We are a principal investment firm that currently acquires and holds a levered
portfolio of residential mortgage-backed securities (“MBS”), consisting
of agency MBS and private-label MBS. Agency MBS include residential mortgage
pass-through certificates for which the principal and interest payments are
guaranteed by a U.S. government agency or government sponsored enterprise (“GSE”),
such as the Federal National Mortgage Association (“Fannie Mae”)
and the Federal Home Loan Mortgage Corporation (“Freddie Mac”).
Private-label MBS, or non-agency MBS, include residential MBS that are not guaranteed
by a GSE or the U.S. government.
We leverage prudently our investment portfolio so as to increase potential returns
to our shareholders. We fund our investments primarily through short-term financing
arrangements.
We are a Virginia corporation and taxed as a C corporation for U.S. federal
tax purposes. We are an internally managed company and do not have an external
investment advisor.
We manage our investment portfolio with the goal of obtaining a high risk-adjusted
return on capital. We evaluate the rates of return that can be achieved in each
asset class and for each individual security within an asset class in which
we participate. We then evaluate opportunities against the returns available
in each of our investment alternatives and attempt to allocate our assets and
capital with an emphasis toward what we believe to be the highest risk-adjusted
return available. We expect this strategy will cause us to have different allocations
of capital and leverage in different market environments.
Currently, based on market conditions, we believe our residential MBS portfolio
has provided us with higher relative risk-adjusted rates of return than most
other investment opportunities we have evaluated. Consequently, we have maintained
a high allocation of our assets and capital in this sector and have continued
to analyze other opportunities and compare risk-adjusted returns to our residential
MBS assets. Within our residential MBS investment portfolio, we have continued
to gradually increase our investment capital allocation to agency MBS from private-label
MBS.
In the future, we may invest in other types of residential mortgage assets such
as residential mortgage loans, mortgage servicing rights and GSE credit risk
transfer securities, as well as other types of assets, including commercial
MBS, asset backed securities, other structured securities, commercial mortgage
loans, commercial loans, and other real estate-related loans and securities.
Agency MBS consist of residential pass-through certificates that are securities
representing undivided interests in "pools" of mortgage loans secured
by residential real property. The monthly payments of both principal and interest
of the securities are guaranteed by a U.S. government agency or GSE to holders
of the securities, in effect "passing through" the monthly payments
made by the individual borrowers on the mortgage loans that underlie the securities
plus “guarantee payments” made in the event of any defaults on such
mortgage loans, net of fees paid to the issuer/guarantor and servicers of the
underlying mortgage loans, to the holders of the securities. In general, mortgage
pass-through certificates distribute cash flows from the underlying collateral
on a pro rata basis among the holders of the securities. Although the principal
and interest payments are guaranteed by a U.S. government agency or GSE to the
security holder, the market value of the agency MBS is not guaranteed by a U.S.
government agency or GSE.
We also invest in private-label MBS, which are residential MBS that are not
issued or guaranteed by a U.S. government agency or a GSE. Private-label MBS
are often referred to as non-agency MBS. The private-label MBS in which we invest
are generally backed by a pool of single-family residential mortgage loans.
These certificates are issued by originators of, investors in, and other owners
of residential mortgage loans, including savings and loan associations, savings
banks, commercial banks, mortgage banks, investment banks and special purpose
“conduit” subsidiaries of these institutions. Private-label MBS
can carry a significantly higher level of credit exposure relative to the credit
exposure of agency MBS. The private-label MBS that we invest in are generally
non-investment grade or not rated by major rating agencies.
In conducting our business, we are exposed to market risks, including interest
rate, prepayment, extension, credit, liquidity and regulatory risks. We use
a variety of strategies to hedge a portion of our exposure to these risks to
the extent we believe to be prudent, taking into account our investment strategy
and the cost of the hedging transactions. As a result, we may not hedge certain
interest rate, prepayment, extension or credit risks if we believe that bearing
such risks enhances our return relative to our risk/return profile.
We hedge some of our exposure to potential interest rate mismatches between
the interest we earn on our longer term investments and the interest we pay
on our shorter term borrowings. We enter into various hedging transactions to
mitigate the interest rate sensitivity of our cost of borrowing and the value
of our MBS portfolio. Because a majority of our funding is in the form of repurchase
agreements, our financing costs fluctuate based on short-term interest rate
indices, such as LIBOR. Because the vast majority of our investments are assets
that have fixed rates of interest and could mature in up to 40 years, the interest
we earn on these assets generally does not move in tandem with the interest
rates that we pay on our funding repurchase agreements, which generally have
a maturity of less than one year. We may experience reduced income, losses,
or a significant reduction in our book value due to adverse interest rate movements.
In order to attempt to mitigate a portion of such risk, we utilize certain hedging
techniques to attempt to lock in a portion of the net spread between the interest
we earn on our assets and the interest we pay on our financing costs.
Additionally, because prepayments on residential mortgages generally accelerate
when interest rates decrease and slow when interest rates increase, mortgage
securities typically have "negative convexity." In other words, certain
mortgage securities in which we invest may increase in value to a lesser degree
than similar duration bonds, or even fall in value, as interest rates decline.
Conversely, certain mortgage securities in which we invest may decrease in value
to a greater degree than similar duration bonds as interest rates increase.
In order to manage this risk, we monitor, among other things, the "duration
gap" between our mortgage assets and our hedge portfolio as well as our
convexity exposure. Duration is an estimate of the relative expected percentage
change in market value of our mortgage assets or our hedge portfolio that would
be caused by a parallel change in short and long-term interest rates. Convexity
exposure relates to the way the duration of our mortgage assets or our hedge
portfolio changes when the interest rate or prepayment environment changes.
Because residential borrowers have the option to prepay their mortgage loans
at par at any time, we face the risk that we will experience a return of principal
on our investments faster than anticipated. Prepayment risk generally increases
when interest rates decline. In this scenario, our financial results may be
adversely affected as we may have to re-invest that principal at potentially
lower yields.
Because residential borrowers have the option to make only scheduled payments
on their mortgage loans, rather than prepay their mortgage loans, we face the
risk that a return of capital on our investment will occur slower than anticipated.
Extension risk generally increases when interest rates rise. In this scenario,
our financial results may be adversely affected as we may have to finance our
investments at potentially higher costs without the ability to reinvest principal
into higher yielding securities.
We accept mortgage credit exposure at levels we deem prudent within the context
of our investment strategy. Therefore, we may retain all or a portion of the
credit risk on the loans underlying our private-label MBS. We seek to manage
this risk through prudent asset selection, pre-acquisition due diligence, post-acquisition
performance monitoring, and the sale of assets for which we identify negative
credit trends. Additionally, we vary the percentage mix of our private-label
and agency MBS investments in an effort to actively adjust our credit exposure
and to improve the risk/return profile of our investment portfolio.
