Armour Residential REIT, Inc. — Q2 2011 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2011. Armour is an externally managed mortgage REIT investing primarily in agency residential mortgage-backed securities (Fannie Mae, Freddie Mac and Ginnie Mae). It funds purchases mainly through short-term repurchase agreements and uses derivatives to manage interest-rate exposure.
Financial and operating performance
- Portfolio and balance sheet: Agency securities were $5.26 billion at fair value, up from $1.16 billion at December 31, 2010. Total assets were $5.53 billion; stockholders’ equity was $534.0 million. Book value per share was $7.14, versus $6.61 at year-end.
- Revenue and earnings: Q2 net interest income was $21.0 million, compared with $1.2 million in Q2 2010. A $25.8 million noncash loss from changes in derivative fair value contributed to a $7.3 million net loss, or $(0.14) per share, versus a $0.7 million loss, or $(0.22) per share, a year earlier. For the first half, net interest income was $31.4 million and net income was $1.3 million, or $0.03 per share, versus a $0.4 million loss, or $(0.14) per share, in the first half of 2010.
- Margins and costs: Q2 asset yield was 3.35%, cost of funds 0.99%, and net interest margin 2.36%. Total interest expense, including swap payments, was $8.5 million for the quarter. Q2 operating expenses were $2.1 million, including $1.5 million of management fees.
- Cash flow and liquidity: For the first half, operating cash flow was $32.7 million, investing cash outflow was $3.89 billion, and financing cash inflow was $4.01 billion. Cash ended at $188.2 million; restricted cash was $55.3 million. Management stated it believed liquidity and capital resources were sufficient for anticipated near-term needs.
- Borrowings and leverage: Repurchase agreements totaled $4.66 billion, up from $972 million at year-end. Reported leverage was approximately 8.72:1 equity; repo weighted-average maturity was 27 days and weighted-average funding rate was 0.23%. The portfolio’s repo haircut averaged about 5.0%.
- Dividends and capital: The company paid monthly dividends of $0.12 per share during the quarter ($0.36 total). Four public offerings issued 51.2 million shares during the first half; the company also reported 7.1 million shares issued under its dividend reinvestment and stock purchase plan since inception. Shares outstanding were 74.8 million at quarter-end.
Material changes versus comparable periods
- The business expanded rapidly: agency securities rose from $1.16 billion at year-end to $5.26 billion at June 30, while repo financing increased from $972 million to $4.66 billion. The growth was supported by equity offerings and increased leverage.
- Net interest income increased substantially versus 2010 as the company deployed newly raised capital. Comparisons are affected by the much smaller portfolio and share count in 2010.
- Derivative losses weighed heavily on reported GAAP results. First-half derivative fair-value losses were $26.1 million, while agency securities generated a $36.5 million unrealized gain recorded in other comprehensive income. The company does not use hedge accounting, so these movements can affect earnings in different periods.
- Management reported first-half average portfolio repayment rates of 10.5%, down from 15.0% in the first half of 2010. The portfolio remained purchased at a premium: weighted-average amortized cost was 103.94% of par, with about $197.9 million of unamortized premium.
Outlook, risks and unusual items
- No specific earnings, margin, portfolio-growth or dividend guidance was provided. The Board said it would review the dividend policy quarterly; dividends are not guaranteed.
- Management described an uncertain rate and economic environment and expected continued interest-rate volatility. It noted that low short-term rates had reduced funding costs, while market conditions and policy changes could affect asset pricing and financing.
- Key exposures include rising short-term borrowing costs, asset/liability repricing mismatches, mortgage prepayments that accelerate premium amortization, and changes in agency-security values. Repo financing is short-term and largely uncommitted; falling collateral values can trigger margin calls or forced asset sales. At quarter-end, 8.72:1 leverage increased this liquidity sensitivity.
- Management warned that a U.S. sovereign credit downgrade or changes to Fannie Mae and Freddie Mac could affect agency-security values and market stability. It also noted uncertainty around housing-finance reform and government mortgage-market actions.
- The company reported no pending, threatened or contemplated litigation and no material change to the risk factors in its 2010 Form 10-K. Subsequent events included approval of an increase in authorized common shares to 500 million and stockholder approval to expand the stock incentive plan to 2 million shares. The Board had proposed broadening permitted investments to include non-agency securities, subject to stockholder approval.
Important facts for investors to verify
- Whether repo counterparties renew or expand financing on acceptable terms, and how margin calls, haircuts and collateral values develop.
- The sensitivity of net interest income and portfolio value to rate changes: the filing’s model estimated a 15.78% decline in net interest income for an immediate 100-basis-point rise and a 2.70% decline in portfolio value, including derivatives.
- Whether hedge performance, derivative fair values and collateral requirements remain manageable; derivative liabilities were $36.0 million at quarter-end, with $1.9 billion of swap notional outstanding.
- Prepayment experience and its effect on premium amortization, asset yields and reinvestment opportunities.
- The relationship between GAAP earnings, REIT taxable income and dividends. Estimated REIT taxable income was $18.6 million for Q2 and $27.4 million for the first half, differing materially from GAAP results.
- The effects of further share issuance, incentive-plan expansion and any change in permitted investment strategy on per-share book value and returns.