Armour Residential REIT, Inc. — Q3 2017 Form 10-Q
Business context and reporting period. Armour is an externally managed mortgage REIT investing primarily in agency mortgage-backed securities (MBS), with additional credit-risk and non-agency MBS and interest-only securities. This unaudited report covers the quarter and nine months ended September 30, 2017; balance-sheet comparisons are with December 31, 2016. Amounts below are in millions unless otherwise noted.
Financial performance and position
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Interest income | $66.8 | $58.4 | $185.4 | $202.7 |
| Net interest income | $39.6 | $41.3 | $119.7 | $148.3 |
| Other income (loss) | $(3.5) | $86.5 | $17.0 | $(259.0) |
| Net income (loss) | $27.7 | $118.7 | $110.1 | $(139.6) |
| Net income (loss) available to common | $23.8 | $114.8 | $98.4 | $(151.3) |
| Diluted earnings (loss) per common share | $0.58 | $3.12 | $2.57 | $(4.12) |
Net interest income was pressured by higher repurchase-agreement interest expense. The company reported a 1.66% net interest rate spread for the first nine months of 2017, versus 1.39% in the comparable 2016 period; management attributed the improvement partly to higher asset yields and slower prepayments, offset by a smaller average MBS portfolio. The filing does not provide a clear quarterly operating margin measure.
- Assets and capital: Total assets were $8,578.2 at September 30, versus $7,978.2 at year-end 2016. Stockholders’ equity was $1,312.7, up from $1,092.1. Agency securities were $7,093.7; credit-risk and non-agency securities were $966.5.
- Debt and liquidity: Repurchase-agreement borrowings totaled $7,225.7, compared with $6,818.5 at year-end. The reported leverage ratio was 5.50:1, or 7.00:1 including forward-purchased TBA securities and excluding debt related to forward-settling sales. Liquidity was $659.0, comprising $299.9 cash and $359.1 unpledged agency securities.
- Cash flows: Nine-month operating cash flow was $96.8, versus $(171.7) in 2016. Investing activities used $530.7, including $105.0 in subordinated loans to BUCKLER; financing activities provided $462.1. Cash rose to $299.9 from $271.8 at year-end.
- Dividends and issuance: Common dividends declared were $0.57 per share for Q3 and $1.71 for the first nine months, down from $0.66 and $2.36, respectively, in 2016. The company raised $116.7 net from a June common-stock offering and $7.5 net from Series B preferred shares sold through an ATM program.
Material changes versus comparable periods
- Quarterly net income fell to $27.7 from $118.7, mainly reflecting the absence of the prior-year period’s large gains on derivatives and credit/non-agency securities. Q3 2017 included a $7.6 loss on credit-risk and non-agency securities and $3.5 of total other loss.
- For the first nine months, results moved from a $139.6 net loss to $110.1 net income. The key comparison is the prior-year $338.8 realized derivative loss, partly offset by 2017’s lower net interest income and other portfolio gains and losses.
- Agency securities’ fair value increased from $6,511.2 at year-end to $7,093.7. Their share of the MBS portfolio declined from 85.7% to 87.7% as reported in the notes; credit-risk/non-agency securities decreased from $1,052.2 to $966.5.
- Credit-risk and non-agency securities were transferred from Level 3 to Level 2 fair-value classification in Q3, reflecting the company’s conclusion that third-party pricing and dealer quotes met Level 2 criteria.
Outlook, risks, contingencies and unusual items
- Management said it believed available liquidity and capital were sufficient for anticipated short-term needs, including investments, financing obligations, expenses and REIT distributions. No earnings, spread or portfolio guidance was provided.
- The business is highly exposed to short-term funding costs, interest rates, MBS spreads, prepayments, leverage and repo-market access. Repo financing is short-term and collateralized; falling collateral values can trigger margin calls, additional collateral requirements or forced sales. At quarter-end, weighted average repo maturity was 36 days and average haircut was 6.76%.
- Interest-rate sensitivity estimates show that an instantaneous 100-basis-point increase could reduce projected net interest income by 7.76%, portfolio value including derivatives by 0.42%, and shareholder equity including hedges by 3.27%. A 25-basis-point widening in MBS spreads was estimated to reduce portfolio market value by 1.33% and portfolio book value by 10.15%. These are model-based estimates, not forecasts.
- The company recognized $10.4 of other-than-temporary impairment on agency securities during the first nine months, including $0.1 in Q3, for securities identified for possible repositioning. The remaining identified low-yield securities had fair value of $825.2 at quarter-end.
- Nine JAVELIN acquisition-related shareholder lawsuits had been filed; the Florida case was dismissed, while the consolidated Maryland case remained unresolved after a motion-to-dismiss hearing. Armour said it could not estimate the outcome and noted possible damages and substantial defense costs.
- Armour provided $105.0 in subordinated loans to BUCKLER Securities, an affiliated broker-dealer in which it holds a 10% interest. BUCKLER began trading on October 25, 2017, after quarter-end. The loans carry a stated zero interest rate, with additional interest tied to earnings on invested loan proceeds.
- Management identified no material changes to the risk factors in its 2016 Form 10-K and stated disclosure controls were effective. The filing reports no material change in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- Whether net interest income and the reported spread can withstand further increases in repo funding costs, and how much of the hedge program offsets those increases.
- Whether $659.0 of reported liquidity remains adequate under stressed margin calls, wider MBS spreads or reduced repo availability, given the short average repo maturity and leverage.
- The sustainability of common dividends relative to REIT taxable income, cash generation and capital needs; reported nine-month estimated REIT taxable income was $16.7 versus $77.2 of total dividends paid.
- The basis and sensitivity of MBS fair values, including the Q3 transfer of $966.5 of credit-risk/non-agency securities from Level 3 to Level 2 and the estimated $825.2 portfolio of identified low-yield agency securities.
- Developments in the JAVELIN litigation and BUCKLER’s operations, financing benefits, related-party governance and repayment of the $105.0 subordinated loans.