liquidity rather than cash on hand.
- Book value per fully diluted share was $19.34, down from $20.49 at December 31, 2010. Accumulated other comprehensive loss was $89.8, versus income of $24.0 at year-end, primarily reflecting the decline in fair value of interest-rate swaps.
Material changes versus the prior comparable period
- Q2 net interest income rose to $74.8 from $22.8, and six-month net income rose to $128.1 from $35.2. Management attributed the increase mainly to rapid portfolio expansion funded by equity offerings and repo borrowing.
- The larger portfolio came with lower yields and narrower spreads: Q2 average portfolio yield fell to 4.29% from 5.71%, and net interest margin contracted to 2.75% from 4.13%. For the first half, margin was 2.89% versus 4.00%.
- Mortgage securities more than doubled from year-end 2010, while repo borrowings also more than doubled. Common shares issued and outstanding increased to 92.9 million from 49.9 million at year-end. June equity offerings included a 19.55-million-share follow-on offering that generated $388.8 million net, plus $27.8 million net through the direct stock purchase plan.
- Book value per share declined despite increased earnings, with management identifying swap valuation losses as the primary cause. The reported dividend was $0.97 per share for Q2, paid July 28, 2011.
Outlook, commentary, risks, and unusual items
- No specific earnings or portfolio guidance was provided. Management said it believed available equity proceeds, operating cash flow, and borrowing capacity would cover anticipated short-term liquidity needs, while longer-term needs depend on access to additional debt and equity financing.
- The company targets aggregate debt-to-equity leverage of 3x–7x and said it generally hedges interest-rate exposure as it considers prudent. Interest-rate swaps had $6,925.0 notional, with a 2.29% average fixed-pay rate and 4.9-year average remaining term.
- Repo financing exposes the company to refinancing, counterparty, collateral and margin-call risks. Agreements generally mature or are renewed within one year; lenders can revalue collateral and demand cash or additional securities. Repo counterparties held $10.4 billion of company securities as collateral, about 109% of repo balances.
- Derivative exposure is material: swap liabilities were $139.1 at June 30, and management estimated $134.6 of accumulated hedge losses would be reclassified as increased interest expense over the following 12 months. Certain derivative agreements include default triggers tied to debt default, net asset value or equity thresholds; the company reported compliance at quarter-end.
- The company had sold credit protection through a CDS with $128.8 notional and $96.6 maximum potential future undiscounted payments; it held $19.8 of cash collateral with the counterparty. CDS income was $1.3 in Q2 and $3.8 for the half, including premiums and fair-value gains.
- Following the quarter, S&P downgraded the U.S. government credit rating. The filing identifies potential declines in asset values, higher borrowing costs, reduced repo advance rates, additional collateral calls and lower liquidity as related risks. Other key risks include interest-rate and spread movements, prepayments and extension risk, credit losses, mortgage-market disruption, and maintaining REIT and Investment Company Act status.
- The company committed up to $100.0 to the Invesco PPIP Fund; about $69.3 had been called, leaving approximately $30.7 of additional commitment. The manager is a related party, charges a fee equal to 1.50% of defined shareholders’ equity annually, and may be reimbursed for expenses without a dollar cap.
- Management reported effective disclosure controls and no material change in internal control over financial reporting during the first half. No legal proceedings were reported at June 30.
Important facts for investors to verify
- Whether repo financing remains available on acceptable terms, and whether the company can meet margin calls during market stress; review repo maturities, haircuts and counterparty concentration.
- How current fair values and the $89.8 accumulated other comprehensive loss affect book value, particularly given $139.1 of swap liabilities and the anticipated $134.6 hedge-loss reclassification.
- Whether portfolio growth can offset the decline in yields and net interest margin, including the effects of funding costs, prepayments and hedging.
- Whether the $0.97 quarterly dividend is supported by taxable income and cash available after debt service and investment needs; REIT status generally requires distributing at least 90% of taxable income.
- How the U.S. credit downgrade and broader rate, spread, credit and mortgage-market changes affect collateral values, financing access and liquidity.
- The outstanding PPIP funding commitment and related-party management fees and expense reimbursements.