AnnAly CApitAl MAnAgeMent, inC.
2012 AnnuAl RepoRt
Corporate profile
Annaly’s principal business objective is to generate net income for distribution
to shareholders from our Investment Securities and from dividends we receive
from our operating subsidiaries. We have elected to be taxed as a real estate
investment trust (REIT). We trade on the New York Stock Exchange under the
ticker symbol NLY.
letteR to ShAReholdeRS
Dear Fellow Shareholders,
2012 was a very difficult year. These words are tough to write because, as most
of you know, our founding CEO, Michael A.J. Farrell, lost his well-fought battle
with cancer. I feel so blessed to have been his long-time partner and friend.
We went through so many challenges together and I learned so many valuable
insights from him, some that have only been revealed upon his passing.
Mike presided over a tremendous success story. He embodied the American
dream. He was a poor, skinny kid from Brooklyn who worked his way from the
back offices of Wall Street to the pinnacle of the investment world. When we
started the company together in 1997, Annaly was an orphan strategy that had
no dedicated place on the investment landscape. Together with our team, we
helped establish mortgage REITs as an enticing entrée on the investment menu
and grew the company into the largest publicly listed mREIT on the New York
Stock Exchange.
As the company moves forward, we face new challenges, which offer new
opportunities. Policy makers continue to thrust complexity upon the markets
through increased regulation, unresolved potential new rules and far off housing
finance reform. The financial markets are also confronted by a dominating,
unconventional influence. This complexity requires a more focused approach
on the eventual transition to a more normalized market environment. Our team
is streamlining our initiatives to prepare for the future. We are reassessing the
value and structure of our businesses in an effort to refine our strategies and
maximize shareholder value.
Mike often wrote of how lucky he was to work with such a loyal, dedicated and
smart group of people. He was incredibly generous with his praise, gracious with
his criticism and he inspired all of us to be more than we ever thought possible.
It was a privilege to be by his side all these years. Mike’s fighting spirit, genuine
values and incredible dedication to protecting and growing shareholder value
will forever inspire and influence our management team as we preserve and
grow his legacy.
Prodesse Non Nocere
Wellington J. Denahan
Chairman and Chief Executive Officer
March 17, 2013
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 2012
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 1-13447
ANNALY CAPITAL MANAGEMENT, INC.
(Exact Name of Registrant as Specified in its Charter)
(State or other jurisdiction of incorporation of organization)
(I.R.S. Employer Identification Number)
MARYLAND
22-3479661
1211 Avenue of the Americas, Suite 2902
New York, New York
(Address of Principal Executive Offices)
10036
(Zip Code)
(212) 696-0100
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class
Name of Each Exchange on Which Registered
Common Stock, par value $.01 per share
New York Stock Exchange
7.875% Series A Cumulative Redeemable Preferred Stock
New York Stock Exchange
7.625% Series C Cumulative Redeemable Preferred Stock
New York Stock Exchange
7.50% Series D Cumulative Redeemable Preferred Stock
New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None.
Indicate by check mark whether the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes X No
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes No X
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive
Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12
months (or for such shorter period that the registrant was required to submit and post such files).
Yes X_ No____
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days:
Yes X_
No ___
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a smaller
reporting company. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer X
Accelerated filer __ Non-accelerated filer __ Smaller reporting company___
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes __ No _X_.
At June 30, 2012, the aggregate market value of the voting stock held by non-affiliates of the Registrant was $16,318,867,645.
The number of shares of the Registrant’s Common Stock outstanding on February 26, 2013 was 947,250,377.
Documents Incorporated by Reference
The registrant intends to file a definitive proxy statement pursuant to Regulation 14A within 120 days of the end of the fiscal year ended
December 31, 2012. Portions of such proxy statement are incorporated by reference into Part III of this Form 10-K.
ANNALY CAPITAL MANAGEMENT, INC.
2012 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PART I
PAGE
ITEM 1.
BUSINESS
ITEM 1A.
RISK FACTORS
ITEM 1B.
UNRESOLVED STAFF COMMENTS
ITEM 2.
PROPERTIES
ITEM 3.
LEGAL PROCEEDINGS
ITEM 4.
MINE SAFETY DISCLOSURE
PART II
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED
STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
ITEM 6.
SELECTED FINANCIAL DATA
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
ITEM 9A.
CONTROLS AND PROCEDURES
ITEM 9B.
OTHER INFORMATION
PART III
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
ITEM 11.
EXECUTIVE COMPENSATION
ITEM 12.
ITEM 13.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
INDEPENDENCE
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
PART IV
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
EXHIBIT INDEX
FINANCIAL STATEMENTS
SIGNATURES
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23
51
51
51
52
53
56
58
77
79
79
79
82
82
82
82
82
82
83
83
86
II-1
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements contained in this annual report may not be based on historical facts and are “forward-
looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking
statements, which are based on various assumptions (some of which are beyond our control), may be identified by
reference to a future period or periods or by the use of forward-looking terminology, such as “may,” “will,” “believe,”
“expect,” “anticipate,” “continue,” or similar terms or variations on those terms or the negative of those terms. Actual
results could differ materially from those set forth in forward-looking statements due to a variety of factors, including,
but not limited to:
•
•
•
•
•
•
•
•
•
•
•
•
•
•
changes in interest rates,
changes in the yield curve,
changes in prepayment rates,
the availability of mortgage-backed securities, other securities and other real estate assets for purchase,
the availability of financing and, if available, the terms of any financing,
changes in the market value of our assets,
changes in business conditions and the general economy,
our ability to integrate the commercial mortgage business,
our ability to consummate any contemplated investment opportunities,
risks associated with the investment advisory business of our wholly owned subsidiaries, including:
o
o
o
the removal by clients of assets managed,
their regulatory requirements, and
competition in the investment advisory business,
risks associated with the broker-dealer business of our subsidiary,
changes in government regulations affecting our business,
our ability to maintain our exemption from registration under the Investment Company Act of 1940, and
our ability to maintain our qualification as a REIT for federal income tax purposes.
No forward-looking statements can be guaranteed and actual future results may vary materially and we caution you not
to place undue reliance on these forward-looking statements. For a discussion of the risks and uncertainties which
could cause actual results to differ from those contained in the forward-looking statements, please see the information
under the caption “Risk Factors” described in this Form 10-K.We do not undertake, and specifically disclaim any
obligation, to publicly release the result of any revisions which may be made to any forward-looking statements to
reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements except
as required by law.
This page intentionally left blank.
ITEM 1. BUSINESS
PART I
All references to “we,” “us,” or “our” mean Annaly Capital Management, Inc. and all entities owned by us,
except where it is made clear that the term means only the parent company. The following defines certain of the
commonly used terms in this annual report on Form 10-K: Agency refers to a federally chartered corporation,
such as Fannie Mae or Freddie Mac, or an agency of the U.S. Government, such as Ginnie Mae; Agency
mortgage-backed securities refers to residential mortgage-backed securities that are issued or guaranteed by an
Agency; Investment Securities refers to Agency mortgage-backed securities, Agency debentures and corporate
debt securities; and Interest-Earning Assets refers to Investment Securities, securities borrowed and U.S.
Treasury Securities.
Background
THE COMPANY
We own, manage, and finance a portfolio of real estate related investments, including mortgage pass-
through certificates, collateralized mortgage obligations (or CMOs), Agency callable debentures, and other
securities representing interests in or obligations backed by pools of mortgage loans. Our principal business
objective is to generate net income for distribution to our stockholders from the spread between the interest
income on our Investment Securities and the costs of borrowing to finance our acquisition of Investment
Securities and from dividends we receive from our subsidiaries. Our wholly-owned subsidiaries offer diversified
real estate, asset management and other financial services. To date over 90% of our total assets have consisted of
Agency mortgage-backed securities and debentures. While we remain committed to the Agency market, given the
current environment, we believe it is prudent to diversify a portion of our investment portfolio. Therefore, we
may allocate up to 25% of our stockholders’ equity to assets other than Agency mortgage-backed securities.
We are a Maryland corporation that commenced operations on February 18, 1997. We are self-advised
and self-managed. We acquired Fixed Income Discount Advisory Company (or FIDAC) on June 4, 2004 and
Merganser Capital Management, Inc. (or Merganser) on October 31, 2008. FIDAC and Merganser manage a
number of investment vehicles and separate accounts for which they earn fee income. Our subsidiary, RCap
Securities, Inc. (or RCap), operates as a broker-dealer, and was granted membership in the Financial Industry
Regulatory Authority (or FINRA) in January 2009. In 2010, we established Shannon Funding LLC (or Shannon),
which provides warehouse financing to residential mortgage originators in the United States. In 2010, we also
established Charlesfort Capital Management LLC (or Charlesfort), which engages in corporate middle market
lending transactions. In 2011, FIDAC established FIDAC Europe Limited (or FIDAC Europe), which we sold in
December 2012. In 2011, we established FIDAC FSI LLC (or FIDAC FSI), which invested in trading securities.
FIDAC FSI was liquidated in August 2012.
We have elected and believe that we are organized and have operated in a manner that qualifies us to be
taxed as a real estate investment trust (or REIT) under the Internal Revenue Code of 1986, as amended (or the
Code). If we qualify for taxation as a REIT, we generally will not be subject to federal income tax on our taxable
income that is distributed to our stockholders. Therefore, substantially all of our assets, other than FIDAC,
Merganser and RCap, which are our taxable REIT subsidiaries, consist of qualified REIT real estate assets (of the
type described in Section 856(c)(5)(B) of the Code). We have financed our purchases of Agency mortgage-
backed securities and Agency debentures with the net proceeds of equity offerings, convertible notes offerings and
borrowings under repurchase agreements whose interest rates adjust based on changes in short-term market
interest rates.
Capital Investment Policy
Under our capital investment policy, at least 75% of our total assets must be comprised of high-quality
mortgage-backed securities and short-term investments. High quality securities means securities that (1) are rated
within one of the two highest rating categories by at least one of the nationally recognized rating agencies, (2) are
unrated but are guaranteed by the United States government or an agency of the United States government, or (3)
are unrated but we determine them to be of comparable quality to high-quality rated mortgage-backed securities.
1
The remainder of our assets, comprising not more than 25% of our total assets, may consist of other
qualified REIT real estate assets which are unrated or rated less than high quality, but which are at least
“investment grade” (rated “BBB” or better by Standard & Poor’s Corporation (or S&P) or the equivalent by
another nationally recognized rating agency) or, if not rated, we determine them to be of comparable credit quality
to an investment which is rated “BBB” or better. In addition, we may directly or indirectly invest part of this
remaining 25% of our assets in other types of securities, including without limitation, unrated debt, equity or
derivative securities, to the extent consistent with our REIT qualification requirements. The derivative securities
in which we invest may include securities representing the right to receive interest only or a disproportionately
large amount of interest, as well as inverse floaters, which may have imbedded leverage as part of their structural
characteristics. We intend to structure our portfolio to maintain a minimum weighted average rating (including our
deemed comparable ratings for unrated mortgage-backed securities) of our mortgage-backed securities of at least
single “A” under the S&P rating system and at the comparable level under the other rating systems.
We may acquire Agency mortgage-backed securities backed by single-family residential mortgage loans
as well as securities backed by loans on multi-family, commercial or other real estate related properties. To date,
substantially all of the Agency mortgage-backed securities that we have acquired have been backed by single-
family residential mortgage loans.
To date, substantially all of the mortgage-backed securities that we have acquired have been Agency
mortgage-backed securities which, although not rated, carry an implied “AAA” rating. Agency mortgage-backed
securities consist of agency pass-through certificates and CMOs issued or guaranteed by an Agency. Pass-through
certificates provide for a pass-through of the monthly interest and principal payments made by the borrowers on
the underlying mortgage loans. CMOs divide a pool of mortgage loans into multiple tranches with different
principal and interest payment characteristics.
Our adjustable-rate pass-through certificates are backed by adjustable-rate mortgage loans and have
coupon rates which adjust over time, subject to interest rate caps and lag periods, in conjunction with changes in
short-term interest rates. Our fixed-rate pass-through certificates are backed by fixed-rate mortgage loans and
have coupon rates which do not adjust over time. CMO floaters are tranches of mortgage-backed securities where
the interest rate adjusts in conjunction with changes in short-term interest rates. CMO floaters may be backed by
fixed-rate mortgage loans or, less often, by adjustable-rate mortgage loans. In this Form 10-K, except where the
context indicates otherwise, we use the term “adjustable-rate interest-earning assets” to refer to adjustable-rate
pass-through certificates, CMO floaters, Agency debentures and corporate debt.
We may also invest in Agency debentures, which consist of debentures issued by the Federal Home Loan
Bank (FHLB), Freddie Mac and Fannie Mae. We intend to continue to invest in adjustable-rate pass-through
certificates, fixed-rate mortgage-backed securities, CMO floaters, and Agency debentures. We may also invest on
a limited basis in derivative securities which include securities representing the right to receive interest only or a
disproportionately large amount of interest as well as inverse floaters, which may have imbedded leverage as part
of their structural characteristics.
Borrowings
We attempt to structure our collateralized borrowings to have interest rate adjustment indices and interest
rate adjustment periods that, on an aggregate basis, correspond generally to the interest rate adjustment indices
and periods of our adjustable-rate interest-earning assets. However, periodic rate adjustments on our
collateralized borrowings are generally more frequent than rate adjustments on our Investment Securities.
We generally expect to maintain a ratio of debt-to-equity of less than 12:1. This ratio varies from time to
time based upon various factors, including our management’s opinion of the level of risk of our assets and
liabilities, our liquidity position, our level of unused borrowing capacity, the availability of credit, over-
collateralization levels required by lenders when we pledge assets to secure borrowings and our assessment of
domestic and international market conditions. Our debt-to-equity ratios have been below our historical average
ratios since the credit crisis of 2008. Specifically, we believe that it is prudent to maintain our existing debt-to-
equity ratio because there continues to be volatility in the mortgage and credit markets primarily driven by the
uncertainty in Europe and U.S. capital markets. For purposes of calculating this ratio, our debt is equal to our
2
repurchase agreements and convertible senior notes as presented on our Statements of Financial Condition. At
December 31, 2012, our ratio of debt-to-equity was 6.5:1.
Our target debt-to-equity ratio is determined under our capital investment policy. Should our actual debt-
to-equity ratio increase above the target level due to asset acquisition or market value fluctuations in assets, we
would cease to acquire new assets. Our management will, at that time, present a plan to our board of directors to
bring us back to our target debt-to-equity ratio; in many circumstances, this would be accomplished over time by
the monthly reduction of the balance of our Agency mortgage-backed securities through principal repayments.
During 2010, we issued $600.0 million in aggregate principal amount of our 4% convertible senior notes
due 2015 (4% Convertible Senior Notes) for net proceeds following underwriting expenses of approximately
$582.0 million. Interest on the notes is paid semi-annually at a rate of 4% per year and the notes will mature on
February 15, 2015 unless repurchased or converted earlier. As of December 31, 2012 the notes were convertible
into shares of common stock at a conversion rate of 70.6980 shares of common stock per $1,000 principal amount
of notes, which is equivalent to a conversion price of approximately $14.1447 per share of common stock, subject
to adjustment in certain circumstances. During 2012, we repurchased approximately $492.5 million of the
outstanding $600.0 million of our 4.00% Convertible Senior Notes for $617.5 million.
During 2012, we issued $750.0 million in aggregate principal amount of our 5% convertible senior notes
due 2015 (5% Convertible Senior Notes) for net proceeds following underwriting expenses of approximately
$727.5 million. Interest on the notes is paid semi-annually at a rate of 5% per year and the notes will mature on
May 15, 2015 unless repurchased or converted earlier. As of December 31, 2012 the notes were convertible into
shares of common stock at a conversion rate of 52.7969 shares of common stock per $1,000 principal amount of
notes, which is equivalent to a conversion price of approximately $18.94 per share of common stock, subject to
adjustment in certain circumstances.
Hedging
To the extent consistent with our election to qualify as a REIT, we enter into hedging transactions to
attempt to protect our Agency mortgage-backed securities and Agency debentures and related borrowings against
the effects of significant interest rate changes. This hedging is used to limit or cap the interest rates on our
borrowings. These transactions are entered into solely for the purpose of hedging interest rate or prepayment risk
and not for speculative purposes. In connection with our interest rate risk management strategy, we hedge a
portion of our interest rate risk by entering into derivative financial instrument contracts. We have elected to not
account our interest rate swaps using hedge accounting. Therefore, changes in fair value on our interest rate
swaps are reflected in earnings.
Our Subsidiaries
FIDAC, an investment advisor registered with the SEC, is a fixed-income investment management
company specializing in managing fixed income investments in residential mortgage-backed securities,
commercial mortgage-backed securities and collateralized debt obligations for various investment vehicles and
separate accounts. FIDAC also has experience in managing and structuring debt financing associated with various
asset classes and as a liquidation agent of collateralized debt obligations. FIDAC commenced active investment
management operations in 1994. At December 31, 2012, FIDAC was the adviser or sub-adviser for REITs and
other investment vehicles. The team managing Annaly performs the same roles at FIDAC.
Merganser, an investment advisor registered with the SEC, has expertise in a variety of fixed income
strategies and focuses on managing each portfolio based on each client’s specific investment principles.
Merganser serves a diverse group of clients in a variety of disciplines nationwide including pension, public,
operating, Taft-Hartley and endowment funds as well as defined contribution plans. Merganser’s investment team
maintains a careful balance of risk management and performance by employing fundamental security analysis and
by trading in an environment supported by state-of-the-art technology, infrastructure and operations.
RCap operates as a broker-dealer and has been a member in the Financial Industry Regulatory Authority
since January 2009.
3
In 2010, we established Shannon, which provides warehouse financing to residential mortgage
originators in the United States. In 2010, we also established Charlesfort, which engages in corporate middle
market lending transactions. In 2011, FIDAC established FIDAC Europe, which we sold in December 2012. In
2011, we established FIDAC FSI, which invested in trading securities. FIDAC FSI was liquidated in August 2012.
We also own an additional subsidiary which owns trading securities.
Compliance with REIT and Investment Company Requirements
We regularly monitor our investments and the income from these investments and, to the extent we enter
into hedging transactions, we monitor income from our hedging transactions as well, so as to ensure at all times
that we maintain our qualification as a REIT and our exemption from registration under the Investment Company
Act of 1940, as amended.
Executive Officers of the Company
The following table sets forth certain information as of February 25, 2013 concerning our executive
officers:
Name
Age
Position held with the Company
Wellington J. Denahan
Kevin G. Keyes
Kathryn F. Fagan
R. Nicholas Singh
James P. Fortescue
Kristopher Konrad
Rose-Marie Lyght
49
45
46
53
39
38
39
Chairman of the Board and Chief Executive Officer
President
Chief Financial Officer and Treasurer
Chief Legal Officer, Secretary, and Chief Compliance Officer
Chief Operating Officer
Co-Chief Investment Officer
Co-Chief Investment Officer
Wellington J. Denahan is Chairman of the Board and Chief Executive Officer of Annaly. Ms. Denahan
was appointed Chairman of the Board and Chief Executive Officer of Annaly on November 5, 2012. Previously,
Ms. Denahan was appointed to serve as Co-Chief Executive Officer of Annaly effective October 8, 2012. Ms.
Denahan was elected on December 5, 1996 to serve as Vice Chairman of the Board and a Chief Investment
Officer of Annaly. Ms. Denahan was Annaly’s Chief Operating Officer from January 2006 to October 2012 and
Chief Investment Officer from 2000 to November 2012. She was a co-founder of Annaly. Ms. Denahan has a
Bachelor of Arts from Florida State University.
Kevin G. Keyes, age 45, is President of Annaly and is also a member of the Board of Directors. Prior to
being named to his current role, Mr. Keyes served as Chief Strategy Officer and Head of Capital Markets at
Annaly. Mr. Keyes has over 20 years of Capital Markets and Investment Banking experience. He joined Annaly
in 2009 from Bank of America Merrill Lynch where he served in various senior management and business
origination roles since 2005. Prior to that, Mr. Keyes also worked at Credit Suisse First Boston from 1997 until
2005 in various capital markets roles and Morgan Stanley Dean Witter from 1990 until 1997 in various
investment banking positions. Mr. Keyes has a B.A. in Economics and a B.S. in Business Administration (ALPA
Program) from the University of Notre Dame.
Kathryn F. Fagan is the Chief Financial Officer and Treasurer of Annaly and FIDAC. Ms. Fagan was
employed as Chief Financial Officer and Treasurer of Annaly in April 1997. From June 1, 1991 to February 28,
1997, Ms. Fagan was Chief Financial Officer and Controller of First Federal Savings & Loan Association of
Opelousas, Louisiana. Ms. Fagan was employed as a bank and savings and loan auditor by John S. Dowling &
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Company, a corporation of Certified Public Accountants. Ms. Fagan has a Bachelor of Arts and a Masters Degree
in Business Administration each from the University of Southwestern Louisiana.
R. Nicholas Singh is Chief Legal Officer, Secretary and Chief Compliance Officer of Annaly and
FIDAC. Mr. Singh was employed by Annaly in February 2005. From 2001 until he joined Annaly, he was a
partner in the law firm of McKee Nelson LLP. Mr. Singh has a Bachelors Degree from Carleton College, a
Masters Degree from Columbia University and a J.D. from American University.
James P. Fortescue was appointed to serve as to serve as Chief Operating Officer of Annaly and FIDAC
effective October 8, 2012. Mr. Fortescue was previously Chief of Staff, Head of Liabilities and Managing
Director of Annaly. Mr. Fortescue joined FIDAC in June of 1995. Mr. Fortescue’s responsibilities included
overseeing FIDAC’s financing on mortgage-backed and corporate bonds, as well as maintaining a pricing service
for a major broker dealer. In September of 1996, Mr. Fortescue assumed responsibility for overseeing financing
activities for the U.S. Dollar Floating Rate Fund Ltd. Mr. Fortescue has been in charge of liability management
for Annaly since its inception, and continues to oversee all financing activities for FIDAC. Mr. Fortescue has a
Bachelors Degree in Finance from Siena College.
Kristopher Konrad was appointed to serve as to serve as Co-Chief Investment Officer of Annaly effective
November 5, 2012. Mr. Konrad was previously a Managing Director and Head Portfolio Manager of Annaly.
Mr. Konrad was the Portfolio Manager for Annaly and has served in this capacity since December of 2000. Prior
to this, he was head of financing for the U.S. Dollar Floating Rate Fund Ltd. and assisted with the management of
FIDAC’s high net worth separate accounts. Mr. Konrad was employed by Annaly in October 1997. Mr. Konrad
has a Bachelors Degree in Business from Ithaca College and has attended the New York Institute of Finance for
intensive mortgage-backed securities studies.
Rose-Marie Lyght was appointed to serve as Co-Chief Investment Officer of Annaly effective November
5, 2012. Ms. Lyght was previously a Managing Director of Annaly and Chief Investment Officer of FIDAC. She
has been involved in the asset selection and financing for the investment vehicles managed by FIDAC. Ms. Lyght
was employed by Annaly in April 1999. Ms. Lyght has a Bachelor of Science in Finance and a Masters Degree in
Business Administration from Villanova University.
Distributions
To maintain our qualification as a REIT, we must distribute substantially all of our taxable income to our
stockholders each year (subject to certain adjustments). We have done this in the past and intend to continue to do
so in the future. We also have declared and paid regular quarterly dividends in the past and intend to do so in the
future. We have adopted a dividend reinvestment plan to enable holders of common stock to reinvest dividends
automatically in additional shares of common stock.
General
BUSINESS STRATEGY
Our principal business objective is to generate net income for distribution to our stockholders from the
spread between the interest income on our Investment Securities and the costs of borrowing to finance our
acquisition of Investment Securities, and from dividends we receive from our subsidiaries. To achieve our
business objective and generate dividend yields, our strategy is:
(cid:131)
to acquire Investment Securities that we believe:
- we have the necessary expertise to evaluate and manage;
- we can readily finance;
-
are consistent with our balance sheet guidelines and risk management objectives; and
5
-
provide attractive investment returns in a range of scenarios;
(cid:131)
(cid:131)
(cid:131)
(cid:131)
to finance purchases of mortgage-backed securities with the proceeds from equity and debt offerings
and repurchase agreements and, to the extent permitted by our capital investment policy, to utilize
leverage to increase potential returns to stockholders through borrowings;
to attempt to structure our borrowings to have interest rate adjustment indices and interest rate
adjustment periods that, on an aggregate basis, generally correspond to the interest rate adjustment
indices and interest rate adjustment periods of our adjustable-rate mortgage-backed securities;
to seek to minimize prepayment risk by structuring a diversified portfolio with a variety of
prepayment characteristics and through other means; and
to issue new equity or debt and increase the size of our balance sheet when opportunities in the
market for mortgage-backed securities are likely to allow growth in earnings per share.
To date over 90% of our total assets have consisted of Agency mortgage-backed securities and
debentures. While we remain committed to the Agency market, given the current environment, we believe it is
prudent to diversify a portion of our investment portfolio. Therefore, we may allocate up to 25% of our
stockholders’ equity to real estate assets other than Agency mortgage-backed securities.
We believe we are able to obtain cost efficiencies through our facilities-sharing arrangement with FIDAC
and RCap and by virtue of our management’s experience in managing portfolios of mortgage-backed securities
and arranging collateralized borrowings. We will strive to become even more cost-efficient over time by:
(cid:131)
(cid:131)
(cid:131)
(cid:131)
(cid:131)
seeking to raise additional capital from time to time in order to increase our ability to invest in
mortgage-backed securities;
seeking to repurchase shares of our capital stock or debt securities from time to time;
striving to lower our effective borrowing costs by seeking direct funding with collateralized lenders,
rather than using financial intermediaries, and investigating the possibility of using commercial
paper and medium term note programs;
improving the efficiency of our balance sheet structure by investigating the issuance of
uncollateralized subordinated debt, preferred stock and other forms of capital; and
utilizing information technology in our business, including improving our ability to monitor the
performance of our Investment Securities and to lower our operating costs.
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Mortgage-Backed Securities
General
To date, substantially all of the mortgage-backed securities that we have acquired have been Agency
mortgage-backed securities which, although not rated, carry an implied “AAA” rating. Agency mortgage-backed
securities are mortgage-backed securities where a government agency or federally chartered corporation, such as
Freddie Mac, Fannie Mae or Ginnie Mae, guarantees payments of principal or interest on the securities. Agency
mortgage-backed securities consist of agency pass-through certificates and CMOs issued or guaranteed by an
Agency.
We intend to acquire only those mortgage-backed securities that we believe we have the necessary
expertise to evaluate and manage, that are consistent with our balance sheet guidelines and risk management
objectives and that we can readily finance. Since we generally hold the mortgage-backed securities we acquire
until maturity, we generally do not seek to acquire assets whose investment returns are attractive in only a limited
range of scenarios. We believe that future interest rates and mortgage prepayment rates are very difficult to
predict. Therefore, we seek to acquire mortgage-backed securities which we believe will provide attractive returns
over a broad range of interest rate and prepayment scenarios. We, from time to time, may purchase or sell to-be-
announced forward contracts (“TBAs”) in order to invest in Agency mortgage-backed securities. Pursuant to
these TBAs, we agree to purchase, for future delivery, Agency mortgage-backed securities with certain principal
and interest terms and certain types of collateral, but the particular Agency mortgage-backed securities to be
delivered to us are not identified until shortly before the TBA settlement date.
At December 31, 2012, our mortgage-backed securities consisted of pass-through certificates and CMOs
issued or guaranteed by Freddie Mac, Fannie Mae or Ginnie Mae.
Description of Mortgage-Backed Securities
The mortgage-backed securities that we acquire provide funds for mortgage loans made primarily to
residential homeowners. Our securities generally represent interests in pools of mortgage loans made by savings
and loan institutions, mortgage bankers, commercial banks and other mortgage lenders. These pools of mortgage
loans are assembled for sale to investors (like us) by various government-related and private organizations.
Mortgage-backed securities differ from other forms of traditional debt securities, which normally provide
for periodic payments of interest in fixed amounts with principal payments at maturity or on specified call dates.
Instead, mortgage-backed securities provide for a monthly payment, which consists of both interest and principal.
In effect, these payments are a “pass-through” of the monthly interest and principal payments made by the
individual borrower on the mortgage loans, net of any fees paid to the issuer or guarantor of the securities.
Additional payments result from prepayments of principal upon the sale, refinancing or foreclosure of the
underlying residential property, net of fees or costs which may be incurred. Some mortgage-backed securities,
such as securities issued by Ginnie Mae, are described as “modified pass-through”. These securities entitle the
holder to receive all interest and principal payments owed on the mortgage pool, net of certain fees, regardless of
whether the mortgagors actually make mortgage payments when due.
The investment characteristics of pass-through mortgage-backed securities differ from those of
traditional fixed-income securities. The major differences include the payment of interest and principal on the
mortgage-backed securities on a more frequent schedule, as described above, and the possibility that principal
may be prepaid at any time due to prepayments on the underlying mortgage loans or other assets. These
differences can result in significantly greater price and yield volatility than is the case with traditional fixed-
income securities.
Various factors affect the rate at which mortgage prepayments occur, including changes in interest rates,
general economic conditions, the age of the mortgage loan, the location of the property and other social and
demographic conditions. Generally prepayments on mortgage-backed securities increase during periods of falling
mortgage interest rates and decrease during periods of rising mortgage interest rates. We may reinvest
prepayments at a yield that is higher or lower than the yield on the prepaid investment, thus affecting the weighted
average yield of our investments.
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To the extent mortgage-backed securities are purchased at a premium, faster than expected prepayments
result in a faster than expected amortization of the premium paid. Conversely, if these securities were purchased
at a discount, faster than expected prepayments accelerate our recognition of income.
CMOs may allow for shifting of prepayment risk from slower-paying tranches to faster-paying tranches.
This is in contrast to mortgage pass-through certificates where all investors share equally in all payments,
including all prepayments, on the underlying mortgages.
Freddie Mac Certificates
Freddie Mac is a privately-owned government-sponsored enterprise created pursuant to an Act of
Congress on July 24, 1970. On September 6, 2008, the Federal Housing Finance Agency, (or FHFA), placed
Freddie Mac into conservatorship. As the conservator of Freddie Mac, the FHFA controls and directs Freddie
Mac’s operations. The principal activity of Freddie Mac currently consists of the purchase of mortgage loans or
participation interests in mortgage loans and the resale of the loans and participations in the form of guaranteed
mortgage-backed securities. Freddie Mac guarantees to each holder of Freddie Mac certificates the timely
payment of interest at the applicable pass-through rate and ultimate collection of all principal on the holder’s pro
rata share of the unpaid principal balance of the related mortgage loans, but does not guarantee the timely payment
of scheduled principal of the underlying mortgage loans. Notwithstanding the conservatorship of Freddie Mac by
the FHFA, the obligations of Freddie Mac under its guarantees are solely those of Freddie Mac and are not backed
by the full faith and credit of the United States. If Freddie Mac were unable to satisfy these obligations,
distributions to holders of Freddie Mac certificates would consist solely of payments and other recoveries on the
underlying mortgage loans and, accordingly, defaults and delinquencies on the underlying mortgage loans would
adversely affect monthly distributions to holders of Freddie Mac certificates.
Freddie Mac certificates may be backed by pools of single-family mortgage loans or multi-family
mortgage loans. These underlying mortgage loans may have original terms to maturity of up to 40 years. Freddie
Mac certificates may be issued under cash programs (composed of mortgage loans purchased from a number of
sellers) or guarantor programs (composed of mortgage loans acquired from one seller in exchange for certificates
representing interests in the mortgage loans purchased).
Freddie Mac certificates may pay interest at a fixed rate or an adjustable rate. The interest rate paid on
adjustable-rate Freddie Mac certificates (Freddie Mac ARMs) adjusts periodically within 60 days prior to the
month in which the interest rates on the underlying mortgage loans adjust. The interest rates paid on certificates
issued under Freddie Mac’s standard ARM programs adjust in relation to the Treasury index. Other specified
indices used in Freddie Mac ARM programs include the 11th District Cost of Funds Index published by the
Federal Home Loan Bank of San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed
Freddie Mac ARM certificates equal the applicable index rate plus a specified number of basis points. The
majority of the series of Freddie Mac ARM certificates issued to date have evidenced pools of mortgage loans
with monthly, semi-annual or annual interest adjustments. Adjustments in the interest rates paid are generally
limited to an annual increase or decrease of either 100 or 200 basis points and to a lifetime cap of 500 or 600 basis
points over the initial interest rate. Certain Freddie Mac programs include mortgage loans which allow the
borrower to convert the adjustable mortgage interest rate to a fixed rate. Adjustable-rate mortgages which are
converted into fixed-rate mortgage loans are repurchased by Freddie Mac or by the seller of the loan to Freddie
Mac at the unpaid principal balance of the loan plus accrued interest to the due date of the last adjustable rate
interest payment.
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Fannie Mae Certificates
Fannie Mae is a privately-owned, federally-chartered corporation organized and existing under the
Federal National Mortgage Association Charter Act. On September 6, 2008, the FHFA placed Fannie Mae into
conservatorship. As the conservator of Fannie Mae, the FHFA controls and directs Fannie Mae’s operations.
Fannie Mae provides funds to the mortgage market primarily by purchasing home mortgage loans from local
lenders, thereby replenishing their funds for additional lending. Fannie Mae guarantees to the registered holder of
a Fannie Mae certificate that it will distribute amounts representing scheduled principal and interest on the
mortgage loans in the pool underlying the Fannie Mae certificate, whether or not received, and the full principal
amount of any such mortgage loan foreclosed or otherwise finally liquidated, whether or not the principal amount
is actually received. Notwithstanding the conservatorship of Fannie Mae by the FHFA, the obligations of Fannie
Mae under its guarantees are solely those of Fannie Mae and are not backed by the full faith and credit of the
United States. If Fannie Mae were unable to satisfy its obligations, distributions to holders of Fannie Mae
certificates would consist solely of payments and other recoveries on the underlying mortgage loans and,
accordingly, defaults and delinquencies on the underlying mortgage loans would adversely affect monthly
distributions to holders of Fannie Mae certificates.
Fannie Mae certificates may be backed by pools of single-family or multi-family mortgage loans. The
original term to maturity of any such mortgage loan generally does not exceed 40 years. Fannie Mae certificates
may pay interest at a fixed rate or an adjustable rate. Each series of Fannie Mae ARM certificates bears an initial
interest rate and margin tied to an index based on all loans in the related pool, less a fixed percentage representing
servicing compensation and Fannie Mae’s guarantee fee. The specified index used in different series has included
the Treasury Index, the 11th District Cost of Funds Index published by the Federal Home Loan Bank of San
Francisco, LIBOR and other indices. Interest rates paid on fully-indexed Fannie Mae ARM certificates equal the
applicable index rate plus a specified number of basis points. The majority of series of Fannie Mae ARM
certificates issued to date have evidenced pools of mortgage loans with monthly, semi-annual or annual interest
rate adjustments. Adjustments in the interest rates paid are generally limited to an annual increase or decrease of
either 100 or 200 basis points and to a lifetime cap of 500 or 600 basis points over the initial interest rate. Certain
Fannie Mae programs include mortgage loans which allow the borrower to convert the adjustable mortgage
interest rate of the ARM to a fixed rate. Adjustable-rate mortgages which are converted into fixed-rate mortgage
loans are repurchased by Fannie Mae or by the seller of the loans to Fannie Mae at the unpaid principal of the loan
plus accrued interest to the due date of the last adjustable rate interest payment.
Ginnie Mae Certificates
Ginnie Mae is a wholly owned corporate instrumentality of the United States within the Department of
Housing and Urban Development (HUD). The National Housing Act of 1934 authorizes Ginnie Mae to guarantee
the timely payment of the principal and interest on certificates which represent an interest in a pool of mortgages
insured by the Federal Housing Administration (FHA) or partially guaranteed by the Department of Veterans
Affairs and other loans eligible for inclusion in mortgage pools underlying Ginnie Mae certificates. Section
306(g) of the Housing Act provides that the full faith and credit of the United States is pledged to the payment of
all amounts which may be required to be paid under any guaranty by Ginnie Mae.
At present, most Ginnie Mae certificates are backed by single-family mortgage loans. The interest rate
paid on Ginnie Mae certificates may be a fixed rate or an adjustable rate. The interest rate on Ginnie Mae
certificates issued under Ginnie Mae’s standard ARM program adjusts annually in relation to the Treasury index.
Adjustments in the interest rate are generally limited to an annual increase or decrease of 100 basis points and to a
lifetime cap of 500 basis points over the initial coupon rate.
Single-Family and Multi-Family Privately-Issued Certificates
Single-family and multi-family privately-issued certificates are pass-through certificates that are not
issued by one of the Agencies and that are backed by a pool of conventional single-family or multi-family
mortgage loans. These certificates are issued by originators of, investors in, and other owners of mortgage loans,
including savings and loan associations, savings banks, commercial banks, mortgage banks, investment banks and
special purpose “conduit” subsidiaries of these institutions.
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While Agency pass-through certificates are backed by the express obligation or guarantee of one of the
Agencies, as described above, privately-issued certificates are generally covered by one or more forms of private
(i.e., non-governmental) credit enhancements. These credit enhancements provide an extra layer of loss coverage
in the event that losses are incurred upon foreclosure sales or other liquidations of underlying mortgaged
properties in amounts that exceed the equity holder’s equity interest in the property. Forms of credit
enhancements include limited issuer guarantees, reserve funds, private mortgage guaranty pool insurance, over-
collateralization and subordination.
Subordination is a form of credit enhancement frequently used and involves the issuance of classes of
senior and subordinated mortgage-backed securities. These classes are structured into a hierarchy to allocate
losses on the underlying mortgage loans and also for defining priority of rights to payment of principal and
interest. Typically, one or more classes of senior securities are created which are rated in one of the two highest
rating levels by one or more nationally recognized rating agencies and which are supported by one or more classes
of mezzanine securities and subordinated securities that bear losses on the underlying loans prior to the classes of
senior securities. In some cases, only classes of senior securities and subordinated securities are issued. By
adjusting the priority of interest and principal payments on each class of a given series of senior-subordinated
mortgage-backed securities, issuers are able to create classes of mortgage-backed securities with varying degrees
of credit exposure, prepayment exposure and potential total return, tailored to meet the needs of sophisticated
institutional investors.
Collateralized Mortgage Obligations and Multi-Class Pass-Through Securities
We may also invest in CMOs and multi-class pass-through securities. CMOs are debt obligations issued
by special purpose entities that are secured by mortgage loans or mortgage-backed certificates, including, in many
cases, certificates issued by government and government-related guarantors, including, Ginnie Mae, Fannie Mae
and Freddie Mac, together with certain funds and other collateral. Multi-class pass-through securities are equity
interests in a trust composed of mortgage loans or other mortgage-backed securities. Payments of principal and
interest on underlying collateral provide the funds to pay debt service on the CMO or make scheduled
distributions on the multi-class pass-through securities. CMOs and multi-class pass-through securities may be
issued by agencies or instrumentalities of the U.S. Government or by private organizations. The discussion of
CMOs in the following paragraphs is similarly applicable to multi-class pass-through securities.
In a CMO, a series of bonds or certificates is issued in multiple classes. Each class of CMOs, often
referred to as a “tranche,” is issued at a specific coupon rate (which, as discussed below, may be an adjustable rate
subject to a cap) and has a stated maturity or final distribution date. Principal prepayments on collateral
underlying a CMO may cause it to be retired substantially earlier than the stated maturity or final distribution date.
Interest is paid or accrues on all classes of a CMO on a monthly, quarterly or semi-annual basis. The principal
and interest on underlying mortgages may be allocated among the several classes of a series of a CMO in many
ways. In a common structure, payments of principal, including any principal prepayments, on the underlying
mortgages are applied to the classes of the series of a CMO in the order of their respective stated maturities or
final distribution dates, so that no payment of principal will be made on any class of a CMO until all other classes
having an earlier stated maturity or final distribution date have been paid in full.
Other types of CMO issues include classes such as parallel pay CMOs, some of which, such as planned
amortization class CMOs (or PAC bonds), provide protection against prepayment uncertainty. Parallel pay CMOs
are structured to provide payments of principal on certain payment dates to more than one class. These
simultaneous payments are taken into account in calculating the stated maturity date or final distribution date of
each class which, as with other CMO structures, must be retired by its stated maturity date or final distribution
date but may be retired earlier. PAC bonds generally require payment of a specified amount of principal on each
payment date so long as prepayment speeds on the underlying collateral fall within a specified range.
Other types of CMO issues include targeted amortization class CMOs (or TAC bonds), which are similar
to PAC bonds. While PAC bonds maintain their amortization schedule within a specified range of prepayment
speeds, TAC bonds are generally targeted to a narrow range of prepayment speeds or a specified prepayment
speed. TAC bonds can provide protection against prepayment uncertainty since cash flows generated from higher
prepayments of the underlying mortgage-related assets are applied to the various other pass-through tranches so as
to allow the TAC bonds to maintain their amortization schedule.
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A CMO may be subject to the issuer’s right to redeem the CMO prior to its stated maturity date, which
may diminish the anticipated return on our investment. Privately-issued CMOs are supported by private credit
enhancements similar to those used for privately-issued certificates and are often issued as senior-subordinated
mortgage-backed securities. We will only acquire CMOs or multi-class pass-through certificates that constitute
debt obligations or beneficial ownership in grantor trusts holding mortgage loans, or regular interests in REMICs,
or that otherwise constitute qualified REIT real estate assets under the Internal Revenue Code (provided that we
have obtained a favorable opinion of our tax advisor or a ruling from the IRS to that effect).
Adjustable-Rate Mortgage Pass-Through Certificates and Floating Rate Mortgage-Backed Securities
Some of the mortgage pass-through certificates we acquire are adjustable-rate mortgage pass-through
certificates. This means that their interest rates may vary over time based upon changes in an objective index,
such as:
• LIBOR or the London Interbank Offered Rate. The interest rate that banks in London offer for
deposits in London of U.S. dollars.
• Treasury Index. A monthly or weekly average yield of benchmark U.S. Treasury securities, as
published by the Federal Reserve Board.
These indices generally reflect short-term interest rates. The underlying mortgages for adjustable-rate
mortgage pass-through certificates are adjustable-rate mortgage loans (or ARMs).
We also acquire CMO floaters. One or more tranches of a CMO may have coupon rates that reset
periodically at a specified increment over an index such as LIBOR. These adjustable-rate tranches are sometimes
known as CMO floaters and may be backed by fixed or adjustable-rate mortgages.
There are two main categories of indices for adjustable-rate mortgage pass-through certificates and floaters:
(1) those based on U.S. Treasury securities, and (2) those derived from calculated measures such as a cost of funds
index or a moving average of mortgage rates. Commonly utilized indices include the one-year Treasury note rate,
the three-month Treasury bill rate, the six-month Treasury bill rate, rates on long-term Treasury securities, the
11th District Federal Home Loan Bank Costs of Funds Index, the National Median Cost of Funds Index, one-
month or three-month LIBOR, the prime rate of a specific bank, or commercial paper rates. Some indices, such as
the one-year Treasury rate, closely mirror changes in market interest rate levels. Others, such as the 11th District
Home Loan Bank Cost of Funds Index, tend to lag changes in market interest rate levels. We seek to diversify our
investments in adjustable-rate mortgage pass-through certificates and floaters among a variety of indices and reset
periods so that we are not at any one time unduly exposed to the risk of interest rate fluctuations. In selecting
adjustable-rate mortgage pass-through certificates and floaters for investment, we will also consider the liquidity
of the market for the different mortgage-backed securities.
Adjustable-rate mortgage pass-through certificates and floaters typically have caps, which limit the
maximum amount by which the interest rate may be increased or decreased at periodic intervals or over the life of
the security. To the extent that interest rates rise faster than the allowable caps on the adjustable-rate mortgage
pass-through certificates and floaters, these securities will behave more like fixed-rate securities. Consequently,
interest rate increases in excess of caps can be expected to cause these securities to behave more like traditional
debt securities than adjustable-rate interest-earning assets and, accordingly, to decline in value to a greater extent
than would be the case in the absence of these caps.
Adjustable-rate mortgage pass-through certificates and floaters, like other mortgage-backed securities,
differ from conventional bonds in that principal is to be paid back over the life of the security rather than at
maturity. As a result, we receive monthly scheduled payments of principal and interest on these securities and
may receive unscheduled principal payments representing prepayments on the underlying mortgages. When we
reinvest the payments and any unscheduled prepayments we receive, we may receive a rate of interest on the
reinvestment which is lower than the rate on the existing security. For this reason, adjustable-rate mortgage pass-
through certificates and floaters are less effective than longer-term debt securities as a means of “locking in”
longer-term interest rates. Accordingly, adjustable-rate mortgage pass-through certificates and floaters, while
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generally having less risk of price decline during periods of rapidly rising interest rates than fixed-rate mortgage-
backed securities of comparable maturities, have less potential for capital appreciation than fixed-rate securities
during periods of declining interest rates.
As in the case of fixed-rate mortgage-backed securities, to the extent these securities are purchased at a
premium, faster than expected prepayments would accelerate our amortization of the premium. Conversely, if
these securities were purchased at a discount, faster than expected prepayments would accelerate our recognition
of income.
Fixed-rate CMOs and floating-rate CMOs may allow for shifting of prepayment risk from slower-paying
tranches to faster-paying tranches. This is in contrast to mortgage pass-through certificates where all investors
share equally in all payments, including all prepayments, on the underlying mortgages.
Other Floating Rate Instruments
We may also invest in structured floating-rate notes issued or guaranteed by government Agencies, such as
Fannie Mae and Freddie Mac. These instruments are typically structured to reflect an interest rate arbitrage (i.e.,
the difference between the Agency’s cost of funds and the income stream from specified assets of the Agency)
and their reset formulas may provide more attractive returns than other floating rate instruments. The indices used
to determine resets are the same as those described above.
Commercial Real Estate Loans
Commercial First Mortgage Loans – First mortgage loans are generally three-to-ten year term loans that are
primarily for fully constructed commercial real estate located in the United States that are current pay and are
either fixed or floating rate. Some of these loans may be syndicated in either a pari passu or in a
senior/subordinated structure. Commercial first mortgages generally provide for a higher recovery rate due to their
senior position.
Construction Loans – We may acquire participations in construction or rehabilitation loans on commercial
properties. These loans will generally provide 40% to 60% of financing on the total cost of the construction or
rehabilitation project and will be secured by first mortgage liens on the property under construction or
rehabilitation. Purchases of construction and rehabilitation loans would generally allow us to earn origination fees
and may also entitle us to a percentage of the underlying property’s net operating income (subject to our
qualification as a REIT) or gross revenues, payable on an ongoing basis, as well as a percentage of any increase in
value of the property, payable upon maturity or refinancing of the loan.
Subordinated Debt
Commercial Subordinated Mortgage Loans or B-Notes – These instruments include structurally
subordinated first mortgage loans and junior participations in first mortgage loans or participations in these types
of assets. A B-Note is typically created from a privately negotiated loan that is secured by a first mortgage on a
single large commercial property or group of related properties and subordinated to an A-Note secured by the
same first mortgage property or group. The subordination of a B-Note typically is evidenced by an intercreditor
agreement with the holder of the A-Note. B-Notes are subject to more credit risk with respect to the underlying
mortgage collateral than the corresponding A-Note. We may create subordinated mortgage loans by tranching or
selling our purchased first mortgage loans through syndication of our senior first mortgages, or buy such assets
directly from third party originators. We may originate B-Notes privately or purchase them in the secondary
market.
Purchasers of subordinated mortgage loans and B-Notes are compensated for the increased risk of such
assets but still benefit from a lien on the related property. Investors’ rights are generally governed through
participations and other agreements that, subject to certain limitations, provide the holders of subordinated
positions of the mortgage loan with the ability to cure certain defaults and control certain decisions of holders of
senior debt secured by the same property or properties.
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Commercial Mezzanine Loans – These loans are secured by a pledge of the borrower’s equity ownership in
the property. Unlike a mortgage, this loan does not represent a lien on the property. Therefore it is always junior
and subordinate to any first-lien as well as second liens, if applicable, on the property. These loans are senior to
any preferred equity or common equity interests. Purchasers of mezzanine loans benefit from a right to foreclose
on the ownership equity in a more efficient means than senior mortgage debt. Also, investor rights are usually
governed by intercreditor agreements that provide holders with the rights to cure defaults and exercise control on
certain decisions of any senior debt secured by the same property. Commercial mezzanine loans may also be
syndicated in either a pari passu or senior/subordinated structure.
Preferred Equity investments- A preferred equity investment is an equity investment in the entity that owns
the underlying property. Preferred equity is not secured by the underlying property, but holders have priority
relative to common equity holders on cash flow distributions and proceeds from capital events. In addition,
preferred equity holders may be able to enhance their position and protect their equity position with covenants that
limit the entity’s activities and grant the holder the exclusive right to control the property after an event of default.
Occasionally, the first mortgage on a property prohibits additional liens and a preferred equity structure provides
an attractive financing alternative. With preferred equity investments, we may become a special limited partner or
member in the entity and may be entitled to take certain actions, or cause liquidation, upon a default. Preferred
equity typically is more highly leveraged, with last-dollar loan-to-value ratios at origination of 85% to more than
90%. We expect our preferred equity to have mandatory redemption dates (that is, maturity dates) that range from
three years to five years, and we expect to hold these investments to maturity.
Commercial Real Properties
Commercial Real Property – We may make acquisitions in commercial real property to take advantage of
attractive opportunities. Additionally, in certain instances we may engage in sale-leaseback transactions with our
commercial real properties. From time to time, our real estate debt investments result in us owning commercial
real property as a result of a loan workout and the exercise of our remedies under the mortgage documents.
Commercial Mortgage-Backed Securities
CMBS are mortgage-backed securities that evidence interests in, or are secured by, a single commercial
mortgage or a pool of commercial mortgage loans. CMBS are typically issued in multiple tranches or split into
different levels of risk thereby allowing an investor to select a credit level that suits its risk profile. Principal
payments are applied sequentially to the most senior tranche of the structure until the most senior class has been
repaid. Losses and other shortfalls are borne by the most subordinate class which receives principal payments only
after the more senior classes are repaid.
Other Commercial Real Estate-Related Assets
Commercial Real Estate Collateralized Debt Obligations – CRE CDOs are multiple class securities, or
bonds, secured by pools of assets such as CMBS, B-Notes, mezzanine loans and REIT debt. In a CRE CDO, the
assets are pledged to a trustee for the benefit of the bond certificate holders. Generally, principal payments are
applied sequentially to the most senior tranche of the structure until the most senior class has been repaid. Losses
and other shortfalls are borne by the most subordinate class which receives principal payments only after the more
senior classes are fully repaid. However, these structures are also subject to further compliance tests pursuant to
their respective indentures, the failure of which can also result in the redirection of cash flow to the most senior
securities.
Loans to REITS and Real Estate Operating Companies – These assets generally are publicly registered,
unsecured corporate obligations made to companies whose primary business is the ownership and operation of
commercial real estate including office, retail, multifamily and industrial properties. These investments generally
pay semi-annually versus monthly for mortgage instruments. Credit protections include both operating and
maintenance covenants.
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Residential Mortgage Loans
We may from time-to-time through our subsidiary Shannon invest a portion of our assets directly in the
ownership or financing of residential mortgage loans (mortgage loans secured by residential real property)
primarily through direct purchases from selected mortgage originators. The acquisition or financing of mortgage
loans generally involves credit risk. We may obtain credit enhancement to mitigate this risk; however, there can
be no assurances that we will be able to obtain credit enhancement or that credit enhancement would mitigate the
credit risk of the underlying mortgage loans.
If we invest in residential mortgage loans, we intend to invest primarily in residential mortgage loans
underwritten to our specifications. The originators perform the credit review of the borrowers, the appraisal of the
properties securing the loan, and maintain other quality control procedures. We would generally consider the
purchase of loans when the originators have verified the borrowers’ income and assets, verified their credit history
and obtained appraisals of the properties. We or a third party would perform an independent underwriting review
of the processing, underwriting and loan closing methodologies that the originators used in qualifying a borrower
for a loan. Depending on the size of the loans, we may not review all of the loans in a pool, but rather select loans
for underwriting review based upon specific risk-based criteria such as property location, loan size, effective loan-
to-value ratio, borrower’s credit score and other criteria we believe to be important indicators of credit risk.
Additionally, before the purchase of loans, we would obtain representations and warranties from each originator
stating that each loan is underwritten to our requirements or, in the event underwriting exceptions have been
made, we are informed so that we may evaluate whether to accept or reject the loans. An originator who breaches
these representations and warranties in making a loan that we would purchase may be obligated to repurchase the
loan from us. As added security, we would use the services of a third-party document custodian to insure the
quality and accuracy of all individual mortgage loan closing documents purchased and to hold the documents in
safekeeping. As a result, all of the original loan collateral documents that are signed by the borrower, other than
the original credit verification documents, would be examined, verified and held by the third-party document
custodian.
We may originate mortgage loans or provide other types of financing to the owners of real estate. We
currently do not intend to establish a loan servicing platform, but expect we would retain highly-rated servicers to
service our mortgage loan portfolio.
We expect that all servicers servicing our loans will be highly rated by the rating agencies. We would also
conduct a due diligence review of each servicer before executing a servicing agreement. Servicing procedures
will typically follow Fannie Mae or Freddie Mac guidelines but would be specified in each servicing agreement.
All servicing agreements would meet standards for inclusion in highly-rated mortgage-backed or asset-backed
securitizations or for inclusion in Agency mortgage-backed securities.
We expect that the loans we would acquire will be first lien, single-family residential traditional fixed-rate,
adjustable-rate and hybrid adjustable-rate loans with original terms to maturity of not more than 40 years and are
either fully amortizing or are interest-only for up to ten years, and fully amortizing thereafter. Fixed-rate
mortgage loans bear an interest rate that is fixed for the life of the loan. All adjustable-rate and hybrid adjustable-
rate residential mortgage loans will bear an interest rate tied to an interest rate index. Most loans have periodic
and lifetime constraints on how much the loan interest rate can change on any predetermined interest rate reset
date. The interest rate on each adjustable-rate mortgage loan resets monthly, semi-annually or annually and
generally adjusts to a margin over a U.S. Treasury index or London Interbank Offer Rate, or LIBOR, index.
Hybrid adjustable-rate loans have a fixed rate for an initial period, generally three to ten years, and then convert to
adjustable-rate loans for their remaining term to maturity.
We may acquire residential mortgage loans for our portfolio with the intention of either securitizing them
and retaining them in our portfolio as securitized mortgage loans (which may be in the form of Agency mortgage-
backed securities) or holding them in our residential mortgage loan portfolio. If we securitize residential
mortgage loans that are not eligible to be Agency mortgage-backed securities or we choose not to securitize the
loans through an Agency, to facilitate the Non-Agency mortgage-backed securities, we would generally create
subordinate certificates, which provide a specified amount of credit enhancement. Until we securitize our
residential mortgage loans, we may elect to finance our residential mortgage loan portfolio through the use of
warehouse facilities and repurchase agreements.
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Middle Market Lending
We may from time-to-time through our subsidiary Charlesfort invest a small percentage of our assets
directly in the ownership of corporate loans for middle market companies. The acquisition of such corporate
loans generally involves credit risk directly related to the middle market company obtaining the loan. We may
obtain credit enhancement to mitigate this risk; however, there can be no assurances that we will be able to obtain
credit enhancement or that credit enhancement would mitigate the credit risk of the underlying corporate loans.
Capital Investment Policy
Asset Acquisitions
Our capital investment policy provides that at least 75% of our total assets will be comprised of high
quality mortgage-backed securities and short-term investments. The remainder of our assets, comprising not more
than 25% of total assets, may consist of mortgage-backed securities and other qualified REIT real estate assets
which are unrated or rated less than high quality but which are at least “investment grade” (rated “BBB” or better)
by S&P or the equivalent by another nationally recognized ratings agency or, if not rated, are determined by us to
be of comparable credit quality to an investment which is rated “BBB” or better. In addition, we may directly or
indirectly invest part of this remaining 25% of our assets in other types of securities, including without limitation,
unrated debt, equity or derivative securities, to the extent consistent with our REIT qualification requirements.
The derivative securities in which we invest may include securities representing the right to receive interest only
or a disproportionately large amount of interest, as well as inverse floaters, which may have imbedded leverage as
part of their structural characteristics.
Our capital investment policy requires that we structure our portfolio to maintain a minimum weighted
average rating (including our deemed comparable ratings for unrated mortgage-backed securities) of our
mortgage-backed securities of at least single “A” under the S&P rating system and at the comparable level under
the other rating systems. To date, substantially all of the mortgage-backed securities we have acquired have been
pass-through certificates or CMOs issued or guaranteed by Freddie Mac, Fannie Mae or Ginnie Mae which,
although not rated, carry an implied “AAA” rating.
To date over 90% of our total assets have consisted of Agency mortgage-backed securities and
debentures. While we remain committed to the Agency market, given the current environment, we believe it is
prudent to diversify a portion of our investment portfolio. Therefore, we may allocate up to 25% of our
stockholders’ equity to real estate assets other than Agency mortgage-backed securities.
We intend to acquire only those mortgage-backed securities that we believe we have the necessary
expertise to evaluate and manage, that we can readily finance and that are consistent with our balance sheet
guidelines and risk management objectives. Since we expect to hold our mortgage-backed securities until
maturity, we generally do not seek to acquire assets whose investment returns are only attractive in a limited range
of scenarios. We believe that future interest rates and mortgage prepayment rates are very difficult to predict and,
as a result, we seek to acquire mortgage-backed securities which we believe provide attractive returns over a
broad range of interest rate and prepayment scenarios. We, from time to time, may purchase or sell to-be-
announced forward contracts (“TBAs”) in order to invest in Agency mortgage-backed securities. Pursuant to
these TBAs, we agree to purchase, for future delivery, Agency mortgage-backed securities with certain principal
and interest terms and certain types of collateral, but the particular Agency mortgage-backed securities to be
delivered to us are not identified until shortly before the TBA settlement date.
Among the asset choices available to us, our policy is to acquire those mortgage-backed securities which
we believe generate the highest returns on capital invested, after consideration of the following:
(cid:131)
(cid:131)
(cid:131)
the amount and nature of anticipated cash flows from the asset;
our ability to pledge the asset to secure collateralized borrowings;
the increase in our capital requirement determined by our capital investment policy resulting from
the purchase and financing of the asset; and
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(cid:131)
the costs of financing, hedging and managing the asset.
Prior to acquisition, we assess potential returns on capital employed over the life of the asset and in a
variety of interest rate, yield spread, financing cost, credit loss and prepayment scenarios.
We also give consideration to balance sheet management and risk diversification issues. We deem a
specific asset which we are evaluating for potential acquisition as more or less valuable to the extent it serves to
increase or decrease certain interest rate or prepayment risks which may exist in the balance sheet, to diversify or
concentrate credit risk, and to meet the cash flow and liquidity objectives our management may establish for our
balance sheet from time-to-time. Accordingly, an important part of the asset evaluation process is a simulation,
using risk management models, the addition of a potential asset and our associated borrowings and hedges to the
balance sheet and an assessment of the impact this potential asset acquisition would have on the risks in and
returns generated by our balance sheet as a whole over a variety of scenarios.
We believe that adjustable-rate mortgage pass-through certificates and floaters are particularly well-
suited to our investment objective of high current income, consistent with modest volatility of net asset value,
because the value of adjustable-rate mortgage pass-through certificates and floaters generally remains relatively
stable as compared to traditional fixed-rate debt securities paying comparable rates of interest. We have, however,
purchased a significant amount of fixed-rate mortgage-backed securities and may continue to do so in the future
if, in our view, the potential returns on capital invested, after hedging and all other costs, would exceed the returns
available from other assets or if the purchase of these assets would serve to reduce or diversify the risks of our
balance sheet.
We may purchase the stock of mortgage REITs or similar companies when we believe that these
purchases would yield attractive returns on capital employed. We do not, however, presently intend to invest in
the securities of other issuers for the purpose of exercising control of other issuers.
We may acquire newly issued mortgage-backed securities, and also may seek to expand our capital base
in order to further increase our ability to acquire new assets, when the potential returns from new investments
appears attractive relative to the return expectations of stockholders. We may in the future acquire mortgage-
backed securities by offering our debt or equity securities in exchange for the mortgage-backed securities.
We generally intend to hold mortgage-backed securities for extended periods. In addition, the REIT
provisions of the Internal Revenue Code limit in certain respects our ability to sell mortgage-backed securities.
We may decide however to sell assets from time to time, for a number of reasons, including our desire to dispose
of an asset as to which credit risk concerns have arisen, to reduce interest rate risk, to substitute one type of
mortgage-backed security for another, to improve yield or to maintain compliance with the 55% requirement of
Section 3(c)(5)(C) of the Investment Company Act, or generally to re-structure the balance sheet when we deem
advisable. Our board of directors has not adopted any policy that would restrict management’s authority to
determine the timing of sales or the selection of mortgage-backed securities to be sold.
We may invest in real estate mortgage investment conduit (REMIC) residuals or other CMO residuals.
To the extent that we invest in REMIC residuals or other CMO residuals, we intend to hold or structure such
investments to ensure that such income is not treated as unrelated business taxable income (UBTI) under the
Internal Revenue Code. As a result, we might be subject to corporate level tax on such income.
As a requirement for maintaining REIT status, we will distribute to stockholders aggregate dividends
equaling at least 90% of our REIT taxable income for each taxable year. We will make additional distributions of
capital when the return expectations of the stockholders appear to exceed returns potentially available to us
through making new investments in mortgage-backed securities. Subject to the limitations of applicable securities
and state corporation laws, we can distribute capital by making purchases of our own capital stock or through
paying down or repurchasing any outstanding uncollateralized debt obligations.
Our asset acquisition strategy may change over time as market conditions change and as we evolve.
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Credit Risk Management
Although we do not expect to encounter credit risk in our Agency mortgage-backed securities and
Agency debentures, we face credit risk on the portions of our portfolio which are not mortgage-backed securities
and Agency debentures. In addition, our use of repurchase agreements and interest rate swaps creates exposure to
credit risk relating to potential losses that could be recognized if the counterparties to these instruments fail to
perform their obligations under the contracts. In the event of a default by the counterparty, we could have
difficulty obtaining our Agency mortgage-backed securities pledged as collateral. We review credit risk and other
risk of loss associated with each investment and determine the appropriate allocation of capital to apply to the
investment under our capital investment policy. Our management will monitor the overall portfolio risk and
determine appropriate levels of provision for loss.
Other than for our Agency mortgage-backed securities and Agency debentures, we may also be exposed
to various levels of credit risk depending on the nature of our investments and the nature and level of the assets
underlying the investments and credit enhancements, if any, supporting our assets. We will evaluate, approve and
monitor credit risk and other risks associated with each investment. We intend to review loan to value metrics
upon either the origination or the acquisition of a new investment but generally not in the course of quarterly
surveillance. For our commercial mortgage and real estate assets, we expect that generally we will review the
most recent financial information produced by the borrower, net operating income, or NOI, debt service coverage
ratios, or DSCR, property debt yields (net cash flow or NOI divided by the amount of outstanding indebtedness),
loan per unit and rent rolls relating to each of our assets, and may consider other factors we deem important. We
intend to review market pricing to determine the ability to refinance such assets. For our commercial mortgage
and real estate assets, we intend to also review economic trends, both macro as well as those directly affecting the
property, and the supply and demand of competing projects in the sub-market in which the subject property is
located. For our commercial mortgage and real estate assets, we also evaluate the borrower’s ability to manage
and operate the properties.
For our commercial mortgage and real estate assets, we intend to assign an internal rating of Performing,
Watch List or Workout. Commercial mortgage and real estate assets that are deemed to be Performing would
meet all present contractual obligations. Watch List would be defined as those whose timing and/or recovery of
investment may be under review. Workout would be defined as those for which we do not expect to recover our
cost basis.
Capital and Leverage
We generally expect to maintain a ratio of debt-to-equity of less than 12:1. This ratio varies from time to
time based upon various factors, including our management’s opinion of the level of risk of our assets and
liabilities, our liquidity position, our level of unused borrowing capacity, the availability of credit, over-
collateralization levels required by lenders when we pledge assets to secure borrowings and our assessment of
domestic and international market conditions. Our debt-to-equity ratios have been below our historical average
ratios since the credit crisis of 2008. Specifically, we believe that it is prudent to maintain our existing debt-to-
equity ratio because there continues to be volatility in the mortgage and credit markets primarily driven by the
uncertainty in Europe and U.S. capital markets. For purposes of calculating this ratio, our debt is equal to our
repurchase agreements and convertible senior notes as presented on our Statements of Financial Condition. At
December 31, 2012, our ratio of debt-to-equity was 6.5:1.
Our target debt-to-equity ratio is determined under our capital investment policy. Should our actual debt-
to-equity ratio increase above the target level due to asset acquisition or market value fluctuations in assets, we
would cease to acquire new assets. Our management will, at that time, present a plan to our board of directors to
bring us back to our target debt-to-equity ratio; in many circumstances, this would be accomplished over time by
the monthly reduction of the balance of our Agency mortgage-backed securities through principal repayments.
Our capital base represents the approximate liquidation value of our investments and approximates the market
value of assets that we can pledge or sell to meet over-collateralization requirements for our borrowings. The
unpledged portion of our capital base is available for us to pledge or sell as necessary to maintain over-
collateralization levels for our borrowings.
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Unless our board of directors determines otherwise, we are prohibited from acquiring additional assets
during periods when our capital base is less than the minimum amount required under our capital investment
policy, except as may be necessary to maintain REIT status or our exemption from the Investment Company Act
of 1940, as amended (or the Investment Company Act). In addition, when our capital base falls below our risk-
managed capital requirement, our management is required to submit to our board of directors a plan for bringing
our capital base into compliance with our capital investment policy guidelines. We anticipate that in most
circumstances we can achieve this goal without overt management action through the natural process of mortgage
principal repayments. We anticipate that our capital base is likely to exceed our risk-managed capital requirement
during periods following new equity offerings and during periods of falling interest rates and that our capital base
could fall below the risk-managed capital requirement during periods of rising interest rates.
The first component of our capital requirement is the current aggregate over-collateralization amount or
“haircut” that lenders require us to hold as capital. The haircut for each mortgage-backed security is determined
by our lenders based on the risk characteristics and liquidity of the asset. Should the market value of our pledged
assets decline, we will be required to deliver additional collateral to our lenders to maintain a constant over-
collateralization level on our borrowings.
The second component of our capital requirement is the “excess capital cushion.” This is the amount of
pledge-able Interest Earning Assets we maintain that is in excess of the collateral required to be pledged under our
borrowings. We maintain the excess capital cushion to meet the demands of our lenders for additional collateral
should the market value of our pledged collateral decline. To ensure that we maintain an appropriate level of
excess capital cushion under our capital investment policy, we determine on a daily basis the fair value of our
pledge-able Interest-Earning Assets.
Our capital investment policy stipulates that at least 25% of the capital base maintained to satisfy the
excess capital cushion must be invested in AAA-rated adjustable-rate mortgage-backed securities or assets with
similar or better liquidity characteristics.
A substantial portion of our borrowings are short-term or variable-rate borrowings. Our borrowings are
implemented primarily through repurchase agreements, but in the future may also be obtained through loan
agreements, lines of credit, dollar-roll agreements (an agreement to sell a security for delivery on a specified
future date and a simultaneous agreement to repurchase the same or a substantially similar security on a specified
future date) and other credit facilities with institutional lenders and issuance of debt securities such as commercial
paper, medium-term notes, CMOs and senior or subordinated notes. We enter into financing transactions only
with institutions that we believe are sound credit risks and follow other internal policies designed to limit our
credit and other exposure to financing institutions.
We expect to continue to use repurchase agreements as our principal financing device to leverage our
mortgage-backed securities portfolio. We anticipate that, upon repayment of each borrowing under a repurchase
agreement, we will use the collateral immediately for borrowing under a new repurchase agreement. We have not
at the present time entered into any commitment agreements under which the lender would be required to enter
into new repurchase agreements during a specified period of time, nor do we presently plan to have liquidity
facilities with commercial banks. We may, however, enter into such commitment agreements in the future. We
enter into repurchase agreements primarily with national broker-dealers, commercial banks and other lenders
which typically offer this type of financing. We enter into collateralized borrowings only with financial
institutions meeting credit standards approved by our board of directors, and we monitor the financial condition of
these institutions on a regular basis.
A repurchase agreement, although structured as a sale and repurchase obligation, acts as a financing
under which we effectively pledge our mortgage-backed securities as collateral to secure a short-term loan.
Generally, the other party to the agreement makes the loan in an amount equal to a percentage of the market value
of the pledged collateral. At the maturity of the repurchase agreement, we are required to repay the loan and
correspondingly receive back our collateral. While used as collateral, the mortgage-backed securities continue to
pay principal and interest which are for our benefit. In the event of our insolvency or bankruptcy, certain
repurchase agreements may qualify for special treatment under the Bankruptcy Code, the effect of which, among
other things, would be to allow the creditor under the agreement to avoid the automatic stay provisions of the
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Bankruptcy Code and to foreclose on the collateral without delay. In the event of the insolvency or bankruptcy of
a lender during the term of a repurchase agreement, the lender may be permitted, under applicable insolvency
laws, to repudiate the contract, and our claim against the lender for damages may be treated simply as an
unsecured creditor. In addition, if the lender is a broker or dealer subject to the Securities Investor Protection Act
of 1970, or an insured depository institution subject to the Federal Deposit Insurance Act, our ability to exercise
our rights to recover our securities under a repurchase agreement or to be compensated for any damages resulting
from the lender’s insolvency may be further limited by those statutes. These claims would be subject to
significant delay and, if and when received, may be substantially less than the damages we actually incur.
Substantially all of our collateralized borrowing agreements require us to deposit additional collateral in
the event the market value of existing collateral declines, which may require us to sell assets to reduce our
borrowings. We have designed our liquidity management policy to maintain a cushion of equity sufficient to
provide required liquidity to respond to the effects under our borrowing arrangements of interest rate movements
and changes in market value of our mortgage-backed securities, as described above. However, a major disruption
of the repurchase or other market that we rely on for short-term borrowings would have a material adverse effect
on us unless we were able to arrange alternative sources of financing on comparable terms.
Our articles of incorporation and bylaws do not limit our ability to incur borrowings, whether secured or
unsecured.
Interest Rate Risk Management
To the extent consistent with our election to qualify as a REIT, we follow an interest rate risk
management program intended to protect our portfolio of mortgage-backed securities and related debt against the
effects of major interest rate changes. Specifically, our interest rate risk management program is formulated with
the intent to offset the potential adverse effects resulting from rate adjustment limitations on our mortgage-backed
securities and the differences between interest rate adjustment indices and interest rate adjustment periods of our
adjustable-rate mortgage-backed securities and related borrowings.
We adjust the average maturity adjustment periods of our borrowings on an ongoing basis by changing
the mix of maturities and interest rate adjustment periods as borrowings come due and are renewed. Through use
of these procedures, we attempt to minimize the differences between the interest rate adjustment periods of our
mortgage-backed securities and related borrowings that may occur.
We enter into interest rate swaps. We may from time to time enter into interest rate collars, interest rate
caps or floors, purchase interest rate swaptions and purchase interest-only mortgage-backed securities and similar
instruments to attempt to mitigate the risk of the cost of our variable rate liabilities increasing at a faster rate than
the earnings on our assets during a period of rising interest rates or to mitigate prepayment risk. We have used
interest rate swaps to provide a level of protection against interest rate risks as well as options to enter into interest
rate swaps (commonly referred to as interest rate swaptions). We may also purchase or sell to-be-announced
forward contracts (commonly referred to as TBAs), specified agency securities on a forward basis, purchase or
write put or call options on TBA securities and invest in other types of mortgage derivatives, such as interest-only
securities. We may hedge as much of the interest rate risk as our management determines is in our best interests,
given the cost of the hedging transactions and the need to maintain our status as a REIT. This determination may
result in our electing to bear a level of interest rate or prepayment risk that could otherwise be hedged when
management believes, based on all relevant facts, that bearing the risk is advisable.
We seek to build a balance sheet and undertake an interest rate risk management program which is likely
to generate positive earnings and maintain an equity liquidation value sufficient to maintain operations given a
variety of potentially adverse circumstances. Accordingly, our interest rate risk management program addresses
both income preservation, as discussed above, and capital preservation concerns. For capital preservation, we
monitor our “duration.” This is the expected percentage change in market value of our assets that would be
caused by a 1% change in short and long-term interest rates. To monitor weighted average duration and the
related risks of fluctuations in the liquidation value of our equity, we model the impact of various economic
scenarios on the market value of our mortgage-backed securities and liabilities. At December 31, 2012, we
estimate that the duration of our assets was 2.1 years and giving effect to the swap transactions, our weighted
average duration was 0.6 years. We believe that our interest rate risk management program will allow us to
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maintain operations throughout a wide variety of potentially adverse circumstances. Nevertheless, in order to
further preserve our capital base (and lower our duration) during periods when we believe a trend of rapidly rising
interest rates has been established, we may decide to increase hedging activities or to sell assets. Each of these
actions may lower our earnings and dividends in the short term to further our objective of maintaining attractive
levels of earnings and dividends over the long term.
We may elect to conduct a portion of our hedging operations through one or more subsidiary
corporations, each of which we would elect to treat as a “taxable REIT subsidiary.” To comply with the asset
tests applicable to us as a REIT, we could own 100% of the voting stock of such subsidiary, provided that the
value of the stock that we own in all such taxable REIT subsidiaries does not exceed 25% of the value of our total
assets at the close of any calendar quarter. A taxable subsidiary, such as FIDAC, Merganser, and RCap, would
not elect REIT status and would distribute any net profit after taxes to us. Any dividend income we receive from
the taxable subsidiaries (combined with all other income generated from our assets, other than qualified REIT real
estate assets) must not exceed 25% of our gross income.
We believe that we have developed a cost-effective asset/liability management program to provide a
level of protection against interest rate and prepayment risks. However, no strategy can completely insulate us
from interest rate changes and prepayment risks. Further, as noted above, the federal income tax requirements
that we must satisfy to qualify as a REIT limit our ability to hedge our interest rate and prepayment risks. We
monitor carefully, and may have to limit, our asset/liability management program to assure that we do not realize
excessive hedging income, or hold hedging assets having excess value in relation to total assets, which could
result in our disqualification as a REIT, the payment of a penalty tax for failure to satisfy certain REIT tests under
the Internal Revenue Code, provided the failure was for reasonable cause. In addition, asset/liability management
involves transaction costs which increase dramatically as the period covered by the hedging protection increases.
Therefore, we may be unable to hedge effectively our interest rate and prepayment risks.
Prepayment Risk Management
We seek to minimize the effects of faster or slower than anticipated prepayment rates through structuring
a diversified portfolio with a variety of prepayment characteristics, investing in mortgage-backed securities with
prepayment prohibitions and penalties, investing in certain mortgage-backed security structures which have
prepayment protections, and balancing assets purchased at a premium with assets purchased at a discount. We
monitor prepayment risk through periodic review of the impact of a variety of prepayment scenarios on our
revenues, net earnings, dividends, cash flow and net balance sheet market value.
Future Revisions in Policies and Strategies
Our board of directors has established the investment policies and operating policies and strategies set
forth in this Form 10-K. The board of directors has the power to modify or waive these policies and strategies
without the consent of the stockholders to the extent that the board of directors determines that the modification or
waiver is in the best interests of our stockholders. Among other factors, developments in the market which affect
our policies and strategies or which change our assessment of the market may cause our board of directors to
revise our policies and strategies. To date over 90% of our total assets have consisted of Agency mortgage-
backed securities and debentures. While we remain committed to the Agency market, given the current
environment, we believe it is prudent to diversify a portion of our investment portfolio. Therefore, we may
allocate up to 25% of our stockholders’ equity to real estate assets or non-real estate assets other than Agency
mortgage-backed securities.
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Potential Acquisitions, Strategic Alliances and Other Investments
From time-to-time we have explored possible transactions to enhance our operations and growth,
including entering into new businesses, acquisitions of other businesses or assets, investments in other entities,
joint venture arrangements, or strategic alliances. We entered into the broker-dealer business during the first
quarter of January 2009, through our subsidiary RCap, which was granted membership in FINRA in January
2009. On October 31, 2008 we consummated our acquisition of Merganser which is a registered investment
advisor. We own approximately 45.0 million shares of common stock of Chimera Investment Corporation, (or
Chimera). Chimera is a publicly traded, specialty finance company that acquires, manages, and finances, directly
or through its subsidiaries, residential mortgage loans, residential mortgage-backed securities, real estate related
securities and various other asset classes. Chimera is externally managed by FIDAC and has elected and qualifies
to be taxed as a REIT for federal income tax purposes.
We own approximately 9.5 million shares of common stock of CreXus Investment Corp., (or CreXus) ,
or approximately 12.4%. CreXus is a publicly traded, specialty finance company that acquires, manages, and
finances, directly or through its subsidiaries, commercial mortgage loans and other commercial real estate debt,
commercial mortgage-backed securities, or CMBS, and other commercial real estate-related assets. CreXus is
externally managed by FIDAC and has elected and qualifies to be taxed as a REIT for federal income tax
purposes. On January 30, 2013, we entered into an Agreement and Plan of Merger (the “Merger Agreement”),
among us, CXS Acquisition Corporation, a Maryland corporation and our wholly-owned subsidiary, and CreXus,
pursuant to which, among other things, Acquisition will commence a tender offer (the “Offer”) to purchase all of
the outstanding shares of CreXus’ common stock, par value $0.01 per share (the “Shares”), that neither we nor
Acquisition own at a price per share of $13.00 in cash, plus a cash payment to reflect a pro-rated quarterly
dividend for the quarter in which the tender offer is closed, subject to the terms and conditions set forth in the
Merger Agreement. If at least 51% of the Shares not owned by us or any of our subsidiaries, officers or directors
are tendered and purchased by Acquisition in the tender offer, and subject to the satisfaction or waiver of certain
limited conditions set forth in the Merger Agreement (including, if required, receipt of approval by CreXus’
stockholders), Acquisition will merge with and into CreXus, with CreXus surviving as a wholly-owned subsidiary
of the Company (the “Merger”). In the Merger, each outstanding Share, other than Shares owned by Acquisition
and us, will be converted into the right to receive the same cash consideration paid in the Offer.
Under the terms of the Merger Agreement, CreXus may solicit, receive, evaluate and enter into
negotiations with respect to alternative proposals from third parties for a period of 45 calendar days continuing
through March 16, 2013 (the “Transaction Solicitation Period”). CreXus may continue discussions after the
Transaction Solicitation Period with parties who made acquisition proposals during the Transaction Solicitation
Period, or who made unsolicited acquisition proposals after the Transaction Solicitation Period, in either case that
CreXus determines, in good faith, would result in, or is reasonably likely to result in, a superior proposal. If
CreXus receives a superior proposal, we and Acquisition have the right to increase our offer price one time to a
price that is at least $0.10 per share greater than the value per share stockholders would receive as a result of the
superior proposal and thereafter CreXus may terminate after providing two business days’ notice. If CreXus
terminates the Merger Agreement during the Transaction Solicitation Period or during the 10-day period
following its expiration to enter into a superior proposal with a party who delivered a written acquisition proposal
during the Transaction Solicitation Period, CreXus will be required to pay to us a termination fee of $15 million.
If CreXus terminates the Merger Agreement thereafter in connection with a superior proposal, the termination fee
will be $25 million. If the Merger Agreement is terminated in either circumstance, CreXus will also be required
to reimburse us for our documented out-of-pocket expenses, up to $5 million. In all cases, the termination fee and
expense reimbursement will be credited against the termination fee payable by CreXus under the management
agreement with FIDAC.
The Merger Agreement includes customary representations, warranties and covenants of CreXus, us and
Acquisition. CreXus has agreed to operate its business in the ordinary course consistent with past practice until
the effective time of the Merger. We have separately agreed to not purchase any Shares in excess of the
approximately 12.4% of the outstanding that we currently own.
Consummation of the Offer is subject to various conditions, including (1) the valid tender of the number
of Shares that would represent at least 51% of the Shares not owned by us or any of our subsidiaries, officers or
directors, (2) the consummation of the Offer or the Merger not being unlawful under any applicable statute, rule or
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regulation, (3) the consummation of the Offer or the Merger not being enjoined by order of any court or other
governmental authority, (4) the absence of a Company Material Adverse Effect (as defined in the Merger
Agreement), (5) neither CreXus’ board of directors nor its special committee of independent directors having
withdrawn its recommendation of the Offer or Merger to CreXus’ stockholders, and (6) the satisfaction of certain
other customary closing conditions. Neither the Offer nor the Merger is subject to a financing condition. We plan
to finance the transaction with cash on hand.
If, after completion of the Offer, we and Acquisition hold at least 90% of the outstanding Shares, the
Merger will be consummated in accordance with the short-form merger provisions under Maryland law without
the approval of the Merger by CreXus’ stockholders. If, after completion of the Offer, we and Acquisition hold
less than 90% of the outstanding Shares, Acquisition will have the right to exercise an irrevocable option (the
“Percentage Increase Option”) granted to it by CreXus under the Merger Agreement to purchase from CreXus that
number of additional Shares that will increase the percentage of outstanding Shares owned by us and our
subsidiaries to one share more than 90% of the outstanding Shares (after giving effect to the issuance of shares
pursuant to the Percentage Increase Option). Upon exercise of the Percentage Increase Option, the Merger will be
consummated in accordance with the short-form merger provisions under Maryland law without approval of the
Merger by CreXus’ stockholders.
CreXus’ board of directors, upon the unanimous recommendation and approval of a special committee
consisting of three independent directors (the “Special Committee”), adopted resolutions (i) determining and
declaring advisable the Merger Agreement and the Offer, the Merger, the Percentage Increase Option and the
other transactions contemplated by the Merger Agreement, (ii) determining that the terms of the Offer, the Merger
Agreement, the Merger and the other transactions contemplated by the Merger Agreement are in the best interests
of, and fair to, CreXus’ stockholders other than us and our affiliates, and (iii) recommending that CreXus’
stockholders (other than us and our affiliates) accept the Offer, tender their Shares into the Offer and, to the extent
required by applicable law to consummate the Merger, vote their Shares in favor of approving the Merger.
We may, from time-to-time, continue to explore possible new businesses, acquisitions, investments, joint
venture arrangements and strategic alliances which may enhance our operations and assist our and our
subsidiaries’ growth. These transactions could be material to our financial condition and results of operations.
The process of integrating an acquired company or business create unforeseen operating difficulties and
expenditures. Our failure to address these risks or other problems encountered in connection with our past or
future acquisitions and investments could cause us to fail to realize the anticipated benefits of such acquisitions or
investments, incur unanticipated liabilities, and harm our business generally. Future acquisitions could also result
in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities, or amortization
expenses, or write-offs of goodwill, any of which could harm our financial condition. Also, the anticipated benefit
of many of our acquisitions or investments may not materialize.
Dividend Reinvestment and Share Purchase Plan
We have adopted a dividend reinvestment and share purchase plan. Under the dividend reinvestment
feature of the plan, existing shareholders can reinvest their dividends in additional shares of our common stock.
Under the share purchase feature of the plan, new and existing shareholders can purchase shares of our common
stock. We have an effective shelf registration statement on Form S-3 which registered 100,000,000 shares of
common stock that could be issued under the plan. We may from time to time sell shares covered by this
registration statement under the plan.
Legal Proceedings
From time-to-time, we are involved in various claims and legal actions arising in the ordinary course of
business. In the opinion of management, the ultimate disposition of these matters will not have a material effect
on our consolidated financial statements.
Employees
As of December 31, 2012, we and our subsidiaries had 147 full time employees. None of our employees
are subject to any collective bargaining agreements. We believe we have good relations with our employees.
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Available Information
Our investor relations website is www.annaly.com. We make available on this website under “SEC
filings,” free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K and amendments to those reports as soon as reasonably practicable after we electronically file or furnish
such materials to the SEC.
COMPETITION
We believe that our principal competition in the acquisition and holding of the types of mortgage-backed
securities we purchase are financial institutions such as banks, savings and loans, life insurance companies,
institutional investors such as mutual funds and pension funds, other lenders, government entities and certain
other mortgage REITs. Some of these entities may not be subject to the same regulatory constraints (i.e., REIT
compliance or maintaining an exemption under the Investment Company Act of 1940, as amended) as us. In
addition, many of these entities have greater financial resources and access to capital than us. Some of our
competitors have greater financial resources and access to capital than we do. Our competitors, as well as
additional competitors which may emerge in the future, may increase the competition for the acquisition of
mortgage-backed securities, which in turn may result in higher prices and lower yields on such assets.
ITEM 1A. RISK FACTORS
An investment in our stock involves a number of risks. Before making an investment decision, you
should carefully consider all of the risks described in this Form 10-K. If any of the risks discussed in this Form
10-K actually occur, our business, financial condition and results of operations could be materially adversely
affected. If this were to occur, the trading price of our stock could decline significantly and you may lose all or
part of your investment.
Risks Associated with Adverse Developments in the Mortgage Finance and Credit Markets
Volatile market conditions for mortgages and mortgage-related assets as well as the broader financial
markets can result in a significant contraction in liquidity for mortgages and mortgage-related assets,
which may adversely affect the value of the assets in which we invest.
Our results of operations are materially affected by conditions in the markets for mortgages and
mortgage-related assets, including Agency mortgage-backed securities, as well as the broader financial markets
and the economy generally. Significant adverse changes in financial market conditions can result in a
deleveraging of the global financial system and the forced sale of large quantities of mortgage-related and other
financial assets. Concerns over economic recession, geopolitical issues, unemployment, the availability and cost
of financing, the mortgage market and a declining real estate market may contribute to increased volatility and
diminished expectations for the economy and markets.
For example, as a result of the financial market conditions beginning in the summer of 2007, many
traditional mortgage investors suffered severe losses in their residential mortgage portfolios and several major
market participants failed or have been impaired, resulting in a significant contraction in market liquidity for
mortgage-related assets. This illiquidity negatively affected both the terms and availability of financing for all
mortgage-related assets. Further increased volatility and deterioration in the markets for mortgages and mortgage-
related assets as well as the broader financial markets may adversely affect the performance and market value of
our Agency mortgage-backed securities. If these conditions persist, institutions from which we seek financing for
our investments may tighten their lending standards or become insolvent, which could make it more difficult for
us to obtain financing on favorable terms or at all. Our profitability may be adversely affected if we are unable to
obtain cost-effective financing for our investments. Continued adverse developments in the broader residential
mortgage market may adversely affect the value of the assets in which we invest.
Since the summer of 2007, the residential mortgage market in the United States experienced a variety of
difficulties and changed economic conditions, including defaults, credit losses and liquidity concerns. These
factors have impacted investor perception of the risk associated with Agency mortgage-backed securities in which
we invest. As a result, values for Agency mortgage-backed securities in which we invest have experienced a
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certain amount of volatility. Further increased volatility and deterioration in the broader residential mortgage and
Agency mortgage-backed securities markets may adversely affect the performance and market value of our
investments. Any decline in the value of our investments, or perceived market uncertainty about their value,
would likely make it difficult for us to obtain financing on favorable terms or at all, or maintain our compliance
with terms of any financing arrangements already in place.
The Agency mortgage-backed securities in which we invest are classified for accounting purposes as
available-for-sale. All assets classified as available-for-sale are reported at fair value with unrealized gains and
losses excluded from earnings and reported as a separate component of stockholders' equity. A decline in fair
values may reduce the book value of our assets. Moreover, if the decline in fair value of an available-for-sale
security is other-than-temporarily impaired, such decline will reduce earnings. If market conditions result in a
decline in the fair value of our Agency mortgage-backed securities, our financial position and results of operations
could be adversely affected.
The potential limit or wind down of the role Fannie Mae and Freddie Mac play in the mortgage-backed
securities market may adversely affect our business, operations and financial condition.
On February 11, 2011, the U.S Department of the Treasury (or Treasury) issued a White Paper titled
“Reforming America's Housing Finance Market” (or the White Paper) that lays out, among other things, proposals
to limit or potentially wind down the role that Fannie Mae and Freddie Mac play in the mortgage market. Any
such proposals, if enacted, may have broad adverse implications for the economy, the mortgage-backed securities
market and our business, operations and financial condition. We expect such proposals to be the subject of
significant discussion and it is not yet possible to determine whether or when such proposals may be enacted,
what form any final legislation or policies might take and how proposals, legislation or policies emanating from
the White Paper may impact the economy, the mortgage-backed securities market and our business, operations
and financial condition. We are evaluating, and will continue to evaluate, the potential impact of the proposals set
forth in the White Paper.
The conservatorship of Fannie Mae and Freddie Mac, their reliance upon the U.S. Government for
solvency, and related efforts that may significantly affect Fannie Mae and Freddie Mac and their
relationship with the U.S. Government, may adversely affect our business, operations and financial
condition.
Due to increased market concerns about Fannie Mae and Freddie Mac’s ability to withstand future credit
losses associated with securities held in their investment portfolios, and on which they provide guarantees,
without the direct support of the U.S. Government Congress passed the Housing and Economic Recovery Act of
2008, (or the HERA). Among other things, the HERA established the Federal Housing Finance Agency, or
FHFA, which has broad regulatory powers over Fannie Mae and Freddie Mac. On September 6, 2008, the FHFA
placed Fannie Mae and Freddie Mac into conservatorship and, together with the Treasury, established a program
designed to boost investor confidence in Fannie Mae’s and Freddie Mac’s debt and mortgage-backed securities.
As the conservator of Fannie Mae and Freddie Mac, the FHFA controls and directs their operations and may (1)
take over the assets of and operate Fannie Mae and Freddie Mac with all the powers of their shareholders,
directors and officers of Fannie Mae and Freddie Mac and conduct all business of Fannie Mae and Freddie Mac;
(2) collect all obligations and money due to Fannie Mae and Freddie Mac; (3) perform all functions of Fannie
Mae and Freddie Mac which are consistent with the conservator’s appointment; (4) preserve and conserve the
assets and property of Fannie Mae and Freddie Mac; and (5) contract for assistance in fulfilling any function,
activity, action or duty of the conservator.
In addition to FHFA becoming the conservator of Fannie Mae and Freddie Mac, the Treasury and Fannie
Mae and Freddie Mac have entered into Preferred Stock Purchase Agreements (or PSPAs) pursuant to which the
Treasury has ensured that each of Fannie Mae and Freddie Mac maintains a positive net worth. On December 24,
2009, the Treasury amended the terms of the PSPAs to remove the $200 billion per institution limit established
under the PSPAs until the end of 2012. The Treasury also amended the PSPAs with respect to the requirements
for Fannie Mae and Freddie Mac to reduce their portfolios. On August 17, 2012, the PSPAs were further amended
to, among other things, change the method for calculating the amount of dividends Fannie Mae and Freddie Mac
are required to pay the Treasury and to re-establish the $200 billion limit per institution beginning in 2013.
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The problems faced by Fannie Mae and Freddie Mac resulting in their placement into federal
conservatorship and receipt of significant U.S. Government support have sparked debate among some federal
policy makers regarding the continued role of the U.S. Government in providing liquidity for mortgage loans and
mortgage-backed securities. With Fannie Mae’s and Freddie Mac’s future under debate, the nature of their
guarantee obligations could be considerably limited relative to historical measurements. Any changes to the
nature of their guarantee obligations could redefine what constitutes an Agency mortgage-backed security and
could have broad adverse implications for the market and our business, operations and financial condition. If
Fannie Mae or Freddie Mac are eliminated, or their structures change radically (i.e., limitation or removal of the
guarantee obligation), we may be unable to acquire additional Agency mortgage-backed securities. A reduction in
the supply of Agency mortgage-backed securities could negatively affect the pricing of Agency mortgage-backed
securities by reducing the spread between the interest we earn on our portfolio of Agency mortgage-backed
securities and our cost of financing that portfolio.
Although the Treasury previously committed capital to Fannie Mae and Freddie Mac through 2012, and
in the White Paper the Treasury committed to providing sufficient capital to enable Fannie Mae and Freddie Mac
to meet their current and future guarantee obligations, there can be no assurance that these actions will be
adequate for their needs. If these actions are inadequate, Fannie Mae and Freddie Mac could continue to suffer
losses and could fail to honor their guarantees and other obligations. Furthermore, the current credit support
provided by the Treasury to Fannie Mae and Freddie Mac, and any additional credit support it may provide in the
future, could have the effect of lowering the interest rates we expect to receive from mortgage-backed securities,
and tightening the spread between the interest we earn on our mortgage-backed securities and the cost of financing
those assets.
In addition, our existing Agency mortgage-backed securities could be materially and adversely impacted.
We rely on our Agency mortgage-backed securities as collateral for our financings under our repurchase
agreements. Any decline in their value, or perceived market uncertainty about their value, would make it more
difficult for us to obtain financing on acceptable terms or at all, or to maintain our compliance with the terms of
any financing transactions.
Future policies that change the relationship between Fannie Mae and Freddie Mac and the U.S.
Government, including those that result in their winding down, nationalization, privatization, or elimination, may
create market uncertainty and have the effect of reducing the actual or perceived credit quality of securities issued
or guaranteed by Fannie Mae or Freddie Mac. As a result, such policies could increase the risk of loss on
investments in Agency mortgage-backed securities guaranteed by Fannie Mae and/or Freddie Mac. It also is
possible that such policies could adversely impact the market for such securities and spreads at which they trade.
All of the foregoing could materially and adversely affect our business, operations and financial condition.
Mortgage loan modification programs, future legislative action and changes in the requirements necessary
to qualify for refinancing a mortgage with Fannie Mae, Freddie Mac or Ginnie Mae may adversely affect
the value of, and the returns on, the assets in which we invest.
The U.S. Government, through the Federal Housing Administration, or FHA, and the FDIC, has
implemented programs designed to provide homeowners with assistance in avoiding residential mortgage loan
foreclosures including the Hope for Homeowners Act of 2008, which allows certain distressed borrowers to
refinance their mortgages into FHA-insured loans. The programs may also involve, among other things, the
modification of mortgage loans to reduce the principal amount of the loans or the rate of interest payable on the
loans, or to extend the payment terms of the loans. These loan modification programs, including future legislative
or regulatory actions and amendments to the bankruptcy laws, that result in the modification of outstanding
mortgage loans, as well as changes in the requirements necessary to qualify for refinancing a mortgage with
Fannie Mae, Freddie Mac or Ginnie Mae may adversely affect the value of, and the returns on, our Agency
mortgage-backed securities and Agency debentures. Depending on whether or not we purchased an instrument at
a premium or discount, the yield we receive may be positively or negatively impacted by any modification.
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The U.S. Government's efforts to encourage for refinancing of certain loans may affect prepayment rates
for mortgage loans in Mortgage-Backed Securities.
In addition to the increased pressure upon residential mortgage loan investors and servicers to engage in
loss mitigation activities, the U.S. Government is pressing for refinancing of certain loans, and this
encouragement may affect prepayment rates for mortgage loans in Agency mortgage-backed securities. To the
extent these and other economic stabilization or stimulus efforts are successful in increasing prepayment speeds
for residential mortgage loans, such as those in Agency mortgage-backed securities, that could potentially have a
negative impact on our income and operating results, particularly in connection with loans or Agency mortgage-
backed securities purchased at a premium or our interest-only securities.
We operate in a highly competitive market for investment opportunities and competition may limit our
ability to acquire desirable investments in our target assets and could also affect the pricing of these
securities.
We operate in a highly competitive market for investment opportunities. Our profitability depends, in
large part, on our ability to acquire our target assets at attractive prices. In acquiring our target assets, we will
compete with a variety of institutional investors, including other REITs, specialty finance companies, public and
private funds (including other funds managed by FIDAC), government entities, commercial and investment banks,
commercial finance and insurance companies and other financial institutions. Many of our competitors are
substantially larger and have considerably greater financial, technical, marketing and other resources than we do.
Several other REITs have recently raised, or are expected to raise, significant amounts of capital, and may have
investment objectives that overlap with ours, which may create additional competition for investment
opportunities. Some competitors may have a lower cost of funds and access to funding sources that may not be
available to us, such as funding from the U.S. Government, if we are not eligible to participate in programs
established by the U.S. Government. Many of our competitors are not subject to the operating constraints
associated with REIT tax compliance or maintenance of an exemption from the Investment Company Act. In
addition, some of our competitors may have higher risk tolerances or different risk assessments, which could
allow them to consider a wider variety of investments and establish more relationships than us. Furthermore,
competition for investments in our target assets may lead to the price of such assets increasing, which may further
limit our ability to generate desired returns. We cannot assure you that the competitive pressures we face will not
have a material adverse effect on our business, financial condition and results of operations. Also, as a result of
this competition, desirable investments in our target assets may be limited in the future and we may not be able to
take advantage of attractive investment opportunities from time to time, as we can provide no assurance that we
will be able to identify and make investments that are consistent with our investment objectives.
Purchases and sales of Agency securities by the Federal Reserve may adversely affect the price and return
associated with Agency mortgage-backed securities
On September 13, 2012, the Federal Reserve announced their third quantitative easing program,
commonly known as QE3, and extended their guidance to keep the federal funds rate at “exceptional low levels”
through at least mid-2015. QE3 entails large-scale purchases of Agency mortgage-backed securities at the pace of
$40 billion per month in addition to the Federal Reserve's existing policy of reinvesting principal payments from
its holdings of Agency mortgage-backed securities into new Agency mortgage-backed securities purchases. While
we cannot predict the impact of this program or any future actions by the Federal Reserve on the prices and
liquidity of Agency mortgage-backed securities, we expect that during periods in which the Federal Reserve
purchases significant volumes of Agency mortgage-backed securities, yields on Agency mortgage-backed
securities will be lower and refinancing volumes will be higher than would have been absent their large scale
purchases. As a result, returns on Agency mortgage-backed securities may be adversely affected. There is also a
risk that as the Federal Reserve reduces their purchases of Agency mortgage-backed securities or if they decide to
sell some or all of their holdings of Agency mortgage-backed securities, the pricing of our Agency mortgage-
backed securities portfolio may be adversely affected.
Risks Related to Our Business
An increase in the interest payments on our borrowings relative to the interest we earn on our Investment
Securities may adversely affect our profitability.
We earn money based upon the spread between the interest payments we earn on our Investment
Securities and the interest payments we must make on our borrowings. If the interest payments on our borrowings
increase relative to the interest we earn on our Investment Securities, our profitability may be adversely affected.
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• Differences in timing of interest rate adjustments on our Investment Securities and our borrowings
may adversely affect our profitability
We rely primarily on short-term borrowings to acquire Investment Securities with long-term maturities.
Accordingly, if short-term interest rates increase, this may adversely affect our profitability.
Some of the Investment Securities we acquire are adjustable-rate interest-earning assets. This means that
their interest rates may vary over time based upon changes in an objective index, such as:
• LIBOR. The interest rate that banks in London offer for deposits in London of U.S. dollars.
• Treasury Rate. A monthly or weekly average yield of benchmark U.S. Treasury securities, as
published by the Federal Reserve Board.
These indices generally reflect short-term interest rates. On December 31, 2012, approximately 7% of
our Investment Securities were adjustable-rate interest-earning assets.
The interest rates on our borrowings similarly vary with changes in an objective index. Nevertheless, the
interest rates on our borrowings generally adjust more frequently than the interest rates on our adjustable-rate
interest-earning assets. For example, on December 31, 2012, our adjustable-rate interest-earning assets had a
weighted average term to next rate adjustment of 35 months, while our borrowings had a weighted average term
of 197 days. Accordingly, in a period of rising interest rates, we could experience a decrease in net income or a
net loss because the interest rates on our borrowings adjust faster than the interest rates on our adjustable-rate
interest-earning assets.
•
Interest rate caps on our Agency mortgage-backed securities and Agency debentures may adversely
affect our profitability
Our adjustable-rate interest-earning assets are typically subject to periodic and lifetime interest rate caps.
Periodic interest rate caps limit the amount an interest rate can increase during any given period. Lifetime interest
rate caps limit the amount an interest rate can increase through maturity of Agency mortgage-backed securities
and Agency debentures. Our borrowings are not subject to similar restrictions. Accordingly, in a period of
rapidly increasing interest rates, we could experience a decrease in net income or experience a net loss because the
interest rates on our borrowings could increase without limitation while the interest rates on our adjustable-rate
interest-earning assets would be limited by caps.
• Because we acquire fixed-rate securities, an increase in interest rates may adversely affect our
profitability
In a period of rising interest rates, our interest payments could increase while the interest we earn on our
fixed-rate mortgage-backed securities would not change. This would adversely affect our profitability. On
December 31, 2012, approximately 93% of our Investment Securities were fixed-rate investments.
An increase in prepayment rates may adversely affect our profitability.
The Agency mortgage-backed securities we acquire are backed by pools of mortgage loans. We receive
payments, generally, from the payments that are made on these underlying mortgage loans. When borrowers
prepay their mortgage loans at rates that are faster-than-expected, this results in prepayments on mortgage-backed
securities that are faster than expected. These faster than expected prepayments may adversely affect our
profitability. We often purchase mortgage-backed securities that have a higher interest rate than the market
interest rate at the time. In exchange for this higher interest rate, we must pay a premium over the market value to
acquire the security. In accordance with accounting rules, we amortize this premium over the term of the
mortgage-backed security. If the mortgage-backed security is prepaid in whole or in part prior to its maturity date,
however, we must expense all or a part of the remaining unamortized portion of the premium that was prepaid at
the time of the prepayment. This adversely affects our profitability.
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Prepayment rates generally increase when interest rates fall and decrease when interest rates rise, but
changes in prepayment rates are difficult to predict. Prepayment rates also may be affected by conditions in the
housing and financial markets, general economic conditions and the relative interest rates on fixed-rate and
adjustable-rate mortgage loans.
We often purchase mortgage-backed securities that have a higher coupon rate than the prevailing market
interest rates. In exchange for a higher coupon rate, we typically pay a premium over par value to acquire these
mortgage-backed securities. In accordance with generally accepted accounting principles (or GAAP), we
amortize the premiums on our mortgage-backed securities over the life of the related mortgage-backed securities.
If the mortgage loans securing these mortgage-backed securities prepay at a more rapid rate than anticipated, we
will have to amortize our premiums on an accelerated basis which may adversely affect our profitability. Defaults
on mortgage loans underlying Agency mortgage-backed securities typically have the same effect as prepayments
because of the underlying Agency guarantee. As of December 31, 2012, we had a net premium of $5.8 billion, or
4.9% of current par value, on our Agency mortgage-backed securities, Agency debentures, and corporate debt.
We may seek to reduce prepayment risk by acquiring mortgage-backed securities at a discount. If a
discounted security is prepaid in whole or in part prior to its maturity date, we will earn income equal to the
amount of the remaining discount. This will improve our profitability if the discounted securities are prepaid
faster than expected.
We also can acquire mortgage-backed securities that are less affected by prepayments. For example, we
can acquire CMOs, a type of mortgage-backed security. CMOs divide a pool of mortgage loans into multiple
tranches that allow for shifting of prepayment risks from slower-paying tranches to faster-paying tranches. This is
in contrast to pass-through or pay-through mortgage-backed securities, where all investors share equally in all
payments, including all prepayments. As discussed below, the Investment Company Act of 1940 imposes
restrictions on our purchase of CMOs.
While we seek to minimize prepayment risk to the extent practical, in selecting investments we must
balance prepayment risk against other risks and the potential returns of each investment. No strategy can
completely insulate us from prepayment risk.
An increase in interest rates may adversely affect the market value of our investment securities and,
therefore, also our book value.
Increases in interest rates may negatively affect the market value of our investment securities because in
a period of rising interest rates, the relative value of interest earning assets we own can be expected to fall and
reduce the book value. In addition, our fixed-rate securities, generally, are more negatively affected by these
increases because in a period of rising interest rates, our interest payments could increase while the interest we
earn on our fixed-rate mortgage-backed securities would not change. We reduce our book value by the amount of
any decrease in the market value of our investment securities.
Failure to procure funding on favorable terms, or at all, would adversely affect our results and may, in
turn, negatively affect the market price of shares of our common stock.
The recent dislocation and weakness in the broader mortgage markets could adversely affect one or more
of our potential lenders and could cause one or more of our potential lenders to be unwilling or unable to provide
us with financing. This could potentially increase our financing costs and reduce our liquidity. If one or more
major market participants fails or otherwise experiences a major liquidity crisis it could negatively impact the
marketability of all fixed income securities, including Agency RMBS, and this could negatively impact the value
of the securities we acquire, thus reducing our net book value. Furthermore, if any of our potential lenders or any
of our lenders are unwilling or unable to provide us with financing, we could be forced to sell our assets at an
inopportune time when prices are depressed.
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The soundness of other financial institutions could adversely affect us.
Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other
relationships. We have exposure to many different industries and counterparties, and routinely execute
transactions with counterparties in the financial services industry, including brokers and dealers, commercial
banks, investment banks, mutual and hedge funds, and other institutional clients. Many of these transactions
expose us to credit risk in the event of default of its counterparty or client. There is no assurance that any such
losses would not materially and adversely impact our revenues and earnings.
Our strategy involves significant leverage.
We incur this leverage by borrowing against a substantial portion of the market value of our investment
securities. By incurring this leverage, we can enhance our returns. Nevertheless, this leverage, which is
fundamental to our investment strategy, also creates significant risks.
• Our leverage may cause substantial losses
Because of our significant leverage, we may incur substantial losses if our borrowing costs increase. Our
borrowing costs may increase for any of the following reasons:
•
•
•
•
short-term interest rates increase;
the market value of our Investment Securities decreases;
interest rate volatility increases; or
the availability of financing in the market decreases.
• Our leverage may cause margin calls and defaults and force us to sell assets under adverse market
conditions
Because of our leverage, a decline in the value of our investment securities may result in our lenders
initiating margin calls. A margin call means that the lender requires us to pledge additional collateral to re-
establish the ratio of the value of the collateral to the amount of the borrowing. Our fixed-rate mortgage-
backed securities generally are more susceptible to margin calls as increases in interest rates tend to more
negatively affect the market value of fixed-rate securities.
If we are unable to satisfy margin calls, our lenders may foreclose on our collateral. This could force us
to sell our investment securities under adverse market conditions. Additionally, in the event of our
bankruptcy, our borrowings, which are generally made under repurchase agreements, may qualify for special
treatment under the Bankruptcy Code. This special treatment would allow the lenders under these agreements
to avoid the automatic stay provisions of the Bankruptcy Code and to liquidate the collateral under these
agreements without delay.
• Liquidation of collateral may jeopardize our REIT status
To continue to qualify as a REIT, we must comply with requirements regarding our assets and our
sources of income. If we are compelled to liquidate our Agency mortgage-backed securities and Agency
debentures, we may be unable to comply with these requirements, ultimately jeopardizing our status as a
REIT and our failure to qualify as a REIT will have adverse tax consequences.
• We may exceed our target leverage ratios
We generally expect to maintain a ratio of debt-to-equity of less than 12:1. However, we are not required
to stay below this leverage ratio. We may exceed this ratio by incurring additional debt without increasing
the amount of equity we have. For example, if we increase the amount of borrowings under our master
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repurchase agreements with our existing or new counterparties, our leverage ratio would increase. If we
increase our debt-to-equity ratio, the adverse impact on our financial condition and results of operations from
the types of risks associated with the use of leverage would likely be more severe.
• We may not be able to achieve our optimal leverage
We use leverage as a strategy to increase the return to our investors. However, we may not be able to
achieve our desired leverage for any of the following reasons:
• we determine that the leverage would expose us to excessive risk;
•
•
our lenders do not make funding available to us at acceptable rates; or
our lenders require that we provide additional collateral to cover our borrowings.
• We may incur increased borrowing costs which would adversely affect our profitability
Currently, all of our collateralized borrowings are in the form of repurchase agreements. If the interest
rates on these repurchase agreements increase, it would adversely affect our profitability.
Our borrowing costs under repurchase agreements generally correspond to short-term interest rates such
as LIBOR or a short-term Treasury index, plus or minus a margin. The margins on these borrowings over or
under short-term interest rates may vary depending upon:
•
•
•
the movement of interest rates;
the availability of financing in the market; or
the value and liquidity of our Investment Securities.
If we are unable to renew our borrowings at favorable rates, our profitability may be adversely affected.
Since we rely primarily on short-term borrowings, our ability to achieve our investment objectives
depends not only on our ability to borrow money in sufficient amounts and on favorable terms, but also on our
ability to renew or replace on a continuous basis our maturing short-term borrowings. If we are not able to renew
or replace maturing borrowings, we would have to sell our assets under possibly adverse market conditions.
If a counterparty to our repurchase transactions defaults on its obligation to resell the underlying security
back to us at the end of the transaction term, or if the value of the underlying security has declined as of the
end of that term, or if we default on our obligations under the repurchase agreement, we will lose money on
our repurchase transactions.
When we engage in repurchase transactions, we generally sell securities to lenders (repurchase
agreement counterparties) and receive cash from these lenders. The lenders are obligated to resell the same
securities back to us at the end of the term of the transaction. Because the cash we receive from the lender when
we initially sell the securities to the lender is less than the value of those securities (this difference is the haircut),
if the lender defaults on its obligation to resell the same securities back to us, we may incur a loss on the
transaction equal to the amount of the haircut (assuming there was no change in the value of the securities). We
would also lose money on a repurchase transaction if the value of the underlying securities has declined as of the
end of the transaction term, as we would have to repurchase the securities for their initial value but would receive
securities worth less than that amount. Further, if we default on one of our obligations under a repurchase
transaction, the lender can terminate the transaction and cease entering into any other repurchase transactions with
us. Repurchase agreements generally contain cross-default provisions, so that if a default occurs under any one
agreement, the lenders under our other agreements could also declare a default. Any losses we incur on our
repurchase transactions could adversely affect our earnings and thus our cash available for distribution to
shareholders.
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Any repurchase agreements that we use to finance our assets may require us to provide additional
collateral or pay down debt.
Our repurchase agreements involve the risk that the market value of the securities pledged or sold by us
to the repurchase agreement counterparty may decline in value, in which case the counterparty may require us to
provide additional collateral or to repay all or a portion of the funds advanced. We may not have additional
collateral or the funds available to repay our debt at that time, which would likely result in defaults unless we are
able to raise the funds from alternative sources, which we may not be able to achieve on favorable terms or at all.
Posting additional collateral would reduce our liquidity and limit our ability to leverage our assets. If we cannot
meet these requirements, the counterparty could accelerate its indebtedness, increase the interest rate on advanced
funds and terminate our ability to borrow funds from them, which could materially and adversely affect our
financial condition and ability to implement our investment strategy. In addition, in the event that the
counterparty files for bankruptcy or becomes insolvent, our securities may become subject to bankruptcy or
insolvency proceedings, thus depriving us, at least temporarily, of the benefit of these assets. Such an event could
restrict our access to bank credit facilities and increase its cost of capital. Repurchase agreement counterparties
may also require us to maintain a certain amount of cash or set aside assets sufficient to maintain a specified
liquidity position that would enhance our ability to satisfy its collateral obligations. As a result, we may not be
able to leverage our assets as fully as we would choose, which could reduce our return on assets. In the event that
we are unable to meet these collateral obligations, our financial condition and prospects could deteriorate rapidly.
Our hedging strategies expose us to risks.
Our policies permit us to enter into interest rate swaps, caps and floors, interest rate swaptions, and other
derivative transactions to help us mitigate our interest rate and prepayment risks described above. We have used
interest rate swaps to provide a level of protection against interest rate risks as well as options to enter into interest
rate swaps (commonly referred to as interest rate swaptions). We may also purchase or sell to-be-announced
forward contracts (commonly referred to as TBAs), specified Agency securities on a forward basis, purchase or
write put or call options on TBA securities and invest in other types of mortgage derivatives, such as interest-only
securities. No hedging strategy can protect us completely. Interest rate hedging may fail to protect or could
adversely affect us because, among other things: interest rate hedging can be expensive, particularly during
periods of rising and volatile interest rates; available interest rate hedges may not correspond directly with the
interest rate risk for which protection is sought; and the duration of the hedge may not match the duration of the
related liability.
• Our hedging strategies may not be successful in mitigating the risks associated with interest rates
We cannot assure you that our use of derivatives will offset the risks related to changes in interest rates.
It is likely that there will be periods in the future during which we will incur losses on our derivative financial
instruments that will not be fully offset by gains on our portfolio. The derivative financial instruments we select
may not have the effect of reducing our interest rate risk. In addition, the nature and timing of hedging
transactions may influence the effectiveness of these strategies. Poorly designed strategies or improperly executed
transactions could significantly increase our risk and lead to material losses. In addition, hedging strategies
involve transaction and other costs. Our hedging strategy and the derivatives that we use may not adequately
offset the risk of interest rate volatility. Moreover, our hedging transactions may result in losses.
• Our use of derivatives may expose us to counterparty risks
We enter into interest rate swap and cap agreements to hedge risks associated with movements in interest
rates. If a swap counterparty cannot perform under the terms of an interest rate swap, we would not receive
payments due under that agreement, we may lose any unrealized gain associated with the interest rate swap, and
the hedged liability would cease to be hedged by the interest rate swap. We may also be at risk for any collateral
we have pledged to secure our obligations under the interest rate swap if the counterparty become insolvent or file
for bankruptcy. Similarly, if a cap counterparty fails to perform under the terms of the cap agreement, in addition
to not receiving payments due under that agreement that would off-set our interest expense, we would also incur a
loss for all remaining unamortized premium paid for that agreement.
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We may face risks of investing in inverse floating rate securities.
We may invest in inverse floaters. The returns on inverse floaters are inversely related to changes in an
interest rate. Generally, income on inverse floaters will decrease when interest rates increase and increase when
interest rates decrease. Investments in inverse floaters may subject us to the risks of reduced or eliminated interest
payments and losses of premium paid. In addition, certain indexed securities and inverse floaters may increase or
decrease in value at a greater rate than the underlying interest rate, which effectively leverages our investment in
such securities. As a result, the market value of such securities will generally be more volatile than that of fixed
rate securities.
Our investment strategy may involve credit risk.
To date over 90% of our total assets have consisted of Agency mortgage-backed securities and Agency
debentures which, although not rated, carry an implied “AAA” rating. Agency certificates are mortgage pass-
through certificates where Freddie Mac, Fannie Mae or Ginnie Mae guarantees payments of principal and interest
on the certificates. Agency debentures are debt instruments issued by Freddie Mac, Fannie Mae, or the FHLB.
Even though our Agency mortgage-backed securities and Agency debentures acquired thus far have been
“AAA”, pursuant to our capital investment policy, we have the ability to acquire securities of lower credit quality.
Under our policy:
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75% of our total assets must be high quality mortgage-backed securities and short-term investments.
High quality securities are securities (1) that are rated within one of the two highest rating categories
by at least one of the nationally recognized rating agencies, (2) that are unrated but are guaranteed by
the United States government or an agency of the United States government, or (3) that are unrated
or whose ratings have not been updated but that our management determines are of comparable
quality to high quality rated mortgage-backed securities;
the remaining 25% of total assets, may consist of mortgage-backed securities and other qualified
REIT real estate assets which are unrated or rated less than high quality, but which are at least
“investment grade” (rated “BBB” or better by Standard & Poor’s Corporation (or S&P) or the
equivalent by another nationally recognized rating agency) or, if not rated, we determine them to be
of comparable credit quality to an investment which is rated “BBB” or better. In addition, we may
directly or indirectly invest part of this remaining 25% of our assets in other types of securities,
including without limitation, unrated debt, equity or derivative securities, to the extent consistent
with our REIT qualification requirements. The derivative securities in which we invest may include
securities representing the right to receive interest only or a disproportionately large amount of
interest, as well as inverse floaters, which may have imbedded leverage as part of their structural
characteristics; and
• we seek to structure our portfolio to maintain a minimum weighted average rating (including our
deemed comparable ratings for unrated mortgage-backed securities) of our mortgage-backed
securities of at least single “A” under the S&P rating system and at the comparable level under the
other rating systems.
While we remain committed to the Agency market, given the current environment, we believe it is
prudent to diversify a portion of our investment portfolio. Therefore, we may allocate up to 25% of our
stockholders’ equity to real estate assets other than Agency mortgage-backed securities.
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Our ongoing investment in new business strategies and new assets is inherently risky, and could disrupt our
ongoing businesses.
We expect to invest in new business strategies and assets. Such endeavors may involve significant risks
and uncertainties, including distraction of management from current operations, expenses associated with these
new investments, inadequate return of capital on our investments, and unidentified issues not discovered in our
due diligence of such strategies and assets. Because these new ventures are inherently risky, no assurance can be
given that such strategies will be successful and will not materially adversely affect our reputation, financial
condition, and operating results.
We may experience declines in the market value of our assets resulting in us recording impairments, which
may have an adverse effect on our results of operations and financial condition.
A decline in the market value of our mortgage-backed securities or other assets may require us to
recognize an “other-than-temporary” impairment (or OTTI) against such assets under GAAP. When the fair value
of our MBS is less than its amortized cost, the security is considered impaired. We assess our impaired securities
on at least a quarterly basis and designate such impairments as either “temporary” or “other-than-temporary.” If
we intend to sell an impaired security, or it is more likely than not that we will be required to sell the impaired
security before its anticipated recovery, then we must recognize an other-than-temporary impairment through
earnings equal to the entire difference between the mortgage-backed securities amortized cost and its fair value at
the balance sheet date. If we do not expect to sell an other-than-temporarily impaired security, only the portion of
the other-than-temporary impairment related to credit losses is recognized through earnings with the remainder
recognized as a component of other comprehensive income/(loss) on our balance sheet. Impairments we recognize
through other comprehensive income/(loss) do not impact our earnings. Following the recognition of an other-
than-temporary impairment through earnings, a new cost basis is established for the mortgage-backed securities
and may not be adjusted for subsequent recoveries in fair value through earnings. However, other-than-temporary
impairments recognized through earnings may be accreted back to the amortized cost basis of the security on a
prospective basis through interest income. The determination as to whether an other-than-temporary impairment
exists and, if so, the amount we consider other-than-temporarily impaired is subjective, as such determinations are
based on both factual and subjective information available at the time of assessment. As a result, the timing and
amount of other-than-temporary impairments constitute material estimates that are susceptible to significant
change.
We have not established a minimum dividend payment level.
We intend to pay quarterly dividends and to make distributions to our stockholders in amounts such that
all or substantially all of our taxable income in each year (subject to certain adjustments) is distributed. This
enables us to qualify for the tax benefits accorded to a REIT under the Code. We have not established a minimum
dividend payment level and our ability to pay dividends may be adversely affected for the reasons described in
this section. All distributions will be made at the discretion of our board of directors and will depend on our
earnings, our financial condition, maintenance of our REIT status and such other factors as our board of directors
may deem relevant from time to time.
Because of competition, we may not be able to acquire mortgage-backed securities at favorable yields.
Our net income depends, in large part, on our ability to acquire mortgage-backed securities at favorable
spreads over our borrowing costs. In acquiring mortgage-backed securities, we compete with other REITs,
investment banking firms, savings and loan associations, banks, insurance companies, mutual funds, other lenders,
government entities and other entities that purchase mortgage-backed securities, many of which have greater
financial resources than us. As a result, in the future, we may not be able to acquire sufficient mortgage-backed
securities at favorable spreads over our borrowing costs.
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We are dependent on our key personnel.
We are dependent on the efforts of our key officers and employees. The loss of any of their services
could have an adverse effect on our operations. Although we have employment agreements with each of them, we
cannot assure you they will remain employed with us.
Our reported GAAP financial results differ from the taxable income results that impact our dividend
distribution requirements and, therefore, our GAAP results may not be an accurate indicator of future
taxable income and dividend distributions.
Generally, the cumulative net income we report over the life of an asset will be the same for GAAP and
tax purposes, although the timing of this income recognition over the life of the asset could be materially different.
Differences exist in the accounting for GAAP net income and REIT taxable income which can lead to significant
variances in the amount and timing of when income and losses are recognized under these two measures. Due to
these differences, our reported GAAP financial results could materially differ from our determination of taxable
income.
We and our shareholders are subject to certain tax risks.
• Our failure to qualify as a REIT would have adverse tax consequences
We believe that since 1997 we have qualified for taxation as a REIT for federal income tax purposes.
We plan to continue to meet the requirements for taxation as a REIT. The determination that we are a
REIT requires an analysis of various factual matters and circumstances that may not be totally within our
control. For example, to qualify as a REIT, at least 75% of our gross income must come from real estate
sources and 95% of our gross income must come from real estate sources and certain other sources that
are itemized in the REIT tax laws. We are also required to distribute to stockholders at least 90% of our
REIT taxable income (determined without regard to the deduction for dividends paid and by excluding
any net capital gain). Even a technical or inadvertent mistake could jeopardize our REIT status.
Furthermore, Congress and the Internal Revenue Service (or IRS) might make changes to the tax laws
and regulations, and the courts might issue new rulings that make it more difficult or impossible for us to
remain qualified as a REIT.
If we fail to qualify as a REIT, we would be subject to federal income tax at regular corporate
rates. Also, unless the IRS granted us relief under certain statutory provisions, we would remain
disqualified as a REIT for four years following the year we first fail to qualify. If we fail to qualify as a
REIT, we would have to pay significant income taxes and would therefore have less money available for
investments or for distributions to our stockholders. This would likely have a significant adverse effect
on the value of our securities. In addition, the tax law would no longer require us to make distributions
to our stockholders.
A REIT that fails the quarterly asset tests for one or more quarters will not lose its REIT status
as a result of such failure if either (i) the failure is regarded as a de minimis failure under standards set
out in the Internal Revenue Code, or (ii) the failure is greater than a de minimis failure but is attributable
to reasonable cause and not willful neglect. In the case of a greater than de minimis failure, however, the
REIT must pay a tax and must remedy the failure within 6 months of the close of the quarter in which the
failure was identified. In addition, the Internal Revenue Code provides relief for failures of other tests
imposed as a condition of REIT qualification, as long as the failures are attributable to reasonable cause
and not willful neglect. A REIT would be required to pay a penalty of $50,000, however, in the case of
each failure.
• We have certain distribution requirements
As a REIT, we must distribute at least 90% of our REIT taxable income (determined without regard
to the deduction for dividends paid and by excluding any net capital gain). The required distribution
limits the amount we have available for other business purposes, including amounts to fund our growth.
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Also, it is possible that because of the differences between the time we actually receive revenue or pay
expenses and the period we report those items for distribution purposes, we may have to borrow funds on
a short-term basis to meet the 90% distribution requirement.
• We are also subject to other tax liabilities
Even if we qualify as a REIT, we may be subject to certain federal, state and local taxes on our
income and property. Any of these taxes would reduce our operating cash flow.
• Limits on ownership of our common stock could have adverse consequences to you and could
limit your opportunity to receive a premium on our stock
To maintain our qualification as a REIT for federal income tax purposes, not more than 50% in value
of the outstanding shares of our capital stock may be owned, directly or indirectly, by five or fewer
individuals (as defined in the federal tax laws to include certain entities). Primarily to facilitate
maintenance of our qualification as a REIT for federal income tax purposes, our charter will prohibit
ownership, directly or by the attribution provisions of the federal tax laws, by any person of more than
9.8% of the lesser of the number or value of the issued and outstanding shares of our common stock and
will prohibit ownership, directly or by the attribution provisions of the federal tax laws, by any person of
more than 9.8% of the lesser of the number or value of the issued and outstanding shares of any class or
series of our preferred stock. Our board of directors, in its sole and absolute discretion, may waive or
modify the ownership limit with respect to one or more persons who would not be treated as
“individuals” for purposes of the federal tax laws if it is satisfied, based upon information required to be
provided by the party seeking the waiver and upon an opinion of counsel satisfactory to the board of
directors, that ownership in excess of this limit will not otherwise jeopardize our status as a REIT for
federal income tax purposes.
The ownership limit may have the effect of delaying, deferring or preventing a change in control
and, therefore, could adversely affect our shareholders’ ability to realize a premium over the then-
prevailing market price for our common stock in connection with a change in control.
• A REIT cannot invest more than 25% of its total assets in the stock or securities of one or more
taxable REIT subsidiaries; therefore, our taxable subsidiaries cannot constitute more than 25% of
our total assets
A taxable REIT subsidiary is a corporation, other than a REIT or a qualified REIT subsidiary, in
which a REIT owns stock and which elects taxable REIT subsidiary status. The term also includes a
corporate subsidiary in which the taxable REIT subsidiary owns more than a 35% interest. A REIT may
own up to 100% of the stock of one or more taxable REIT subsidiaries. A taxable REIT subsidiary may
earn income that would not be qualifying income if earned directly by the parent REIT. Overall, at the
close of any calendar quarter, no more than 25% of the value of a REIT’s assets may consist of stock or
securities of one or more taxable REIT subsidiaries.
The stock and securities of our taxable REIT subsidiaries are expected to represent less than 25% of
the value of our total assets. Furthermore, we intend to monitor the value of our investments in the stock
and securities of our taxable REIT subsidiaries to ensure compliance with the above-described 25%
limitation. We cannot assure you, however, that we will always be able to comply with the 25%
limitation so as to maintain REIT status.
• Taxable REIT subsidiaries are subject to tax at the regular corporate rates, are not required to
distribute dividends, and the amount of dividends a taxable REIT subsidiary can pay to its parent
REIT may be limited by REIT gross income tests
A taxable REIT subsidiary must pay income tax at regular corporate rates on any income that it
earns. Our taxable REIT subsidiaries will pay corporate income tax on their taxable income, and their
after-tax net income will be available for distribution to us. Such income, however, is not required to
be distributed.
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Moreover, the annual gross income tests that must be satisfied to ensure REIT qualification may
limit the amount of dividends that we can receive from our taxable REIT subsidiaries and still maintain
our REIT status. Generally, not more than 25% of our gross income can be derived from non-real estate
related sources, such as dividends from a taxable REIT subsidiary. If, for any taxable year, the dividends
we received from our taxable REIT subsidiaries, when added to our other items of non-real estate related
income, represented more than 25% of our total gross income for the year, we could be denied REIT
status, unless we were able to demonstrate, among other things, that our failure of the gross income test
was due to reasonable cause and not willful neglect.
The limitations imposed by the REIT gross income tests may impede our ability to distribute assets
from our taxable REIT subsidiaries to us in the form of dividends. Certain asset transfers may, therefore,
have to be structured as purchase and sale transactions upon which our taxable REIT subsidiaries
recognize taxable gain.
•
If interest accrues on indebtedness owed by a taxable REIT subsidiary to its parent REIT at a rate
in excess of a commercially reasonable rate, or if transactions between a REIT and a taxable
REIT subsidiary are entered into on other than arm’s-length terms, the REIT may be subject to a
penalty tax
If interest accrues on an indebtedness owed by a taxable REIT subsidiary to its parent REIT at a rate
in excess of a commercially reasonable rate, the REIT is subject to tax at a rate of 100% on the excess of
(i) interest payments made by a taxable REIT subsidiary to its parent REIT over (ii) the amount of
interest that would have been payable had interest accrued on the indebtedness at a commercially
reasonable rate. A tax at a rate of 100% is also imposed on any transaction between a taxable REIT
subsidiary and its parent REIT to the extent the transaction gives rise to deductions to the taxable REIT
subsidiary that are in excess of the deductions that would have been allowable had the transaction been
entered into on arm’s-length terms. We will scrutinize all of our transactions with our taxable REIT
subsidiaries in an effort to ensure that we do not become subject to these taxes. We may not be able to
avoid application of these taxes.
Risks Related To Commercial Mortgage and Real Estate Assets
A prolonged economic slowdown or continued declining real estate values could impair the assets we may
own and harm our operating results.
Many of the commercial mortgage and real estate assets we may own may be susceptible to economic
slowdowns or recessions, which could lead to financial losses in our assets and a decrease in revenues, net income
and asset values. Unfavorable economic conditions also could increase our funding costs, limit our access to the
capital markets or result in a decision by lenders not to extend credit to us. These events could result in significant
diminution in the value of our assets, prevent us from increasing our assets and have an adverse effect on our
operating results.
Continued adverse developments in the broader residential and commercial mortgage market may
adversely affect the value of the assets in which we expect to invest.
For the past few years, the residential and commercial mortgage market in the United States has
experienced a variety of difficulties and changed economic conditions, including defaults, credit losses and
liquidity concerns. Certain commercial banks, investment banks and insurance companies have announced
extensive losses from exposure to the residential and commercial mortgage market. These losses have reduced
financial industry capital, leading to reduced liquidity for some institutions. These factors have impacted investor
perception of the risk associated with CMBS and commercial mortgage loans which we may acquire. As a result,
values for CMBS and commercial mortgage loans in which we expect to invest may experience volatility. Further
increased volatility and deterioration in the broader residential and commercial mortgage and mortgage-backed
securities markets may adversely affect the performance and market value of the assets we expect to acquire.
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Any decline in the value of our assets, or perceived market uncertainty about their value, would likely
continue to make it difficult for us to obtain financing on favorable terms or at all, or maintain our compliance
with terms of any financing arrangements already in place. The CMBS in which we expect to invest is classified
for accounting purposes as available-for-sale. All assets classified as available-for-sale will be reported at fair
value with unrealized gains and losses excluded from earnings and reported as a separate component of
stockholders’ equity. As a result, a decline in fair values may reduce the book value of our assets. Moreover, if the
decline in fair value of an available-for-sale security is other-than-temporarily impaired, such decline will reduce
earnings. If market conditions result in a decline in the fair value of the CMBS we expect to acquire, our financial
position and results of operations could be adversely affected.
The commercial mortgage loans we expect to acquire and the mortgage loans underlying the CMBS assets
we expect to acquire depend on the ability of the commercial property owner to generate net income from
operating the property. Failure to do so may result in delinquency and/or foreclosure.
Commercial mortgage loans are secured by multifamily or commercial property and are subject to risks
of delinquency and foreclosure, and risks of loss that may be greater than similar risks associated with loans made
on the security of single-family residential property. The ability of a borrower to repay a loan secured by an
income-producing property typically is dependent primarily upon the successful operation of such property rather
than upon the existence of independent income or assets of the borrower. If the net operating income of the
property is reduced, the borrower’s ability to repay the loan may be impaired. Net operating income of an income-
producing property can be adversely affected by, among other things,
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tenant mix;
success of tenant businesses;
property management decisions;
property location, condition and design;
competition from comparable types of properties;
changes in laws that increase operating expenses or limit rents that may be charged;
changes in national, regional or local economic conditions or specific industry segments, including
the credit and securitization markets;
declines in regional or local real estate values;
declines in regional or local rental or occupancy rates;
increases in interest rates, real estate tax rates and other operating expenses;
costs of remediation and liabilities associated with environmental conditions;
the potential for uninsured or underinsured property losses;
changes in governmental laws and regulations, including fiscal policies, zoning ordinances and
environmental legislation and the related costs of compliance; and
acts of God, terrorist attacks, social unrest and civil disturbances.
In the event of any default under a mortgage loan held directly by us, we will bear a risk of loss of
principal to the extent of any deficiency between the value of the collateral and the principal and accrued interest
of the mortgage loan, which could have a material adverse effect on our cash flow from operations and limit
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amounts available for distribution to our stockholders. In the event of the bankruptcy of a mortgage loan
borrower, the mortgage loan to such borrower will be deemed to be secured only to the extent of the value of the
underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the
mortgage loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the
extent the lien is unenforceable under state law. Foreclosure of a mortgage loan can be an expensive and lengthy
process, which could have a substantial negative effect on our anticipated return on the foreclosed mortgage loan.
Because assets we expect to acquire may experience periods of illiquidity, we may lose profits or be
prevented from earning capital gains if we cannot sell mortgage-related assets at an opportune time.
We bear the risk of being unable to dispose of our targeted assets at advantageous times or in a timely
manner because mortgage-related assets generally experience periods of illiquidity, including the recent period of
delinquencies and defaults with respect to commercial mortgage loans. The lack of liquidity may result from the
absence of a willing buyer or an established market for these assets, as well as legal or contractual restrictions on
resale or the unavailability of financing for these assets. As a result, our ability to vary our portfolio in response to
changes in economic and other conditions may be relatively limited, which may cause us to incur losses.
The lack of liquidity in the assets we expect to acquire may adversely affect our business.
The illiquidity of our commercial mortgage and real estate assets we expect to acquire may make it
difficult for us to sell such assets if the need or desire arises. Many of the securities we expect to purchase are not
be registered under the relevant securities laws, resulting in a prohibition against their transfer, sale, pledge or
their disposition except in a transaction that is exempt from the registration requirements of, or otherwise in
accordance with, those laws. In addition, certain assets such as B-Notes, mezzanine loans, preferred equity and
bridge and other loans are also particularly illiquid assets due to their potential unsuitability for securitization and
the greater difficulty of recovery in the event of a borrower’s default. Moreover, turbulent market conditions, such
as those recently in effect, could significantly and negatively impact the liquidity of our assets. It may be difficult
or impossible to obtain third party pricing on the assets we purchase. Illiquid assets typically experience greater
price volatility, as a ready market does not exist, and can be more difficult to value. In addition, validating third
party pricing for illiquid assets may be more subjective than more liquid assets. As a result, we expect many of the
assets we may acquire will be illiquid and if we are required to liquidate all or a portion of our portfolio quickly,
we may realize significantly less than the value at which we have previously recorded our assets. Further, we may
face other restrictions on our ability to liquidate an asset in a business entity to the extent that we have or could be
attributed with material, nonpublic information regarding such business entity. As a result, our ability to vary our
portfolio in response to changes in economic and other conditions may be relatively limited, which could
adversely affect our results of operations and financial condition.
The real estate investments we expect to acquire will be illiquid.
Because real estate investments are relatively illiquid, our ability to adjust the portfolio promptly in
response to economic or other conditions will be limited. Certain significant expenditures generally do not change
in response to economic or other conditions, including: (i) debt service (if any), (ii) real estate taxes, and (iii)
operating and maintenance costs. This combination of variable revenue and relatively fixed expenditures may
result, under certain market conditions, in reduced earnings and could have an adverse effect on our financial
condition.
The CMBS assets we expect to acquire are subject to losses.
The CMBS we expect to acquire are subject to losses. In general, losses on a mortgaged property
securing a mortgage loan included in a securitization will be borne first by the equity holder of the property, then
by the holder of a mezzanine loan or B-Note, if any, then by the “first loss” subordinated security holder
generally, the “B-Piece” buyer, and then by the holder of a higher-rated security. In the event of default and the
exhaustion of any equity support, mezzanine loans or B-Notes, and any classes of securities junior to those which
we acquire, we will not be able to recover all of our capital in the securities we purchase. In addition, if the
underlying mortgage portfolio has been overvalued by the originator, or if the values subsequently decline and, as
a result, less collateral is available to satisfy interest and principal payments due on the related mortgage-backed
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securities. The prices of lower credit quality CMBS are generally less sensitive to interest rate changes than more
highly rated CMBS, but more sensitive to adverse economic downturns or individual issuer developments. The
projection of an economic downturn, for example, could cause a decline in the price of lower credit quality CMBS
because the ability of obligors of mortgages underlying CMBS to make principal and interest payments may be
impaired. In such event, existing credit support in the securitization structure may be insufficient to protect us
against loss of our principal on these securities.
We may not control the special servicing of the mortgage loans included in the CMBS in which we may
invest and, in such cases, the special servicer may take actions that could adversely affect our interests.
With respect to the CMBS in which we may invest, overall control over the special servicing of the
related underlying mortgage loans will be held by a “directing certificate holder” or a “controlling class
representative,” which is appointed by the holders of the most subordinate class of CMBS in such series. To the
extent that we focus on acquiring classes of existing series of CMBS originally rated AAA, we will not have the
right to appoint the directing certificate holder. In connection with the servicing of the specially serviced mortgage
loans, the related special servicer may, at the direction of the directing certificate holder, take actions with respect
to the specially serviced mortgage loans that could adversely affect our interests.
If we overestimate the yields or incorrectly prices the risks of our assets, we may experience losses.
We will value our potential assets based on yields and risks, taking into account estimated future losses
on the mortgage loans and the underlying collateral included in the securitization’s pools, and the estimated
impact of these losses on expected future cash flows and returns. Our loss estimates may not prove accurate, as
actual results may vary from estimates. In the event that we underestimate the asset level losses relative to the
price we pay for a particular asset, we may experience losses with respect to such asset.
Purchases of non-conforming and non-investment grade rated loans or securities involve increased risk of
loss.
It is possible that some of the loans we acquire will not conform to conventional loan standards applied
by traditional lenders and either will not be rated or will be rated as non-investment grade by the rating agencies.
The non-investment grade ratings for these assets typically result from the overall leverage of the loans, the lack
of a strong operating history for the properties underlying the loans, the borrowers’ credit history, the properties’
underlying cash flow or other factors. As a result, these loans will have a higher risk of default and loss than
investment grade rated assets. Any loss we incur may be significant and may reduce distributions to our
stockholders and adversely affect the market value of our common shares.
Any credit ratings assigned to our assets will be subject to ongoing evaluations and revisions, and we cannot
assure you that those ratings will not be downgraded.
Some of our assets may be rated by Moody’s Investors Service, Fitch Ratings, Standard & Poor’s,
DBRS, Inc., Realpoint LLC or other credit ratings organizations. Any credit ratings on our assets are subject to
ongoing evaluation by credit rating agencies, and we cannot assure you that any such ratings will not be changed
or withdrawn by a rating agency in the future if, in its judgment, circumstances warrant. If rating agencies assign a
lower-than-expected rating or reduce or withdraw, or indicate that they may reduce or withdraw, their ratings of
our assets in the future, the value of these assets could significantly decline, which would adversely affect the
value of our portfolio and could result in losses upon disposition or the failure of borrowers to satisfy their debt
service obligations to us.
The B-Notes that we may acquire may be subject to additional risks related to the privately negotiated
structure and terms of the transaction, which may result in losses to us.
We may acquire B-Notes. A B-Note is a mortgage loan typically (1) secured by a first mortgage on a
single large commercial property or group of related properties and (2) subordinated to an A-Note secured by the
same first mortgage on the same collateral. As a result, if a borrower defaults, there may not be sufficient funds
remaining for B-Note holders after payment to the A-Note holders. However, because each transaction is privately
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negotiated, B-Notes can vary in their structural characteristics and risks. For example, the rights of holders of B-
Notes to control the process following a borrower default may vary from transaction to transaction. Further, B-
Notes typically are secured by a single property and so reflect the risks associated with significant concentration.
Significant losses related to our B-Notes would result in operating losses for us and may limit our ability to make
distributions to our stockholders.
The mezzanine loan assets that we expect to acquire will involve greater risks of loss than senior loans
secured by income-producing properties.
We may acquire mezzanine loans, which take the form of subordinated loans secured by second
mortgages on the underlying property or loans secured by a pledge of the ownership interests of either the entity
owning the property or a pledge of the ownership interests of the entity that owns the interest in the entity owning
the property. These types of assets involve a higher degree of risk than long-term senior mortgage lending secured
by income-producing real property, because the loan may become unsecured as a result of foreclosure by the
senior lender. In the event of a bankruptcy of the entity providing the pledge of its ownership interests as security,
we may not have full recourse to the assets of such entity, or the assets of the entity may not be sufficient to
satisfy our mezzanine loan. If a borrower defaults on our mezzanine loan or debt senior to our loan, or in the event
of a borrower bankruptcy, our mezzanine loan will be satisfied only after the senior debt. As a result, we may not
recover some or all of our initial expenditure. In addition, mezzanine loans may have higher loan-to-value ratios
than conventional mortgage loans, resulting in less equity in the property and increasing the risk of loss of
principal. Significant losses related to our mezzanine loans would result in operating losses for us and may limit
our ability to make distributions to our stockholders.
We may be required to repurchase mortgage loans or indemnify investors if we breach representations and
warranties, which could harm our earnings.
When we sell loans, we will be required to make customary representations and warranties about such
loans to the loan purchaser. Our commercial mortgage loan sale agreements will require us to repurchase or
substitute loans in the event we breach a representation or warranty given to the loan purchaser. In addition, we
may be required to repurchase loans as a result of borrower fraud or in the event of early payment default on a
mortgage loan. Likewise, we may be required to repurchase or substitute loans if we breach a representation or
warranty in connection with our securitizations. The remedies available to a purchaser of mortgage loans are
generally broader than those available to us against the originating broker or correspondent. Further, if a purchaser
enforces its remedies against us, we may not be able to enforce the remedies we have against the sellers. The
repurchased loans typically can only be financed at a steep discount to their repurchase price, if at all. They are
also typically sold at a significant discount to the unpaid principal balance. Significant repurchase activity could
harm our cash flow, results of operations, financial condition and business prospects.
We and our third party loan originators and servicers’ due diligence of potential assets may not reveal all
of the liabilities associated with such assets and may not reveal other weaknesses in such assets, which could
lead to losses.
Before making an asset acquisition, we will assess the strengths and weaknesses of the originator or
issuer of the asset as well as other factors and characteristics that are material to the performance of the asset. In
making the assessment and otherwise conducting customary due diligence, we will rely on resources available to
it, including our third party loan originators and servicers. This process is particularly important with respect to
newly formed originators or issuers because there may be little or no information publicly available about these
entities and assets. There can be no assurance that our due diligence process will uncover all relevant facts or that
any asset acquisition will be successful.
The real estate assets we expect to acquire are subject to risks particular to real property, which may
adversely affect our returns from certain assets and our ability to make distributions to our stockholders.
We will own assets secured by real estate and own real estate directly, in the future, we may own real
estate directly either through direct purchases or upon a default of mortgage loans. Real estate assets are subject to
various risks, including:
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acts of God, including earthquakes, hurricanes, floods and other natural disasters, which may result
in uninsured losses;
acts of war or terrorism, including the consequences of terrorist attacks, such as those that occurred
on September 11, 2001;
adverse changes in national and local economic and market conditions;
changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related
costs of compliance with laws and regulations, fiscal policies and ordinances;
costs of remediation and liabilities associated with environmental conditions such as indoor mold;
and
the potential for uninsured or under-insured property losses.
If any of these or similar events occurs, it may reduce our return from an affected property or investment
and reduce or eliminate our ability to make distributions to stockholders.
Construction loans involve an increased risk of loss.
We may acquire construction loans. If we fail to fund our entire commitment on a construction loan or if
a borrower otherwise fails to complete the construction of a project, there could be adverse consequences
associated with the loan, including: a loss of the value of the property securing the loan, especially if the borrower
is unable to raise funds to complete it from other sources; a borrower claim against us for failure to perform under
the loan documents; increased costs to the borrower that the borrower is unable to pay; a bankruptcy filing by the
borrower; and abandonment by the borrower of the collateral for the loan.
Risks of cost overruns and noncompletion of renovation of the properties underlying rehabilitation loans
may result in significant losses. The renovation, refurbishment or expansion by a borrower under a mortgaged
property involves risks of cost overruns and noncompletion. Estimates of the costs of improvements to bring an
acquired property up to standards established for the market position intended for that property may prove
inaccurate. Other risks may include rehabilitation costs exceeding original estimates, possibly making a project
uneconomical, environmental risks and rehabilitation and subsequent leasing of the property not being completed
on schedule. If such renovation is not completed in a timely manner, or if it costs more than expected, the
borrower may experience a prolonged impairment of net operating income and may not be able to make payments
on our investment, which could result in significant losses.
We use analytical models and data in connection with the valuation of our assets, and any incorrect,
misleading or incomplete information used in connection therewith would subject us to potential risks.
Given the complexity of our expected assets and strategies, we must rely heavily on analytical models
(both proprietary models developed by us and those supplied by third parties) and information and data supplied
by our third party loan originators and servicers, or models and data. Models and data are used to value assets or
potential asset purchases and also in connection with hedging our assets. When models and data prove to be
incorrect, misleading or incomplete, any decisions made in reliance thereon expose us to potential risks. For
example, by relying on models and data, especially valuation models, we may be induced to buy certain assets at
prices that are too high, to sell certain other assets at prices that are too low or to miss favorable opportunities
altogether. Similarly, any hedging based on faulty models and data may prove to be unsuccessful. Furthermore,
any valuations of our assets that are based on valuation models may prove to be incorrect.
Some of the risks of relying on analytical models and third-party data are particular to analyzing tranches
from securitizations, such as CMBS or RMBS. These risks include, but are not limited to, the following: (i)
collateral cash flows and/or liability structures may be incorrectly modeled in all or only certain scenarios, or may
be modeled based on simplifying assumptions that lead to errors; (ii) information about collateral may be
incorrect, incomplete, or misleading; (iii) collateral or bond historical performance (such as historical
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prepayments, defaults, cash flows, etc.) may be incorrectly reported, or subject to interpretation (e.g., different
issuers may report delinquency statistics based on different definitions of what constitutes a delinquent loan); or
(iv) collateral or bond information may be outdated, in which case the models may contain incorrect assumptions
as to what has occurred since the date information was last updated.
Some of the analytical models used by us, such as mortgage prepayment models or mortgage default
models, are predictive in nature. The use of predictive models has inherent risks. For example, such models may
incorrectly forecast future behavior, leading to potential losses on a cash flow and/or a mark-to-market basis. In
addition, the predictive models used by us may differ substantially from those models used by other market
participants, with the result that valuations based on these predictive models may be substantially higher or lower
for certain assets than actual market prices. Furthermore, since predictive models are usually constructed based on
historical data supplied by third parties, the success of relying on such models may depend heavily on the
accuracy and reliability of the supplied historical data and the ability of these historical models to accurately
reflect future periods.
All valuation models rely on correct market data inputs. If incorrect market data is entered into even a
well-founded valuation model, the resulting valuations will be incorrect. However, even if market data is inputted
correctly, “model prices” will often differ substantially from market prices, especially for securities with complex
characteristics, such as derivative securities.
We may experience a decline in the fair value of our expected assets.
A decline in the fair market value of our expected assets may require us to recognize an “other-than-
temporary” impairment against such assets under GAAP if we were to determine that, with respect to any assets in
unrealized loss positions, we do not have the ability and intent to hold such assets to maturity or for a period of
time sufficient to allow for recovery to the amortized cost of such assets. If such a determination were to be made,
we would recognize unrealized losses through earnings and write down the amortized cost of such assets to a new
cost basis, based on the fair value of such assets on the date they are considered to be other-than-temporarily
impaired. Such impairment charges reflect non-cash losses at the time of recognition; subsequent disposition or
sale of such assets could further affect our future losses or gains, as they are based on the difference between the
sale price received and adjusted amortized cost of such assets at the time of sale.
Some of our portfolio assets may be recorded at fair value and, as a result, there will be uncertainty as to
the value of these assets. Some of our portfolio assets are in the form of positions or securities that are not publicly
traded. The fair value of securities and other investments that are not publicly traded may not be readily
determinable. We will value these assets quarterly at fair value. Because such valuations are subjective, the fair
value of certain of our assets may fluctuate over short periods of time and our determinations of fair value may
differ materially from the values that would have been used if a ready market for these securities existed. The
value of our common stock could be adversely affected if our determinations regarding the fair value of these
investments were materially higher than the values that we ultimately realize upon their disposal.
Liability relating to environmental matters may impact the value of properties that we may acquire or
foreclosure on.
If we acquire or foreclose on properties with respect to which we have extended mortgage loans, we may
be subject to environmental liabilities arising from such foreclosed properties. Under various U.S. federal, state
and local laws, an owner or operator of real property may become liable for the costs of removal of certain
hazardous substances released on its property. These laws often impose liability without regard to whether the
owner or operator knew of, or was responsible for, the release of such hazardous substances.
The presence of hazardous substances may adversely affect an owner’s ability to sell real estate or
borrow using real estate as collateral. To the extent that an owner of a property underlying one of our debt
investments becomes liable for removal costs, the ability of the owner to make payments to us may be reduced,
which in turn may adversely affect the value of the relevant mortgage asset held by us and our ability to make
distributions to our stockholders. If we acquire any properties, the presence of hazardous substances on a property
may adversely affect our ability to sell the property and we may incur substantial remediation costs, thus harming
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our financial condition. The discovery of material environmental liabilities attached to such properties could have
a material adverse effect on our results of operations and financial condition and our ability to make distributions
to our stockholders.
Our reserves for loan losses may prove inadequate, which could have a material adverse effect on our
financial results.
We maintain financial reserves to protect against potential losses and conduct a review of the adequacy
of these reserves on a quarterly basis. Our reserves reflect management’s current judgment of the probability and
severity of losses within our overall portfolio, based on this quarterly review. However, estimation of ultimate
loan losses, projected expenses and loss reserves is a complex process and there can be no assurance that
management’s judgment will prove to be correct and that reserves will be adequate over time to protect against
future losses. Such losses could be caused by factors including, but not limited to, unanticipated adverse changes
in the economy or events adversely affecting specific assets, co-venturers, borrowers, industries in which our
borrowers operate or markets in which our borrowers or their properties are located. If our reserves for credit
losses prove inadequate we may suffer additional losses which would have a material adverse effect on our
financial performance and results of operations.
We may suffer losses when a borrower defaults on a loan and the underlying collateral value is less than the
amount due.
If a borrower defaults on a non-recourse loan, we will only have recourse to the real estate-related assets
collateralizing the loan. If the underlying collateral value is less than the loan amount, we will suffer a loss.
Conversely, some of our loans may be unsecured or are secured only by equity interests in the borrowing entities.
These loans are subject to the risk that other lenders in the capital stack may be directly secured by the real estate
assets of the borrower or may otherwise have a superior right to repayment. Upon a default, those collateralized
lenders would have priority over us with respect to the proceeds of a sale of the underlying real estate. In cases
described above, we may lack control over the underlying asset collateralizing our loan or the underlying assets of
the borrower before a default, and, as a result, the value of the collateral may be reduced by acts or omissions by
owners or managers of the assets. In addition, the value of the underlying real estate may be adversely affected by
some or all of the risks referenced above with respect to our owned real estate.
Some of our loans may be backed by individual or corporate guarantees from borrowers or their affiliates
which are not secured. If the guarantees are not fully or partially secured, we typically rely on financial covenants
from borrowers and guarantors which are designed to require the borrower or guarantor to maintain certain levels
of creditworthiness. Where we do not have recourse to specific collateral pledged to satisfy such guarantees or
recourse loans, we will only have recourse as an unsecured creditor to the general assets of the borrower or
guarantor, some or all of which may be pledged as collateral for other lenders. There can be no assurance that a
borrower or guarantor will comply with its financial covenants, or that sufficient assets will be available to pay
amounts owed to us under our loans and guarantees. As a result of these factors, we may suffer additional losses
which could have a material adverse effect on our financial performance.
Upon a borrower bankruptcy, we may not have full recourse to the assets of the borrower to satisfy our
loan. In addition, certain of our loans are subordinate to other debt of certain borrowers. If a borrower defaults on
our loan or on debt senior to our loan, or upon a borrower bankruptcy, our loan will be satisfied only after the
senior debt receives payment. Where debt senior to our loan exists, the presence of intercreditor arrangements
may limit our ability to amend our loan documents, assign our loans, accept prepayments, exercise our remedies
(through “standstill” periods) and control decisions made in bankruptcy proceedings. Bankruptcy and borrower
litigation can significantly increase collection costs and the time needed for us to acquire title to the underlying
collateral (if applicable), during which time the collateral and/or a borrower’s financial condition may decline in
value, causing us to suffer additional losses.
If the value of collateral underlying a loan declines or interest rates increase during the term of a loan, a
borrower may not be able to obtain the necessary funds to repay our loan at maturity through refinancing because
the underlying property revenue cannot satisfy the debt service coverage requirements necessary to obtain new
financing. If a borrower is unable to repay our loan at maturity, we could suffer additional loss which may
adversely impact our financial performance.
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We are subject to additional risks associated with loan participations.
Some of our loans may be participation interests or co-lender arrangements in which we share the rights,
obligations and benefits of the loan with other lenders. We may need the consent of these parties to exercise our
rights under such loans, including rights with respect to amendment of loan documentation, enforcement
proceedings upon a default and the institution of, and control over, foreclosure proceedings. Similarly, certain
participants may be able to take actions to which we object but to which we will be bound if our participation
interest represents a minority interest. We may be adversely affected by this lack of control.
Lease expirations, lease defaults and lease terminations may adversely affect our revenue.
Lease expirations and lease terminations may result in reduced revenues if the lease payments received
from replacement tenants are less than the lease payments received from the expiring or terminating tenants. In
addition, lease defaults or lease terminations by one or more significant tenants or the failure of tenants under
expiring leases to elect to renew their leases, could cause us to experience long periods of vacancy with no
revenue from a facility and to incur substantial capital expenditures and/or lease concessions to obtain
replacement tenants.
We operate in a highly competitive market for asset acquisition opportunities and more established
competitors may be able to compete more effectively for asset acquisition opportunities than we can.
A number of entities compete with us to purchase the types of CMBS and commercial real estate assets
that we expect to acquire. We compete with other REITs, public and private funds, commercial and investment
banks and commercial finance companies, including some of the third parties with which we expect to have
relationships. Many of our competitors are substantially larger and have considerably greater financial, technical
and marketing resources than we do. Several other REITs have recently raised, or may raise, significant amounts
of capital, and may have objectives that overlap with ours, which may create competition for asset acquisition
opportunities. Some competitors may have a lower cost of funds and access to funding sources that are not
available to us. In addition, some of our competitors may have higher risk tolerances or different risk assessments,
which could allow them to consider a wider variety of asset acquisitions and establish more relationships than us.
We cannot assure you that the competitive pressures we face will not have a material adverse effect on our
business, financial condition and results of operations. Also, as a result of this competition, we may not be able to
take advantage of attractive asset acquisition opportunities from time to time, and we can offer no assurance that
we will be able to identify and purchase assets that are consistent with our objectives.
The increasing number of proposed federal, state and local laws may increase our risk of liability with
respect to certain mortgage loans and could increase our cost of doing business.
The United States Congress and various state and local legislatures are considering legislation, which,
among other provisions, would permit limited assignee liability for certain violations in the mortgage loan
origination process and “credit risk” retention by originators or securitizers of mortgage loans. We cannot predict
whether or in what form Congress or the various state and local legislatures may enact legislation affecting our
business. We are evaluating the potential impact of these initiatives, if enacted, on our practices and results of
operations. As a result of these and other initiatives, we are unable to predict whether federal, state or local
authorities will require changes in our practices in the future. These changes, if required, could adversely affect
our profitability, particularly if we make such changes in response to new or amended laws, regulations or
ordinances in any state where we acquire a significant portion of our mortgage loans, or if such changes result in
us being held responsible for any violations in the mortgage loan origination process.
Accounting rules for certain of our transactions are highly complex and involve significant judgment and
assumptions, and changes in accounting treatment may adversely affect our profitability and impact our
financial results.
Accounting rules for mortgage loan sales and securitizations, valuations of financial instruments,
investment consolidations and other aspects of our anticipated operations are highly complex and involve
significant judgment and assumptions. These complexities could lead to a delay in preparation of financial
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information and the delivery of this information to our shareholders. Changes in accounting interpretations or
assumptions could impact our financial statements and our ability to timely prepare our financial statements in a
timely fashion. Our inability to timely prepare our financial statements in a timely fashion in the future would
likely adversely affect our share price significantly.
The fair value at which our assets may be recorded may not be an indication of their realizable value.
Ultimate realization of the value of an asset depends to a great extent on economic and other conditions. Further,
fair value is only an estimate based on good faith judgment of the price at which an investment can be sold since
market prices of investments can only be determined by negotiation between a willing buyer and seller. If we
were to liquidate a particular asset, the realized value may be more than or less than the amount at which such
asset is valued. Accordingly, the value of our common shares could be adversely affected by our determinations
regarding the fair value of our investments, whether in the applicable period or in the future. Additionally, such
valuations may fluctuate over short periods of time.
If we utilize non-recourse long-term securitizations, such structures may expose us to risks which could
result in losses to us.
We may utilize non-recourse long-term securitizations of our assets in mortgage loans, especially loan
originations, when they are available. Prior to any such financing, we may seek to finance assets with relatively
short-term facilities until a sufficient portfolio is accumulated. As a result, we would be subject to the risk that we
would not be able to acquire, during the period that any short-term facilities are available, sufficient eligible assets
to maximize the efficiency of a securitization. We also would bear the risk that we would not be able to obtain
new short-term facilities or would not be able to renew any short-term facilities after they expire should we need
more time to seek and acquire sufficient eligible assets for a securitization. In addition, conditions in the capital
markets, including the recent unprecedented volatility and disruption in the capital and credit markets, may not
permit a non-recourse securitization at any particular time or may make the issuance of any such securitization
less attractive to us even when we do have sufficient eligible assets. While we would intend to retain the unrated
equity component of securitizations and, therefore, still have exposure to any assets included in such
securitizations, our inability to enter into such securitizations would increase our overall exposure to risks
associated with direct ownership of such assets, including the risk of default. Our inability to refinance any short-
term facilities would also increase our risk because borrowings thereunder would likely be recourse to us as an
entity. If we are unable to obtain and renew short-term facilities or to consummate securitizations to finance our
assets on a long-term basis, we may be required to seek other forms of potentially less attractive financing or to
liquidate assets at an inopportune time or price.
Any warehouse facilities that we may obtain in the future may limit our ability to acquire assets, and we
may incur losses if the collateral is liquidated.
If securitization financings become available, we may utilize, if available, warehouse facilities pursuant
to which we would accumulate commercial mortgage loans in anticipation of a securitization financing, which
assets would be pledged as collateral for such facilities until the securitization transaction is consummated. To
borrow funds to acquire assets under any future warehouse facilities, we expect that our lenders thereunder would
have the right to review the potential assets for which we are seeking financing. We may be unable to obtain the
consent of a lender to acquire assets that we believe would be beneficial to us and we may be unable to obtain
alternate financing for such assets. In addition, no assurance can be given that a securitization structure would be
consummated with respect to the assets being warehoused. If the securitization is not consummated, the lender
could liquidate the warehoused collateral, and we would then have to pay any amount by which the original
purchase price of the collateral assets exceeds its sale price, subject to negotiated caps, if any, on our exposure. In
addition, regardless of whether the securitization is consummated, if any of the warehoused collateral is sold
before the consummation, we would have to bear any resulting loss on the sale.
Securitizations would expose us to additional risks.
In a securitization structure, we would convey a pool of assets to a special purpose vehicle, the issuing
entity, and the issuing entity would issue one or more classes of non-recourse notes pursuant to the terms of an
indenture. The notes would be secured by the pool of assets. In exchange for the transfer of assets to the issuing
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entity, we would receive the cash proceeds of the sale of non-recourse notes and a 100% interest in the equity of
the issuing entity. The securitization of our portfolio might magnify our exposure to losses because any equity
interest we retain in the issuing entity would be subordinate to the notes issued to investors and we would,
therefore, absorb all of the losses sustained with respect to a securitized pool of assets before the owners of the
notes experience any losses. Moreover, we cannot be assured that we will be able to access the securitization
market or be able to do so at favorable rates. The inability to securitize our portfolio could hurt our performance
and our ability to grow our business.
Lenders may require us to enter into restrictive covenants relating to our operations that may inhibit our
ability to grow our business and increase revenues.
If or when we obtain debt financing, lenders (especially in the case of bank credit facilities) may impose
restrictions on us that would affect our ability to incur additional debt, make certain allocations or acquisitions,
reduce liquidity below certain levels, make distributions to our shareholders, redeem debt or equity securities and
impact our flexibility to determine our operating policies and strategies. For example, our loan documents may
contain negative covenants that limit, among other things, our ability to repurchase our common shares, distribute
more than a certain amount of our net income or funds from operations to our shareholders, employ leverage
beyond certain amounts, sell assets, engage in mergers or consolidations, grant liens, and enter into transactions
with affiliates. If we fail to meet or satisfy any of these covenants, we would be in default under these agreements,
and our lenders could elect to declare outstanding amounts due and payable, terminate their commitments, require
the posting of additional collateral and enforce their interests against existing collateral. We may also be subject to
cross-default and acceleration rights and, with respect to collateralized debt, the posting of additional collateral
and foreclosure rights upon default. Furthermore, this could also make it difficult for us to satisfy the qualification
requirements necessary to maintain our status as a REIT for U.S. federal income tax purposes. A default and
resulting repayment acceleration could significantly reduce our liquidity, which could require us to sell our assets
to repay amounts due and outstanding. This could also significantly harm our business, financial condition, results
of operations and ability to make distributions, which could cause the value of our capital stock to decline. A
default could also significantly limit our financing alternatives such that we would be unable to pursue our
leverage strategy, which could adversely affect our returns.
Our assets may become non-performing and sub-performing assets in the future, which are subject to
increased risks relative to performing loans.
Our assets may in the near or the long term become non-performing and sub-performing assets, which
are subject to increased risks relative to performing assets. Loans may become non-performing or sub-performing
for a variety of reasons, such as the underlying property being too highly leveraged, decreasing income generated
from the underlying property, or the financial distress of the borrower, in each case, that results in the borrower
being unable to meet its debt service and/or repayment obligations. Such non-performing or sub-performing assets
may require a substantial amount of workout negotiations and/or restructuring, which may involve substantial cost
and divert the attention of our management from other activities and entail, among other things, a substantial
reduction in interest rate, the capitalization of interest payments and a substantial write-down of the principal of
the loan. Even if a restructuring were successfully accomplished, the borrower may not be able or willing to
maintain the restructured payments or refinance the restructured mortgage upon maturity.
From time to time we find it necessary or desirable to foreclose on some, if not many, of the loans we
acquire, and the foreclosure process may be lengthy and expensive. Borrowers may resist foreclosure actions by
asserting numerous claims, counterclaims and defenses to payment against us (such as lender liability claims and
defenses) even when such assertions may have no basis in fact or law, in an effort to prolong the foreclosure
action and force the lender into a modification of the loan or a favorable buy-out of the borrower’s position. In
some states, foreclosure actions can take several years or more to litigate. At any time prior to or during the
foreclosure proceedings, the borrower may file for bankruptcy, which would have the effect of staying the
foreclosure actions and further delaying the resolution of our claims. Foreclosure may create a negative public
perception of the related property, resulting in a diminution of its value. Even if we are successful in foreclosing
on a loan, the liquidation proceeds upon sale of the underlying real estate may not be sufficient to recover our cost
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basis in the loan, resulting in a loss to us. Furthermore, any costs or delays involved in the foreclosure of a loan or
a liquidation of the underlying property will further reduce the proceeds and thus increase our loss. Any such
reductions could materially and adversely affect the value of the commercial loans in which we invest.
Whether or not we have participated in the negotiation of the terms of a mortgage, there can be no
assurance as to the adequacy of the protection of the terms of the loan, including the validity or enforceability of
the loan and the maintenance of the anticipated priority and perfection of the applicable security interests.
Furthermore, claims may be asserted that might interfere with enforcement of our rights. In the event of a
foreclosure, we may assume direct ownership of the underlying real estate. The liquidation proceeds upon sale of
that real estate may not be sufficient to recover our cost basis in the loan, resulting in a loss to us. Any costs or
delays involved in the effectuation of a foreclosure of the loan or a liquidation of the underlying property will
further reduce the proceeds and increase our loss.
Whole loan mortgages are also subject to “special hazard” risk (property damage caused by hazards, such
as earthquakes or environmental hazards, not covered by standard property insurance policies), and to bankruptcy
risk (reduction in a borrower’s mortgage debt by a bankruptcy court). In addition, claims may be assessed against
us on account of our position as mortgage holder or property owner, including responsibility for tax payments,
environmental hazards and other liabilities, which could have a material adverse effect on our results of
operations, financial condition and our ability to make distributions to our stockholders.
When we foreclose on an asset, we may come to own and operate the property securing the loan, which
would expose us to the risks inherent in that activity.
When we foreclose on an asset, we may take title to the property securing that asset, and if we do not or
cannot sell the property, we would then come to own and operate it as “real estate owned.” Owning and operating
real property involves risks that are different (and in many ways more significant) than the risks faced in owning
an asset secured by that property. In addition, we may end up owning a property that we would not otherwise have
decided to acquire directly at the price of our original investment or at all. Further, some of the property
underlying the assets we are acquiring is of a different type or class than property we have had experience owning
directly, including properties such as hotels. Accordingly, we may not manage these properties as well as they
might be managed by another owner, and our returns to investors could suffer. If we foreclose on and come to
own property, our financial performance and returns to investors could suffer.
Risks of Ownership of Our Common Stock
We may change our policies without stockholder approval.
Our board of directors and management determine all of our policies, including our investment, financing
and distribution policies. They may amend or revise these policies at any time without a vote of our stockholders.
Policy changes could adversely affect our financial condition, results of operations, the market price of our
common stock or our ability to pay dividends or distributions.
Our governing documents and Maryland law impose limitations on the acquisition of our common stock
and changes in control that could make it more difficult for a third party to acquire us.
Maryland Business Combination Act
The Maryland General Corporation Law establishes special requirements for “business combinations”
between a Maryland corporation and “interested stockholders” unless exemptions are applicable. An interested
stockholder is any person who beneficially owns 10% or more of the voting power of our then-outstanding voting
stock. Among other things, the law prohibits for a period of five years a merger and other similar transactions
between us and an interested stockholder unless the board of directors approved the transaction prior to the party’s
becoming an interested stockholder. The five-year period runs from the most recent date on which the interested
stockholder became an interested stockholder. The law also requires a super majority stockholder vote for such
transactions after the end of the five-year period. This means that the transaction must be approved by at least:
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80% of the votes entitled to be cast by holders of outstanding voting shares; and
two-thirds of the votes entitled to be cast by holders of outstanding voting shares other than
shares held by the interested stockholder or an affiliate of the interested stockholder with whom
the business combination is to be effected.
As permitted by the Maryland General Corporation Law, we have elected not to be governed by the
Maryland business combination statute. We made this election by opting out of this statute in our articles of
incorporation. If, however, we amend our articles of incorporation to opt back in to the statute, the business
combination statute could have the effect of discouraging offers to acquire us and of increasing the difficulty of
consummating any such offers, even if our acquisition would be in our stockholders’ best interests.
Maryland Control Share Acquisition Act
Maryland law provides that “control shares” of a Maryland corporation acquired in a “control share
acquisition” have no voting rights except to the extent approved by a vote of the stockholders. Two-thirds of the
shares eligible to vote must vote in favor of granting the “control shares” voting rights. “Control shares” are
shares of stock that, taken together with all other shares of stock the acquirer previously acquired, would entitle
the acquirer to exercise voting power in electing directors within one of the following ranges of voting power:
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one-tenth or more but less than one third of all voting power;
one-third or more but less than a majority of all voting power; or
a majority or more of all voting power.
Control shares do not include shares of stock the acquiring person is entitled to vote as a result of having
previously obtained stockholder approval. A “control share acquisition” means the acquisition of control shares,
subject to certain exceptions.
If a person who has made (or proposes to make) a control share acquisition satisfies certain conditions
(including agreeing to pay expenses), he may compel our board of directors to call a special meeting of
stockholders to consider the voting rights of the shares. If such a person makes no request for a meeting, we have
the option to present the question at any stockholders’ meeting.
If voting rights are not approved at a meeting of stockholders then, subject to certain conditions and
limitations, we may redeem any or all of the control shares (except those for which voting rights have previously
been approved) for fair value. We will determine the fair value of the shares, without regard to voting rights, as of
the date of either:
•
•
the last control share acquisition; or
the meeting where stockholders considered and did not approve voting rights of the control
shares.
If voting rights for control shares are approved at a stockholders’ meeting and the acquirer becomes
entitled to vote a majority of the shares of stock entitled to vote, all other stockholders may obtain rights as
objecting stockholders and, thereunder, exercise appraisal rights. This means that you would be able to force us to
redeem your stock for fair value. Under Maryland law, the fair value may not be less than the highest price per
share paid in the control share acquisition. Furthermore, certain limitations otherwise applicable to the exercise of
dissenters’ rights would not apply in the context of a control share acquisition. The control share acquisition
statute would not apply to shares acquired in a merger, consolidation or share exchange if we were a party to the
transaction. The control share acquisition statute could have the effect of discouraging offers to acquire us and of
increasing the difficulty of consummating any such offers, even if our acquisition would be in our stockholders’
best interests.
48
The market price and trading volume of our shares of common stock may be volatile and issuances of large
amounts of shares of our common stock could cause the market price of our common stock to decline.
If we issue a significant number of shares of common stock or securities convertible into common stock
in a short period of time, there could be a dilution of the existing common stock and a decrease in the market price
of the common stock.
The market price of our shares of common stock may be highly volatile and could be subject to wide
fluctuations. In addition, the trading volume in our shares of common stock may fluctuate and cause significant
price variations to occur. We cannot assure you that the market price of our shares of common stock will not
fluctuate or decline significantly in the future. Some of the factors that could negatively affect our share price or
result in fluctuations in the price or trading volume of our shares of common stock include those set forth under
“Special Note Regarding Forward-Looking Statements” as well as:
•
•
•
•
•
•
•
•
•
•
•
•
•
•
actual or anticipated variations in our quarterly operating results or business prospects;
changes in our earnings estimates or publication of research reports about us or the real estate
industry;
an inability to meet or exceed securities analysts' estimates or expectations;
increases in market interest rates;
hedging or arbitrage trading activity in our shares of common stock;
capital commitments;
changes in market valuations of similar companies;
adverse market reaction to any increased indebtedness we incur in the future;
additions or departures of management personnel;
actions by institutional shareholders;
speculation in the press or investment community;
changes in our distribution policy;
general market and economic conditions; and
future sales of our shares of common stock or securities convertible into, or exchangeable or
exercisable for, our shares of common stock.
Holders of our shares of common stock will be subject to the risk of volatile market prices and wide
fluctuations in the market price of our shares of common stock. These factors may cause the market price of our
shares of common stock to decline, regardless of our financial condition, results of operations, business or
prospects. It is impossible to assure you that the market prices of our shares of common stock will not fall in the
future.
There may be future sales or other dilution of our equity, which may adversely affect the market price of
our common stock.
Under our charter, we have 2,000,000,000 authorized shares of capital stock, par value of $0.01 per
share, consisting of 1,956,937,500 shares classified as Common Stock, 7,412,500 shares classified as 7.875%
49
Series A Cumulative Redeemable Preferred Stock, 4,600,000 shares classified as 6.00% Series B Cumulative
Convertible Preferred Stock, 12,650,000 shares classified as 7.625% Series C Cumulative Redeemable Preferred
Stock and 18,400,000 shares classified as 7.50% Series D Cumulative Redeemable Preferred Stock.
Sales of a substantial number of shares of our common stock or other equity-related securities in the
public market, or any hedging or arbitrage trading activity that may develop involving our common stock, could
depress the market price of our common stock and impair our ability to raise capital through the sale of additional
equity securities. We cannot predict the effect that future sales of our common stock or other equity-related
securities would have on the market price of our common stock.
The repurchase right in our Convertible Senior Notes triggered by a fundamental change could discourage
a potential acquiror.
If we undergo certain fundamental changes, such as the acquisition of 50% of the voting power of all
shares of our common equity entitled to vote generally in the election of directors, holders of our Convertible
Senior Notes may require us to repurchase all or a portion of their notes at a price equal to 100% of the principal
amount of the notes to be purchased plus any accrued and unpaid interest up to, but excluding, the repurchase
date. We will pay for all notes so repurchased with shares of our common stock using a price per share equal to
the average daily volume-weighted average price of our common stock for the 20 consecutive trading days ending
on the trading day immediately prior to the occurrence of the fundamental change. The issuance of these shares of
common stock upon certain fundamental changes could discourage a potential acquiror.
Broad market fluctuations could negatively impact the market price of our shares of common stock.
The stock market has experienced extreme price and volume fluctuations that have affected the market
price of many companies in industries similar or related to ours and that have been unrelated to these companies’
operating performance. These broad market fluctuations could reduce the market price of our shares of common
stock. Furthermore, our operating results and prospects may be below the expectations of public market analysts
and investors or may be lower than those of companies with comparable market capitalizations, which could lead
to a material decline in the market price of our shares of common stock.
Regulatory Risks
Loss of Investment Company Act exemption would adversely affect us.
We intend to conduct our business so as not to become regulated as an investment company under the
Investment Company Act of 1940, as amended (the “Investment Company Act”). If we fail to qualify for this
exemption, our ability to use leverage would be substantially reduced, and we would be unable to conduct our
business as we currently conduct it.
We currently rely on the exemption from registration provided by Section 3(c)(5)(C) of the Investment
Company Act. Section 3(c)(5)(C) as interpreted by the staff of the SEC, requires us to invest at least 55% of our
assets in “mortgages and other liens on and interest in real estate” (or Qualifying Real Estate Assets) and at least
80% of our assets in Qualifying Real Estate Assets plus real estate related assets. The assets that we acquire,
therefore, are limited by the provisions of the Investment Company Act and the rules and regulations promulgated
under the Investment Company Act.
We rely on an interpretation that “whole pool certificates” that are issued or guaranteed by Fannie Mae,
Freddie Mac or Ginnie Mae (or Agency Whole Pool Certificates) are Qualifying Real Estate Assets under Section
3(c)(5)(C). This interpretation was promulgated by the SEC staff in a no-action letter over 30 years ago, was
reaffirmed by the SEC in 1992 and has been commonly relied on by mortgage REITs.
On August 31, 2011, the SEC issued a concept release titled “Companies Engaged in the Business of
Acquiring Mortgages and Mortgage-Related Instruments” (SEC Release No. IC-29778). Under the concept
release, the SEC is reviewing interpretive issues related to the Section 3(c)(5)(C) exemption. Among other things,
the SEC requested comments on whether it should revisit whether Agency Whole Pool Certificates may be treated
50
as interests in real estate (and presumably Qualifying Real Estate Assets) and whether companies, such as us,
whose primary business consists of investing in Agency Whole Pool Certificates are the type of entities that
Congress intended to be encompassed by the exclusion provided by Section 3(c)(5)(C). The potential outcomes
of the SEC’s actions are unclear as is the SEC’s timetable for its review and actions.
If the SEC determines that any of these securities are not Qualifying Real Estate Assets or real estate
related assets, adopts a contrary interpretation with respect to Agency Whole Pool Certificates or otherwise
believes we do not satisfy the exemption under Section 3(c)(5)(C), we could be required to restructure our
activities or sell certain of our assets. The net effect of these factors will be to lower our net interest income. If we
fail to qualify for exemption from registration as an investment company, our ability to use leverage would be
substantially reduced, and we would not be able to conduct our business as described. Our business will be
materially and adversely affected if we fail to qualify for this exemption.
Compliance with proposed and recently enacted changes in securities laws and regulations increases our
costs.
The Dodd-Frank Act contains many regulatory changes and calls for future rulemaking that may affect
our business, including, but not limited to resolutions involving derivatives, risk-retention in securitizations and
short-term financings. We are evaluating, and will continue to evaluate the potential impact of regulatory change
under the Dodd-Frank Act.
We are highly dependent on information systems and third parties, and systems failures could significantly
disrupt our business, which may, in turn, negatively affect the market price of our common stock and our
ability to pay dividends to our stockholders.
Our business is highly dependent on communications and information systems. Any failure or
interruption of our systems or cyber-attacks or security breaches of our networks or systems could cause delays or
other problems in our securities trading activities, including mortgage-backed securities trading activities, which
could have a material adverse effect on our operating results and negatively affect the market price of our
common stock and our ability to pay dividends to our stockholders. In addition, we also face the risk of
operational failure, termination or capacity constraints of any of the third parties with which we do business or
that facilitate our business activities, including clearing agents or other financial intermediaries we use to facilitate
our securities transactions.
Computer malware, viruses, and computer hacking and phishing attacks have become more prevalent in
our industry and may occur on our systems in the future. We rely heavily on our financial, accounting and other
data processing systems. It is difficult to determine what, if any, negative impact may directly result from any
specific interruption or cyber-attacks or security breaches of our networks or systems or any failure to maintain
performance, reliability and security of our technical infrastructure. As a result, any such computer malware,
viruses, and computer hacking and phishing attacks may negatively affect our operations.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
PROPERTIES
Our executive and administrative office is located at 1211 Avenue of the Americas, Suite 2902 New
York, New York 10036, telephone 212-696-0100. This office is leased under a non-cancelable lease expiring
December 31, 2014.
ITEM 3.
LEGAL PROCEEDINGS
From time to time, we are involved in various claims and legal actions arising in the ordinary course of
business. In the opinion of management, the ultimate disposition of these matters will not have a material effect
on our consolidated financial statements.
51
ITEM 4. MINE SAFETY DISCLOSURE
None.
52
PART II
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
PURCHASES OF EQUITY SECURITIES
Our common stock began trading publicly on October 8, 1997 and is traded on the New York Stock Exchange
under the trading symbol “NLY.” As of February 15, 2013, we had 947,250,377 shares of common stock issued and
outstanding which were held by approximately 646,000 beneficial holders.
The following table sets forth, for the periods indicated, the high, low, and closing sales prices per share of our
common stock as reported on the New York Stock Exchange composite tape and the cash dividends declared per share
of our common stock.
Quarter ended March 31, 2012
Quarter ended June 30, 2012
Quarter ended September 30, 2012
Quarter ended December 31, 2012
Quarter ended March 31, 2011
Quarter ended June 30, 2011
Quarter ended September 30, 2011
Quarter ended December 31, 2011
Quarter ended March 31, 2012
Quarter ended June 30, 2012
Quarter ended September 30, 2012
Quarter ended December 31, 2012
Quarter ended March 31, 2011
Quarter ended June 30, 2011
Quarter ended September 30, 2011
Quarter ended December 31, 2011
Stock Prices
High
Low
$17.20
$15.52
$15.52
$17.19
$17.75 $16.00
$13.72
$16.93
High
Low
$18.16
$18.79
$18.58
$17.12
$17.31
$17.15
$14.05
$14.65
Common Dividends
Declared Per Share
Close
$15.82
$16.78
$16.84
$14.04
Close
$17.45
$18.04
$16.63
$15.96
$0.55
$0.55
$0.50
$0.45
$0.62
$0.65
$0.60
$0.57
We intend to pay quarterly dividends and to distribute to our stockholders all or substantially all of our
taxable income in each year (subject to certain adjustments). This will enable us to qualify for the tax benefits
accorded to a REIT under the Code. We have not established a minimum dividend payment level and our ability to
pay dividends may be adversely affected for the reasons described under the caption “Risk Factors.” All distributions
will be made at the discretion of our board of directors and will depend on our earnings, our financial condition,
maintenance of our REIT status and such other factors as our board of directors may deem relevant from time to time.
No dividends can be paid on our common stock unless we have paid full cumulative dividends on our preferred stock.
From the date of issuance of our preferred stock through December 31, 2012, we have paid full cumulative dividends
on our preferred stock.
53
SHARE PER
RFORMANCE
E GRAPH
Th
he following g
e total return on
cumulative
x or S&P 500 I
stock Index
REITs. The co
mortgage R
ent of dividend
reinvestme
December 31,
indices on
the BBG R
REIT Index.
graph and table
n our common
Index, and the
omparison is fo
ds. The graph a
2007. Upon w
e set forth certa
n stock to the cu
Bloomberg RE
or the period fr
and table assum
written request
ain information
umulative total
EIT Mortgage
om December
me that $100 w
we will provid
n comparing the
l return of the S
Index, or BBG
31, 2007 to De
was invested in
de stockholder
e yearly percen
Standard & Po
G REIT index,
ecember 31, 20
our common s
rs with a list of
n
ntage change in
te 500
oor’s Composit
dex of
an industry ind
mes the
012 and assum
stock and the tw
f the REITs inc
wo other
cluded in
200
175
150
125
100
75
50
25
0
100
100
99
64
65
120
80
77
13
36
139
91
9
88
8
93
87
140
106
95
12/31/07
8
12/31/08
12/31/
/09
12/3
31/10
12
2/31/11
12/31/12
Annaly Ca
apital Manage
ment, Inc.
S&P
P 500 Index
BB
G Reit Index
Annaly Ca
Inc.
apital Manageme
ent,
S&P 500 I
Index
BBG Reit
Index
12/31
1/2007
12/31
1/2008
12/3
1/2009
12/3
31/2010
12/3
31/2011
12/
/31/2012
00
10
00
10
00
10
99
9
64
6
65
6
120
1
80
77
136
91
88
139
93
87
140
106
95
Th
he information
ut neither its ac
reliable, bu
arily indicative
not necessa
share performance.
n in the share p
ccuracy nor its
e of future perf
performance gr
completeness
formance. Acc
aph and table h
can be guarant
cordingly, we d
has been obtain
teed. The histo
do not make or
ned from sourc
orical informat
r endorse any p
ces believed to
tion set forth ab
predictions as t
be
bove is
o future
54
EQUITY COMPENSATION PLAN INFORMATION
On May 27, 2010, at our 2010 Annual Meeting of Stockholders, our stockholders approved the 2010 Equity
Incentive Plan. The 2010 Equity Incentive Plan authorizes the Compensation Committee of the board of directors to
grant options, stock appreciation rights, dividend equivalent rights, or other share-based award, including restricted
shares up to an aggregate of 25,000,000 shares, subject to adjustments as provided in the 2010 Equity Incentive Plan.
On June 26, 2012, we granted to each non-management director of the Company options to purchase 1,250 shares of
our common stock under the 2010 Equity Incentive Plan. The stock options were issued at the current market price on
the date of grant and immediately vested with a contractual term of 5 years. The grant date fair value is calculated
using the Black-Scholes option valuation model. For a description of our 2010 Equity Incentive Plan, see Notes to
Consolidated Financial Statements
We had previously adopted a long term stock incentive plan for executive officers, key employees and
nonemployee directors (the Incentive Plan). The Incentive Plan authorized, the Compensation Committee of the board
of directors to grant awards, including incentive stock options as defined under Section 422 of the Code (ISOs) and
non-qualified stock options. The Incentive Plan authorized the granting of options or other awards for an aggregate of
the greater of 500,000 shares or 9.5% of the outstanding shares of our common stock up to a ceiling of 8,932,921
shares. No further awards will be made under the Incentive Plan, although existing awards will remain effective.
Stock options were issued at the current market price on the date of grant, subject to an immediate or four year vesting
in four equal installments with a contractual term of 5 or 10 years. The grant date fair value is calculated using the
Black-Scholes option valuation model. For a description of our Incentive Plan, see Notes to Consolidated Financial
Statements.
The following table provides information as of December 31, 2012 concerning shares of our common stock
authorized for issuance under the 2010 Incentive Plan and Incentive Plan (the Incentive Plans).
Plan Category
Equity compensation plans approved
by security holders
Equity compensation plans not
approved by security holders
Total
Number of securities to be
issued upon exercise of
outstanding options,
warrants and rights
Weighted-average exercise price
of outstanding options, warrants
and rights
5,618,686
-
5,618,686
$15.74
-
$15.74
SHARE REPURCHASES
Number of securities remaining
available for future issuance
under the Incentive Plans
(excluding previously issued)
24,952,754
-
24,952,754
On October 16, 2012 the Company announced that its Board of Directors has authorized the repurchase of up
to $1.5 billion of its outstanding common shares over a 12 month period. All common shares purchased were part of a
publicly announced plan in open-market transactions.
The following table provides information as of December 31, 2012 concerning the common shares purchased
by the Company pursuant to this authorization.
November 2012
December 2012
Total
Total number of shares
purchased
5,819,596
21,979,523
27,799,119
Average Price Paid Per
Share
$14.44
14.24
$14.28
Maximum Dollar Value of Shares that
May Yet Be Purchased Under the Plan
(dollars in thousands)
$1,415,948
$1,102,950
55
ITEM 6.
SELECTED FINANCIAL DATA
The following selected financial data are derived from our audited financial statements for the years ended
December 31, 2012, 2011, 2010, 2009, and 2008. The selected financial data should be read in conjunction with the
more detailed information contained in the Financial Statements and Notes thereto and “Management’s Discussion and
Analysis of Financial Condition and Results of Operations” included elsewhere in this Form 10-K.
SELECTED FINANCIAL DATA
(dollars in thousands, except for per share data)
Statement of Operations Data
Interest income:
Investments
U.S. Treasury Securities
Securities loaned
Total interest income
Interest expense:
Repurchase agreements
Convertible Senior Notes
U.S. Treasury Securities sold, not yet purchased
Securities borrowed
Total interest expense
2012
$3,232,020
17,222
9,903
3,259,145
577,243
67,221
15,114
7,594
667,172
For the Years Ended December 31,
2011
2010
2009
$3,558,015
14,706
6,897
3,579,618
426,769
35,017
13,081
5,459
480,326
$2,676,307
2,830
3,997
2,683,134
$2,922,499
-
103
2,922,602
397,971
24,228
2,649
3,377
428,225
575,867
-
-
92
575,959
2008
$3,115,428
-
-
3,115,428
1,560,976
-
-
-
1,560,976
Net interest income
2,591,973
3,099,292
2,254,909
2,346,643
1,554,452
Other income (loss):
Investment advisory and other fee income
Net gains (losses) on disposal of investments
Net loss on extinguishment of 4% Convertible Senior Notes
Dividend income from affiliates
Net gains (losses) on trading assets
Loss on other-than-temporarily impaired securities
Net unrealized gain (losses) on Agency interest-only mortgage-
backed securities
Loss on receivable from Prime Broker
Income from underwriting
Subtotal
Realized gains (losses) on interest rate swaps(1)
Realized gains (losses) on termination of interest rate swaps
Unrealized gains (losses) on interest rate swaps
Subtotal
Total other income (loss)
Expenses:
Distribution fees
Compensation expense
Other general and administrative expenses
Total expenses
82,663
432,139
(162,340)
28,336
22,910
-
(59,937)
-
-
343,771
(893,769)
(2,385)
(32,219)
(928,373)
(584,602)
-
190,702
44,857
235,559
79,205
206,846
-
31,516
21,398
-
(106,657)
-
5,618
237,926
(882,395)
-
(1,815,107)
(2,697,502)
(2,459,576)
-
206,251
31,093
237,344
58,073
181,791
-
31,038
(2,351)
-
-
-
2,095
270,646
(735,107)
-
(318,832)
(1,053,939)
(783,293)
360
146,958
24,529
171,847
48,952
99,128
-
17,184
-
-
-
(13,613)
-
151,651
(719,803)
-
349,521
(370,282)
(218,631)
1,756
111,416
18,736
131,908
27,891
10,713
-
2,713
9,695
(31,834)
-
-
-
19,178
(327,936)
-
(768,268)
(1,096,204)
(1,077,026)
1,589
87,412
16,210
105,211
Income (loss) before income taxes and income from equity
method investment in affiliate
1,771,812
402,372
1,299,769
1,996,104
372,215
Income taxes
(35,912)
(59,051)
(35,434)
(34,381)
(25,977)
Income (loss) on equity method investment in affiliate
-
1,140
2,945
(252)
-
Income before noncontrolling interest
1,735,900
344,461
1,267,280
1,961,471
346,238
Noncontrolling interest
Net income (loss)
-
-
-
-
58
1,735,900
344,461
1,267,280
1,961,471
346,180
Dividends on preferred stock
39,530
16,854
18,033
18,501
21,177
Net income (loss) available (related) to common shareholders
$1,696,370
$327,607
$1,249,247
$1,942,970
$325,003
56
Basic net income per average common share
Diluted net income per average common share
$1.74
$1.71
$0.37
$0.37
$2.12
$2.04
$3.55
$3.52
$0.64
$0.64
Other Financial Data
Total assets
6.00% Series B Cumulative Convertible Preferred Stock
Dividends declared per common share
$133,452,295
-
$2.05
$109,630,002
$32,272
$2.44
$83,026,590
$40,032
$2.65
$69,376,190
$63,114
$2.54
$57,597,615
$96,042
$2.08
(1)
Interest expense related to the Company’s interest rate swaps is recorded in realized gains (losses) on interest rate swaps on the Consolidated Statements of Comprehensive
Income
57
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Special Note Regarding Forward-Looking Statements
Certain statements contained in this quarterly report, and certain statements contained in our future filings
with the Securities and Exchange Commission (the SEC or the Commission"), in our press releases or in our other
public or shareholder communications may not be based on historical facts and are "forward-looking statements"
within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. Forward-looking statements, which are based on various assumptions, (some of
which are beyond our control) may be identified by reference to a future period or periods, or by the use of forward-
looking terminology, such as "may," "will," "believe," "expect," "anticipate," "continue," or similar terms or variations
on those terms, or the negative of those terms. Actual results could differ materially from those set forth in forward-
looking statements due to a variety of factors, including, but not limited to, changes in interest rates, changes in the
yield curve, changes in prepayment rates, the availability of mortgage-backed securities and other securities and other
real estate assets for purchase, the availability of financing, and, if available, the terms of any financings, changes in
the market value of our assets, changes in business conditions and the general economy, our ability to integrate the
commercial mortgage business, our ability to consummate any contemplated investment opportunities, changes in
governmental regulations affecting our business, our ability to maintain our classification as a REIT for federal income
tax purposes, our ability to maintain our exemption from registration under the Investment Company Act of 1940, and
risks associated with the business of our subsidiaries, including the investment advisory businesses of our subsidiaries,
including the removal by their clients of assets they manage, their regulatory requirements, and competition in the
investment advisory business, and risks associated with the broker dealer business of our subsidiary. For a discussion
of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking
statements, see our most recent Annual Report on Form 10-K and any subsequent Quarterly Reports on Form 10-Q.
We do not undertake and specifically disclaim any obligation, to publicly release the result of any revisions which may
be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or
circumstances after the date of such statements.
Overview
We own, manage, and finance a portfolio of real estate related investments, including mortgage pass-through
certificates, collateralized mortgage obligations (or CMOs), Agency callable debentures, and other securities
representing interests in or obligations backed by pools of mortgage loans. Our principal business objective is to
generate net income for distribution to our stockholders from the spread between the interest income on our
Investment Securities and the costs of borrowing to finance our acquisition of Investment Securities and from
dividends we receive from our subsidiaries. Our wholly-owned subsidiaries offer diversified real estate, asset
management and other financial services. To date over 90% of our total assets have consisted of Agency mortgage-
backed securities. While we remain committed to the Agency market, given the current environment, we believe it is
prudent to diversify a portion of our investment portfolio. Therefore, we may allocate up to 25% of our stockholders’
equity to real estate assets other than Agency mortgage-backed securities.
We are a Maryland corporation that commenced operations on February 18, 1997. We are self-advised and
self-managed. We acquired Fixed Income Discount Advisory Company (or FIDAC) on June 4, 2004 and Merganser
Capital Management, Inc. (or Merganser) on October 31, 2008. FIDAC and Merganser manage a number of
investment vehicles and separate accounts for which they earn fee income. Our subsidiary, RCap Securities, Inc. (or
RCap), operates as a broker-dealer, and was granted membership in the Financial Industry Regulatory Authority (or
FINRA) in January 2009. In 2010, we established Shannon Funding LLC (or Shannon), which provides warehouse
financing to residential mortgage originators in the United States. In 2010, we also established Charlesfort Capital
Management LLC (or Charlesfort), which engages in corporate middle market lending transactions. We also own an
additional subsidiary which owns trading securities.
We have elected and believe that we are organized and have operated in a manner that qualifies us to be taxed
as a real estate investment trust (or REIT) under the Internal Revenue Code of 1986, as amended (or the Code). If we
qualify for taxation as a REIT, we generally will not be subject to federal income tax on our taxable income that is
58
distributed to our stockholders. Therefore, substantially all of our assets, other than FIDAC, Merganser and RCap,
which are our taxable REIT subsidiaries, consist of qualified REIT real estate assets (of the type described in Section
856(c)(5)(B) of the Code). We have financed our purchases of Agency mortgage-backed securities and Agency
debentures with the net proceeds of equity offerings, convertible notes offerings and borrowings under repurchase
agreements whose interest rates adjust based on changes in short-term market interest rates.
Capital Investment Policy
Under our capital investment policy, at least 75% of our total assets must be comprised of high-quality
mortgage-backed securities and short-term investments. High quality securities means securities that (1) are rated
within one of the two highest rating categories by at least one of the nationally recognized rating agencies, (2) are
unrated but are guaranteed by the United States government or an agency of the United States government, or (3) are
unrated but we determine them to be of comparable quality to high-quality rated mortgage-backed securities.
The remainder of our assets, comprising not more than 25% of our total assets, may consist of other qualified
REIT real estate assets which are unrated or rated less than high quality, but which are at least “investment grade”
(rated “BBB” or better by Standard & Poor’s Corporation (or S&P) or the equivalent by another nationally recognized
rating agency) or, if not rated, we determine them to be of comparable credit quality to an investment which is rated
“BBB” or better. In addition, we may directly or indirectly invest part of this remaining 25% of our assets in other
types of securities, including without limitation, unrated debt, equity or derivative securities, to the extent consistent
with our REIT qualification requirements. The derivative securities in which we invest may include securities
representing the right to receive interest only or a disproportionately large amount of interest, as well as inverse
floaters, which may have imbedded leverage as part of their structural characteristics.
We may acquire Agency mortgage-backed securities backed by single-family residential mortgage loans as
well as securities backed by loans on multi-family, commercial or other real estate related properties. To date over
90% of our total assets have consisted of Agency mortgage-backed securities and debentures. While we remain
committed to the Agency market, given the current environment, we believe it is prudent to diversify a portion of our
investment portfolio. Therefore, we may allocate up to 25% of our stockholders’ equity to real estate assets other than
Agency mortgage-backed securities.
The results of our operations are affected by various factors, many of which are beyond our control. Our
results of operations primarily depend on, among other things, our net interest income, the market value of our assets
and the supply of and demand for such assets. Our net interest income, which reflects the amortization of purchase
premiums and accretion of discounts, varies primarily as a result of changes in interest rates, borrowing costs and
prepayment speeds, the behavior of which involves various risks and uncertainties. Prepayment speeds, as reflected by
the Constant Prepayment Rate, or CPR, and interest rates vary according to the type of investment, conditions in
financial markets, competition and other factors, none of which can be predicted with any certainty. In general, as
prepayment speeds on our Agency mortgage-backed securities portfolio increase, related purchase premium
amortization increases, thereby reducing the net yield on such assets. The CPR on our Agency mortgage-backed
securities portfolio averaged 19% and 17% for the years ended December 31, 2012 and 2011, respectively. Since
changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our
ability to effectively manage interest rate risks and prepayment risks while maintaining our status as a REIT. We
continue to explore alternative business strategies, alternative investments and other strategic initiatives to complement
our core business strategy of investing, on a leveraged basis, in high quality Investment Securities. No assurance,
however, can be provided that any such strategic initiative will or will not be implemented in the future.
The table below provides quarterly and annual information regarding our average interest-earning assets,
interest income, yield on average interest-earning assets, average interest-bearing liabilities, economic interest
expense, average cost of interest-bearing liabilities, economic net interest income, and net interest rate spreads for the
periods presented.
59
Average
Interest-
Earning
Assets(1)
Total
Interest
Income
Yield on
Average
Interest-
Earning
Assets
Average
Interest-
Bearing
Liabilities
Economic
Interest
Expense (2)
Average
Cost of
Interest-
Bearing
Liabilities
Economic
Net
Interest
Income(3)
Net
Interest
Rate
Spread
(ratios for the quarters have been annualized, dollars in thousands)
Year Ended December 31, 2012
Year Ended December 31, 2011
Year Ended December 31, 2010
Year Ended December 31, 2009
Year Ended December 31, 2008
$116,356,100 $3,259,145
$3,579,618
$96,675,016
$2,683,134
$66,981,887
$2,922,602
$58,554,200
$3,115,428
$55,962,519
Quarter Ended December 31, 2012
Quarter Ended September 30, 2012
Quarter Ended June 30, 2012
Quarter Ended March 31, 2012
$123,378,860
$119,880,120
$116,458,864
$105,706,554
$756,661
$761,265
$886,324
$854,895
2.80%
3.70%
4.01%
4.99%
5.57%
2.45%
2.54%
3.04%
3.23%
$103,362,717
$84,595,933
$60,242,842
$52,361,607
$50,270,226
$1,560,941
$1,362,721
$1,163,332
$1,295,762
$1,888,912
$110,257,173
$106,973,056
$103,668,465
$92,552,175
$413,646
$406,165
$388,445
$352,685
1.51%
1.61%
1.93%
2.47%
3.76%
1.50%
1.52%
1.50%
1.52%
$1,698,204
$2,216,897
$1,519,802
$1,626,840
$1,226,516
$343,015
$355,100
$497,879
$502,210
1.29%
2.09%
2.08%
2.52%
1.81%
0.95%
1.02%
1.54%
1.71%
(1) Does not reflect unrealized gains/ (losses) or premium/ (discount).
(2) Economic interest expense includes interest expense on interest rate swaps.
(3) Economic net interest income includes interest expense on interest rate swaps
Our net interest rate spread has declined each quarter in 2012. The declining net interest rate spread is
primarily attributable to the continuing low interest rate environment and marginally higher CPR which, as discussed
above, reduces the net yield on our Agency mortgage-backed securities portfolio.
The following table presents the CPR experienced on our Agency mortgage-backed securities portfolio, on an
annualized basis, for the quarterly periods presented.
Quarter Ended
December 31, 2012
September 30, 2012
June 30, 2012
March 31, 2012
GAAP and Non-GAAP Reconciliation
CPR
19%
20%
19%
19%
This Management Discussion and Analysis section contains analysis and discussion of non-GAAP
measurements reflected in the Management’s Discussion and Analysis of Financial Condition and Results of
Operations. The Non-GAAP measurements are non-GAAP total stockholders’ equity, economic interest expense and
economic net interest income .
For the purpose of calculating average interest-earning assets and interest-bearing liabilities, daily balances
are used. For the purposes of computing ratios relating to equity measures throughout this report, equity includes
Series B preferred stock, which has been treated under GAAP as temporary equity. For the purpose of computing net
interest income and ratios relating to cost of funds measures throughout this report, interest expense includes interest
expense on interest rate swaps, which is classified in the Consolidated Statements of Comprehensive Income as
Realized gains (losses) on interest rate swaps. Interest rate swaps are used to hedge the increase in interest expense on
repurchase agreements in a rising rate environment. Presenting the contractual interest payments on interest rate
swaps with the interest expense on interest-bearing liabilities reflects total contractual interest payments. This
presentation depicts the economic value of our investment strategy. Interest expense, including interest expense on
interest rate swaps, is referred to as economic interest expense. Net interest income, including interest expense on
interest rate swaps, is referred to as economic net interest income.
60
The following table compares the GAAP and non-GAAP measurements reflected in the Management’s
Discussion and Analysis of Financial Condition and Results of Operations. The non-GAAP measurements are non-
GAAP total stockholders’ equity, economic interest expense and economic net interest income.
For the Year Ended December 31, 2012
For the Year Ended December 31, 2011
For the Year Ended December 31, 2010
For the Year Ended December 31, 2009
For the Year Ended December 31, 2008
For the Quarter Ended December 31, 2012
For the Quarter Ended September 30, 2012
For the Quarter Ended June 30, 2012
For the Quarter Ended March 31, 2012
GAAP Total
Stockholders’
Equity
$15,924,444
$15,760,642
$9,864,900
$9,554,426
$7,183,272
$15,924,444
$17,090,663
$16,284,586
$15,940,605
Non-GAAP Total
Stockholders’
Equity
GAAP
Interest
Expense
Economic
Interest
Expense
GAAP Net
Interest
Income
Economic
Net interest
Income
(dollars in thousands)
$15,924,444
$15,792,914
$9,904,932
$9,617,540
$7,279,314
$15,924,444
$17,090,663
$16,284,586
$15,940,605
$667,172
$480,326
$428,225
$575,959
$1,560,976
$185,491
$188,893
$166,443
$133,345
$1,560,941
$1,362,721
$1,163,332
$1,295,762
$1,888,912
$413,646
$406,165
$388,445
$352,685
$2,591,973
$3,099,292
$2,254,909
$2,346,643
$1,554,452
$571,170
$579,372
$719,881
$721,550
$1,698,204
$2,216,897
$1,519,802
$1,626,840
$1,226,516
$343,015
$355,100
$497,879
$502,210
We believe that the non-GAAP total stockholders’ equity, economic interest expense and economic net
interest income provides meaningful information to consider, in addition to the respective amounts prepared in
accordance with GAAP. The non-GAAP measures help us to evaluate our financial position and performance without
the effects of certain transactions and GAAP adjustments that are not necessarily indicative of our current investment
portfolio, operations, capitalization, or stockholders’ equity.
Our presentation of the economic value of our investment strategy has important limitations. Other market
participants may calculate total stockholders’ equity, economic interest expense and economic net interest income
differently than we calculate them.
Although we believe that the calculation of the economic value of our investment strategy described above
helps our financial position and performance without the effects of certain transactions, it is of limited usefulness as an
analytical tool. Therefore, the economic value of our investment strategy should not be viewed in isolation and is not
a substitute for total stockholders’ equity, economic interest expense and economic net interest income computed in
accordance with GAAP.
Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with GAAP, which require us to make
estimates and assumptions (see Note 1 to the consolidated financial statements). We believe that of our significant
accounting policies, the following involve a higher degree of judgment and complexity:
Valuation of Financial Instruments
Agency mortgage-backed securities and debentures:
There is an active market for Agency mortgage-backed securities and debentures. Since we primarily invest
in securities that can be measured from actively quoted prices, there is a high degree of observable inputs and less
subjectivity measuring fair value. Internal market values are determined using quoted prices from the TBA market,
the Treasury curve, and the underlying characteristics of the individual securities, which may include coupon, periodic
and life caps, reset dates, and the expected life of the security. All internal market values are compared to external
sources or dealer quotes to determine reasonableness. Additionally, securities used as collateral for repurchase
agreements are priced daily by counterparties to ensure sufficient collateralization, providing additional verification of
our internal pricing.
61
Interest rate swaps:
We use the overnight indexed swap (“OIS”) curve as an input to value substantially all of our interest rate
swaps. We believe using the OIS curve, which reflects the interest rate typically paid on cash collateral, more
accurately reflects the fair value of interest rate swaps. Consistent with market practice, we have individually
negotiated agreements with certain counterparties to exchange collateral (“margining”) based on the level of fair
values of the interest rate swaps. Through this margining process, one party or each party to a derivative contract
provides the other party with information about the fair value of the derivative contract to calculate the amount of
collateral required, providing additional verification of our recorded fair value of the interest rate swaps.
Revenue Recognition
Interest income on Agency mortgage-backed securities and debentures is recognized over the projected life of
the securities using the interest method. The projected life of the securities is determined based on expected
prepayment speeds, past prepayment history of the security, government initiatives that would affect the Agency
mortgage-backed securities market, and market consensus. Gains or losses on investment securities are recorded on
trade date based on the average cost of the security.
Income Taxes
We elected to be taxed as a REIT, under Sections 856 through 860 of the Internal Revenue Code, beginning
with our taxable year ended December 31, 1997. To qualify as a REIT, we must meet certain organizational and
operational requirements, including a requirement to distribute at least 90% of our ordinary taxable income, if any, to
stockholders. As a REIT, we generally will not be subject to U.S. federal income tax on taxable income that we
distribute to our stockholders. If we fail to qualify as a REIT in any taxable year, we will then be subject to U.S.
federal income taxes on our taxable income at regular corporate rates and we will not be permitted to qualify for
treatment as a REIT for U.S. federal income tax purposes for four years following the year during which qualification
is lost unless the Internal Revenue Service grants us relief under certain statutory provisions. Such an event could
materially adversely affect our net income and net cash available for distributions to stockholders. However, we
believe that we will be organized and operate in such a manner as to qualify for treatment as a REIT and we intend to
operate in the foreseeable future in such a manner so that we will qualify as a REIT for U.S. federal income tax
purposes. We may, however, be subject to certain state and local taxes and our Taxable REIT Subsidiaries are subject
to federal, state and local taxes.
Exposure to European financial counterparties
A significant portion of our Agency mortgage-backed securities are financed with repurchase agreements.
We secure our borrowings under these agreements by pledging our Agency mortgage-backed securities as collateral to
the lender. The collateral we pledge exceeds the amount of the borrowings under each agreement, typically with the
extent of over-collateralization being at least 3% of the amount borrowed. If the counterparty to the repurchase
agreement defaults on its obligations and we are not able to recover our pledged assets, we are at risk of losing the
over-collateralized amount. The amount of this exposure is the difference between the amount loaned to us plus
interest due to the counterparty and the fair value of the collateral pledged by us to the lender including accrued
interest receivable on such collateral.
We also use interest rate swaps to manage our interest rate risks. Under these swap agreements, we pledge
Agency mortgage-backed securities as collateral as part of a margin arrangement for interest rate swaps that are in an
unrealized loss position. If a counterparty were to default on its obligation, we would be exposed to a loss to a swap
counterparty to the extent that the amount of our Agency mortgage-backed securities pledged exceeded the unrealized
loss on the associated swaps and we were not able to recover the excess collateral.
Over the past several years, several large European financial institutions have experienced financial difficulty
and have been either rescued by government assistance or by other large European banks or institutions. Some of
these financial institutions or their U.S. subsidiaries have provided us financing under repurchase agreements or we
62
have entered into interest rate swaps with such institutions. We have entered into repurchase agreements and/or
interest rate swaps with 12 financial institution counterparties that are either domiciled in Europe or a U.S.-based
subsidiary of a European domiciled financial institution. The following table summarizes our exposure to such
counterparties at December 31, 2012.
Country
Number of
Counterparties
Repurchase
Agreement
Financing
Interest Rate Swaps
at Fair Value
Exposure(1)
Exposure as a
Percentage of Total
Assets
(dollars in thousands)
France
Germany
Netherlands
Scotland
Switzerland
England
4
1
2
1
2
2
12
$ 4,425,895
2,688,716
4,319,218
1,382,453
5,281,563
12,397,882
$30,495,727
($187,071)
(366,386)
(33,500)
-
(397,094)
(127,469)
($1,111,520)
$ 240,101
217,680
274,867
88,858
426,303
617,024
$1,864,833
0.18%
0.16%
0.21%
0.07%
0.32%
0.46%
1.40%
Total
(1) Represents the amount of cash and/or securities pledged as collateral to each counterparty less the aggregate of repurchase agreement financing and unrealized loss on
swaps for each counterparty.
At December 31, 2012, we did not use credit default swaps or other forms of credit protection to hedge the
exposures summarized in the table above.
If the European credit crisis continues to impact these major European financial institutions, it is possible that
it will also impact the operations of their U.S. subsidiaries. Our financings and operations could be adversely affected
by such events. We monitor our exposure to our repurchase agreement and swap counterparties on a regular basis,
using various methods, including review of recent rating agency actions, financial relief plans, credit spreads or other
developments and by monitoring the amount of cash and securities collateral pledged and the associated loan amount
under repurchase agreements and/or the fair value of swaps with our counterparties. We make reverse margin calls on
our counterparties to recover excess collateral as permitted by the agreements governing our financing arrangements or
interest rate swaps, or may try to take other actions to reduce the amount of our exposure to a counterparty when
necessary.
Results of Operations:
Net Income Summary
For the year ended December 31, 2012 our net income was $1.7 billion or $1.74 per average common share,
as compared to net income of $344.5 million or $0.37 per average common share for the year ended December 31,
2011 and net income of $1.3 billion or $2.12 per average common share for the year ended December 31, 2010. Net
income per average share increased by $1.37 per average common share and the total net income increased $1.4
billion for the year ended December 31, 2012, when compared to the year ended December 31, 2011. We attribute the
majority of the increase in net income for the year ended December 31, 2012 from the year ended December 31, 2011
to the unrealized losses on interest rate swaps of $32.2 million for the year ended December 31, 2012, as compared to
an unrealized loss on interest rate swaps of $1.8 billion for the year ended December 31, 2011.
Net income per average share decreased by $1.75 per average share available to common shareholders and
total net income decreased $922.8 million for the year ended December 31, 2011, when compared to the year ended
December 31, 2010. We attribute the decrease in total net income for the year ended December 31, 2011 from the
year ended December 31, 2010 to the unrealized losses on interest rate swaps of $1.8 billion for the year ended
December 31, 2011, compared to an unrealized loss on interest rate swaps of $318.8 million for the year ended
December 31, 2010.
63
Net Income Summary
(dollars in thousands, except for per share data)
For the Years Ended December 31,
2011
2012
2010
Interest income:
Investments
U.S. Treasury Securities
Securities loaned
Total interest income
Interest expense:
Repurchase agreements
Convertible Senior Notes
U.S. Treasury Securities sold, not yet purchased
Securities borrowed
Total interest expense
$3,232,020
17,222
9,903
3,259,145
577,243
67,221
15,114
7,594
667,172
$3,558,015
14,706
6,897
3,579,618
426,769
35,017
13,081
5,459
480,326
$2,676,307
2,830
3,997
2,683,134
397,971
24,228
2,649
3,377
428,225
Net interest income
2,591,973
3,099,292
2,254,909
Other income (loss):
Investment advisory and other fee income
Net gains (losses) on disposal of investments
Net loss on extinguishment of 4% Convertible Senior Notes
Dividend income from affiliates
Net gains (losses) on trading assets
Net unrealized gain (losses) on Agency interest-only mortgage-backed securities
Income from underwriting
Subtotal
Realized gains (losses) on interest rate swaps(1)
Realized gains (losses) on termination of interest rate swaps
Unrealized gains (losses) on interest rate swaps
Subtotal
Total other income (loss)
Expenses:
Distribution fees
Compensation expense
Other general and administrative expenses
Total expenses
82,663
432,139
(162,340)
28,336
22,910
(59,937)
-
343,771
(893,769)
(2,385)
(32,219)
(928,373)
(584,602)
-
190,702
44,857
235,559
79,205
206,846
-
31,516
21,398
(106,657)
5,618
237,926
(882,395)
-
(1,815,107)
(2,697,502)
(2,459,576)
-
206,251
31,093
237,344
58,073
181,791
-
31,038
(2,351)
-
2,095
270,646
(735,107)
-
(318,832)
(1,053,939)
(783,293)
360
146,958
24,529
171,847
Income (loss) before income taxes and income from equity method investment
in affiliate
Income taxes
1,771,812
402,372
1,299,769
(35,912)
(59,051)
(35,434)
Income (loss) from equity method investment in affiliate
-
1,140
2,945
Net income (loss)
Dividends on preferred stock
1,735,900
344,461
1,267,280
39,530
16,854
18,033
Net income (loss) available (related) to common shareholders
$1,696,370
$327,607
$1,249,247
Net income (loss) per share available (related) to common shareholders:
Basic
Diluted
$1.74
$1.71
$0.37
$0.37
$2.12
$2.04
Weighted average number of common shares outstanding:
Basic
Diluted
Average total assets
972,902,459
874,212,039
588,192,659
1,005,755,057
874,518,938
625,307,174
$126,649,002
$101,054,583
$76,242,938
Average equity
Return on average total assets
Return on average equity
$9,701,233
1.66%
13.06%
Interest expense related to the Company’s interest rate swaps is recorded in realized gains (losses) on interest rate swaps on the Consolidated Statements
of Comprehensive Income
$13,700,771
0.34%
2.51%
$16,206,642
1.37%
10.71%
(1)
64
Interest Income and Average Earning Asset Yield
Our interest income for the years ended December 31, 2012, 2011, and 2010 was $3.3 billion, $3.6 billion
and $2.7 billion, respectively. We had average interest earning assets of $116.4 billion, $96.7 billion and $67.0
billion, and the yield on our average interest earning assets was 2.80%, 3.70%, and 4.01% for the years ended
December 31, 2012, 2011 and 2010, respectively. Even though our average interest earning assets increased for the
year ended December 31, 2012 by $19.7 billion when compared to the year ended December 31, 2011, interest income
decreased by $320.5 million, due to the decline in yield on interest earning assets of 0.90%.
Interest income increased by $896.5 million for the year ended December 31, 2011, as compared to the year
ended December 31, 2010, due to the increase in interest earning assets during the year 2011. Average interest-
earning assets increased by $29.7 billion over the year in 2011 as compared to 2010.
Economic Interest Expense and the Cost of Interest-Bearing Liabilities
Our largest expense is the cost of interest-bearing liabilities and net interest payments on interest rate swaps.
We had average interest-bearing liabilities of $103.4 billion and total economic interest expense of $1.6 billion, which
includes $893.8 million in interest expense on interest rate swaps, for the year ended December 31, 2012. We had
average interest-bearing liabilities of $84.6 billion and total economic interest expense of $1.4 billion, which includes
$882.4 million in interest expense on interest rate swaps, for the year ended December 31, 2011. We had average
interest-bearing liabilities of $60.2 billion and total economic interest expense of $1.2 billion, which includes $735.1
million in interest expense on interest rate swaps, for the year ended December 31, 2010. Our average cost of interest-
bearing liabilities was 1.51%, 1.61%, 1.93%, including interest expense on interest rate swaps, for the years ended
December 31, 2012, 2011, and 2010, respectively. Economic interest expense, including interest expense on interest
rate swaps, for the year ended December 31, 2012 increased by $198.2 million when compared to the year ended
December 31, 2011, due to the increase in interest-bearing liabilities and the increase in notional amount on interest
rate swaps. The cost of interest-bearing liabilities decreased by 10 basis points and the average interest-bearing
liabilities increased by $18.8 billion for the year ended December 31, 2012, when compared to the year ended
December 31, 2011.
Economic interest expense, including interest expense on interest rate swaps, for the year ended December
31, 2011 increased by $199.4 million when compared to the year ended December 31, 2010, due to the increase in
interest-bearing liabilities and the increase in notional amount on interest rate swaps. The cost of interest-bearing
liabilities rate decreased by 32 basis points and the average interest-bearing liabilities increased by $24.4 billion for the
year ended December 31, 2011 when compared to the year ended December 31, 2010.
The table below shows our average interest-bearing liabilities and average cost of interest-bearing liabilities
as compared to average one-month and average six-month LIBOR for the years ended December 31, 2012, 2011,
2010, 2009, and 2008 and the four quarters in 2012.
65
Average Cost of Interest-Bearing Liabilities
(Quarterly ratios have been annualized, dollars in thousands)
Average
Interest-
Bearing
Liabilities
Interest-
Bearing
Liabilities
at Period
End
Average
Cost of
Interest-
Bearing
Liabilities
Average
One-
Month
LIBOR
Average
Six-
Month
LIBOR
Economic
Interest
Expense(1)
Average
Cost of
Interest-
Bearing
Liabilities
Relative to
Average
One-
Month
LIBOR
Average
Cost of
Interest
Bearing
Liabilities
Relative to
Average
Six-Month
LIBOR
Average
One-Month
LIBOR
Relative to
Average
Six-Month
LIBOR
For the Year Ended
December 31, 2012
For the Year Ended
December 31, 2011
For the Year Ended
December 31, 2010
For the Year Ended
December 31, 2009
For the Year Ended
December 31, 2008
For the Quarter Ended
December 31, 2012
For the Quarter Ended
September 30, 2012
For the Quarter Ended
June 30, 2012
For the Quarter Ended
March 31, 2012
$103,362,717
$105,914,990
$1,560,941
1.51%
0.24%
0.69%
(0.45%)
1.27%
$84,595,933
$86,269,611
$1,362,721
1.61%
0.23%
0.51%
(0.28%)
1.38%
$60,242,842
$67,260,840
$1,163,332
1.93%
0.27%
0.52%
(0.25%)
1.66%
$52,361,607
$54,627,186
$1,295,762
2.47%
0.33%
1.11%
(0.78%)
2.14%
$50,270,226
$46,674,885
$1,888,912
3.76%
2.68%
3.06%
(0.38%)
1.08%
0.82%
1.10%
1.41%
1.36%
0.70%
$110,257,173 $105,914,990
$413,646
1.50%
0.21%
0.54%
(0.33%)
1.29%
0.96%
$106,973,056 $104,700,613
$406,165
1.52%
0.24%
0.71%
$103,668,465 $101,004,741
$388,445
1.50%
0.24%
0.73%
$92,552,175
$95,700,039
$352,685
1.52%
0.26%
0.76%
(0.47%)
(0.49%)
(0.50%)
1.28%
1.26%
1.26%
0.81%
0.77%
0.76%
(1) Economic interest expense includes interest expense on interest rate swaps.
We do not manage our portfolio to have a pre-designated amount of borrowings at quarter or year end. Our
borrowings at period end are a snapshot of borrowings as of a date, and this number should be expected to differ from
average borrowings over the period for a number of reasons. The mortgage-backed securities we own pay principal
and interest towards the end of each month and the mortgage-backed securities we purchase are typically settled
during the beginning of the month. As a result, depending on the amount of mortgage-backed securities we have
committed to purchase, we may retain the principal and interest we receive in the prior month, or we may use it to pay
down our borrowings. Moreover, we use interest rate swaps to hedge our portfolio and as we pledge or receive
collateral under these agreements, our borrowings on any given day may be increased or decreased. Our average
borrowings during a quarter will differ from period end borrowings as we implement our portfolio management
strategies and risk management strategies over changing market conditions by increasing or decreasing leverage.
Additionally, these numbers will differ during periods when we conduct capital raises, as in certain instances we may
purchase additional assets and increase leverage with the expectation of a successful capital raise. Since our average
borrowings and period end borrowings can be expected to differ, we believe our average borrowings during a period
provides a more accurate representation of our exposure to the risks associated with leverage.
Economic Net Interest Income
Our economic net interest income, including interest expense on interest rate swaps, totaled $1.7 billion, $2.2
billion and $1.5 billion for the years ended December 31, 2012, 2011 and 2010, respectively. Even though our
average interest-earning assets increased from during the year ended December 31, 2012, as compared to the year
ended December 31, 2011, by $19.7 billion, economic net interest income declined. The decline was due to reduced
economic interest rate spread. Our economic net interest rate spread for the year ended December 31, 2012 was 1.29%
or 0.80% less than the interest rate spread for the year ended December 31, 2011 of 2.09%.
Our economic net interest income increased by $697.1 million for the year ended December 31, 2011, as
compared to the year ended December 31, 2010 because of the increase in average interest-earnings assets, as a result
66
of raising $5.4 billion in additional capital in 2011. Our economic net interest rate spread for the year ended
December 31, 2011 was 2.09%, or 1 basis point more than the interest rate spread for the year ended December 31,
2010 of 2.08%.
The table below shows our economic interest income by average interest earning assets held, total interest
income, yield on average interest earning assets, average balance of repurchase agreements, interest expense, average
cost of funds, net interest income, and net interest rate spread for the years ended December 31, 2012, 2011, 2010,
2009, and 2008 and the four quarters in 2012.
For the Year Ended
December 31, 2012
For the Year Ended
December 31, 2011
For the Year Ended
December 31, 2010
For the Year Ended
December 31, 2009
For the Year Ended
December 31, 2008
For the Quarter Ended
December 31, 2012
For the Quarter Ended
September 30, 2012
For the Quarter Ended
June 30, 2012
For the Quarter Ended
March 31, 2012
Economic Net Interest Income
(Quarterly ratios have been annualized, dollars in thousands)
Average
Interest
Earning
Assets
Total
Interest
Income
Yield on
Average
Interest
Earning
Assets
Average
Interest-
Bearing
Liabilities
Economic
Interest
Expense(1)
Average
Cost of
Interest-
Bearing
Liabilities
Economic
Net
Interest
Income(1)
Net
Interest
Rate
Spread
$116,356,100
$3,259,145
2.80%
$103,362,717
$1,560,941
1.51%
$1,698,204
1.29%
$96,675,016
$3,579,618
3.70%
$84,595,933
$1,362,721
1.61%
$2,216,897
2.09%
$66,981,887
$2,683,134
4.01%
$60,242,842
$1,163,332
1.93%
$1,519,802
2.08%
$58,554,200
$2,922,602
4.99%
$52,361,607
$1,295,762
2.47%
$1,626,840
2.52%
$55,962,519
$3,115,428
5.57%
$50,270,226
$1,888,912
3.76%
$1,226,516
1.81%
$123,378,860
$756,661
2.45%
$110,257,173
$413,646
1.50%
$343,015
0.95%
$119,880,120 $761,265
2.54%
$106,973,056
$406,165
$116,458,864 $886,324
3.04%
$103,668,465
$388,445
(1) Economic interest expense and economic net interest income include interest expense on interest rate swaps.
$105,706,554 $854,895
3.23%
$92,552,175
$352,685
1.52%
1.50%
1.52%
$355,100
1.02%
$497,879
1.54%
$502,210
1.71%
Investment Advisory and Other Fee Income
FIDAC and Merganser are registered investment advisors specializing in managing fixed income securities.
Net investment advisory and fees for the years ended December 31, 2012, 2011, and 2010 totaled $82.7 million, $79.2
million, and $57.7 million, respectively, net of fees paid to third parties pursuant to distribution service agreements for
facilitating and promoting distribution of shares or units to FIDAC’s and Merganser’s clients.
Gains and Losses on Disposal of Investments
For the years ended December 31, 2012, 2011, and 2010, we disposed of investments with a carrying value of
$32.3 billion, $20.1 billion, and $10.6 billion for an aggregate net gain of $439.7 million, $206.8 million, and $181.8
million, respectively. We do not expect to sell assets on a frequent basis, but may from time to time sell existing assets
to acquire new assets, which our management believes might have higher risk-adjusted returns, or to manage our
balance sheet as part of our asset/liability management strategy.
Dividend Income from Available-For-Sale Equity Securities
Dividend income from our investments in Chimera Investment Corporation and CreXus Investment Corp.,
which are managed pursuant to management contracts by our wholly owned subsidiary FIDAC, totaled $28.3 million,
$31.5 million, and $31.0 million for the years ended December 31, 2012, 2011 and 2010, respectively.
67
General and Administrative Expenses
General and administrative (or G&A) expenses were $235.6 million, $237.3 million, and $171.5 million for
the years ended December 31, 2012, 2011 and 2010, respectively. G&A expenses as a percentage of average total
assets were 0.19%, 0.23%, and 0.22% for the years ended December 31, 2012, 2011, and 2010, respectively. The
increase in G&A expenses of $65.8 million for the year December 31, 2011 when compared to the year ended
December 31, 2010 was primarily the result of increased compensation costs related to us and our subsidiaries. Staff
increased from 114 at the end of 2010 to 147 at the end of 2011.
The table below shows our total G&A expenses as compared to average total assets and average equity for the
periods presented.
G&A Expenses and Operating Expense Ratios
(ratios for the quarters have been annualized, dollars in thousands)
For the Year Ended December 31, 2012
For the Year Ended December 31, 2011
For the Year Ended December 31, 2010
For the Year Ended December 31, 2009
For the Year Ended December 31, 2008
For the Quarter Ended December 31, 2012
For the Quarter Ended September 30, 2012
For the Quarter Ended June 30, 2012
For the Quarter Ended March 31, 2012
Total G&A
Expenses
$235,559
$237,344
$171,487
$130,152
$103,622
$40,084
$63,004
$64,556
$67,915
Total G&A
Expenses/Average Assets
0.19%
0.23%
0.22%
0.20%
0.18%
0.12%
0.19%
0.21%
0.24%
Total G&A
Expenses/Average Equity
1.45%
1.73%
1.76%
1.51%
1.55%
0.97%
1.51%
1.60%
1.71%
Net Income and Return on Average Equity
Our net income was $1.7 billion, $344.5 million and $1.3 billion for the years ended December 31, 2012,
2011 and 2010, respectively. Our return on average equity was 10.71%, 2.51% and 13.06% for the respective years.
Net income increased by $1.4 billion for the year ended December 31, 2012, as compared to the year ended December
31, 2011, the majority of the increase was due to the unrealized loss on interest rate swaps of $32.2 million for the year
ended December 31, 2012, as compared to an unrealized loss on interest rate swaps of $1.8 billion for the year ended
December 31, 2011. The reduction in the unrealized loss on interest rate swaps was partially offset by the decline in
economic net interest income of $518.7 million and the net loss on extinguishment of 4% Convertible Senior Notes of
$162.3 million.
We attribute the decrease in total net income for the year ended December 31, 2011 from the year ended
December 31, 2010 primarily due the unrealized loss on interest rate swaps of $1.8 billion, as compared to the
unrealized loss on interest rate swaps of $318.8 million for the year ended December 31, 2010.
68
The table below shows the components of our return on average equity for the periods presented.
Components of Return on Average Equity
(Ratios for the quarters have been annualized)
Economic
Net Interest
Income/
Average
Equity(1)
Net
Investment
Advisory and
Service
Fees/Average
Equity
Realized and
Unrealized
Gains and
Losses/Averag
e Equity
Dividend
Income from
Available-for-
Sale Equity
Securities/
Average Equity
Income
from
Under-
writing/
Average
Equity
Income
from
Equity
Investmen
t Method/
Average
Equity
G&A
Expenses/
Average
Equity
Income
Taxes/
Average
Equity
Return on
Average
Equity
10.48%
0.51%
1.22%
0.17%
-
-
(1.45%)
(0.22%)
10.71%
16.18%
0.58%
(12.36%)
0.23%
0.04%
0.00%
(1.73%)
(0.43%)
2.51%
15.67%
0.59%
(1.44%)
0.32%
0.02%
0.03%
(1.76%)
(0.37%)
13.06%
18.82%
0.55%
5.03%
18.36%
0.39%
(11.67%)
8.31%
8.51%
0.46%
0.50%
8.85%
(1.95%)
12.37%
0.54%
(13.44%)
0.20%
0.04%
0.17%
0.17%
0.16%
0.19%
-
-
-
-
-
-
-
-
-
-
-
-
(1.51%)
(0.40%)
22.69%
(1.55%)
(0.39%)
5.18%
(0.97%)
0.15%
16.97%
(1.51%)
(0.33%)
5.39%
(1.60%)
(0.29%)
(2.26%)
(1.71%)
(0.42%)
22.73%
For the Year Ended
December 31, 2012
For the Year Ended
December 31, 2011
For the Year Ended
December 31, 2010
For the Year Ended
December 31, 2009
For the Year Ended
December 31, 2008
For the Quarter Ended
December 31, 2012
For the Quarter Ended
September 30, 2012
For the Quarter Ended
June 30, 2012
For the Quarter Ended
March 31, 2012
11.49%
12.66%
(1) Economic net interest income includes interest expense on interest rate swaps.
0.52%
Financial Condition
Investment Securities
Substantially all of our Agency mortgage-backed securities at December 31, 2012, 2011, and 2010 were
mortgage-backed securities backed by single-family mortgage loans. Substantially all of the mortgage assets
underlying our Agency mortgage-backed securities were secured with a first lien position on the underlying single-
family properties. Substantially all of our mortgage-backed securities were Freddie Mac, Fannie Mae or Ginnie Mae
pass-through certificates or CMOs, which carry an actual or implied “AAA” rating. We carry all of our Agency
mortgage-backed securities at fair value.
We accrete discount balances as an increase in interest income over the expected life of the related interest
earning assets and we amortize premium balances as a decrease in interest income over the expected life of on the
related interest earning assets. At December 31, 2012, 2011, and 2010 we had on our balance sheet a total of $27.4
million, $27.3 million and $35.6 million, respectively, of unamortized discount (which is the difference between the
remaining principal value and current historical amortized cost of our Investment Securities acquired at a price below
principal value) and a total of $5.9 billion, $3.4 billion and $2.3 billion, respectively, of unamortized premium (which
is the difference between the remaining principal value and the current historical amortized cost of our Investment
Securities acquired at a price above principal value).
We received mortgage principal repayments of $35.1 billion, $23.6 billion and $29.0 billion for the years
ended December 31, 2012, 2011 and 2010, respectively. The average prepayment speed for the year ended December
31, 2012, 2011 and 2010 was 19%, 17%, and 27%, respectively. Given our current portfolio composition, if mortgage
principal prepayment rates were to increase over the life of our mortgage-backed securities, all other factors being
equal, our net interest income would decrease during the life of these mortgage-backed securities as we would be
required to amortize our net premium balance into income over a shorter time period. Similarly, if mortgage principal
prepayment rates were to decrease over the life of our mortgage-backed securities, all other factors being equal, our
net interest income would increase during the life of these mortgage-backed securities as we would amortize our net
premium balance over a longer time period.
69
The table below summarizes certain characteristics of our Agency mortgage-backed securities, Agency
debentures and corporate debt as of the dates presented.
Agency Mortgage-Backed Securities, Agency Debentures and Corporate Debt
(dollars in thousands)
At December 31, 2012
At December 31, 2011
At December 31, 2010
At December 31, 2009
At December 31, 2008
At September 30, 2012
At June 30, 2012
At March 31, 2012
Principal Amount Net Premium
$5,828,840
$3,333,416
$2,307,839
$1,247,717
$555,043
$5,448,108
$4,463,950
$3,815,555
$118,291,085
$98,904,501
$76,129,522
$62,508,927
$54,508,672
$123,176,544
$111,975,194
$105,296,991
Amortized
Cost
$124,119,925
$102,237,917
$78,437,361
$63,756,644
$55,063,715
$128,624,652
$116,439,144
$109,112,546
Amortized
Cost/Principal
Amount
104.93%
103.37%
103.03%
102.00%
101.02%
104.42%
103.99%
103.62%
Carrying
Value
$127,036,719
$105,192,708
$79,570,274
$65,721,477
$55,645,940
$132,598,180
$119,811,793
$111,841,645
Carrying
Value/Principal
Amount
107.39%
106.35%
104.52%
105.14%
102.09%
107.65%
107.00%
106.22%
Weighted
Average
Yield
2.75%
3.22%
3.88%
4.51%
5.15%
2.79%
3.17%
3.21%
The tables below summarize certain characteristics of our Agency mortgage-backed securities, Agency
debentures and corporate debt at December 31, 2012, 2011, 2010, 2009, and 2008 and September 30, 2012, June 30,
2012, and March 31, 2012. The index level for adjustable-rate Agency mortgage-backed securities, Agency
debentures and corporate debt is the weighted average rate of the various short-term interest rate indices, which
determine the coupon rate.
Adjustable-Rate Mortgage-Backed Securities, Agency Debentures and Corporate Debt
Characteristics
(dollars in thousands)
Weighted
Average
Coupon
Rate
3.29%
3.88%
4.28%
4.55%
4.75%
3.28%
3.67%
3.72%
Principal Amount
$8,363,385
$9,268,113
$11,011,839
$16,196,473
$19,540,152
$9,285,709
$8,648,932
$9,104,082
Weighted
Average Term
to Next
Adjustment
Weighted
Average
Lifetime Cap
Weighted
Average
Asset
Yield
Principal Amount at
Period End as % of
Total Interest-
Earning Assets
35 months
41 months
39 months
33 months
36 months
39 months
38 months
38 months
8.21%
9.64%
10.16%
10.09%
10.00%
8.39%
9.42%
8.80%
2.59%
2.79%
3.04%
3.23%
3.93%
2.59%
2.80%
2.78%
7.07%
9.37%
14.46%
25.91%
35.85%
7.54%
7.72%
8.65%
At December 31, 2012
At December 31, 2011
At December 31, 2010
At December 31, 2009
At December 31, 2008
At September 30, 2012
At June 30, 2012
At March 31, 2012
Fixed-Rate Agency Mortgage-Backed Securities, Agency Debentures and Corporate Debt Characteristics
(dollars in thousands)
At December 31, 2012
At December 31, 2011
At December 31, 2010
At December 31, 2009
At December 31, 2008
At September 30, 2012
At June 30, 2012
At March 31, 2012
Principal
Amount
$109,927,700
$89,636,388
$65,117,683
$46,312,455
$34,968,520
$113,890,835
$103,326,262
$96,192,909
Weighted Average
Coupon Rate
4.04%
4.71%
4.92%
5.78%
6.13%
4.17%
4.52%
4.63%
Weighted
Average Asset
Yield
2.76%
3.07%
4.00%
4.95%
5.84%
2.80%
3.20%
3.25%
Principal Amount at Period
End as % of Total Investment
Securities
92.93%
90.63%
85.54%
74.09%
64.15%
92.46%
92.28%
91.35%
At December 31, 2012 and 2011, we held Agency mortgage-backed securities, Agency debentures and
corporate debt with coupons linked to various indices. The following tables detail the portfolio characteristics by
index.
70
Adjustable-Rate Agency Mortgage-Backed Securities, Agency Debentures and Corporate Debt by Index
December 31, 2012
Weighted Average Term to Next Adjustment
Weighted Average Annual Period Cap
Weighted Average Lifetime Cap at December 31, 2012
Investment Principal Value as Percentage of
Investment Securities at December 31, 2012
One-
Month
Libor
Six-
Month
Libor
Twelve
Month
Libor
12-Month
Moving
Average
11th
District
Cost of
Funds
1-Year
Treasury
Index
Other
Indexes(1)
1 mo.
0.82%
6.10%
5 mo.
1.70%
11.15%
42 mo.
2.00%
9.85%
3 mo.
0.00%
9.44%
3 mo.
0.17%
10.71%
23 mo.
1.89%
11.34%
40 mo.
0.00%
4.82%
0.10%
0.30%
3.71%
0.21%
0.20%
0.25%
2.30%
(1) Combination of indices that account for less than 0.05% of total or adjust over time, without a reset index.
Adjustable-Rate Agency Mortgage-Backed Securities, Agency Debentures and Corporate Debt by Index
December 31, 2011
One-
Month
Libor
Six-
Month
Libor
Twelve
Month
Libor
12-
Month
Moving
Average
11th
District
Cost of
Funds
1-Year
Treasury
Index
Other
Indexes(1)
Weighted Average Term to Next Adjustment
Weighted Average Annual Period Cap
Weighted Average Lifetime Cap at December 31, 2011
Investment Principal Value as Percentage of
Investment Securities at December 31, 2011
1 mo.
6.25%
6.84%
7 mo.
1.63%
11.10%
52 mo.
2.00%
9.93%
4 mo.
0.03%
9.46%
4 mo.
0.20%
10.66%
31 mo.
1.88%
10.35%
31 mo.
0.61%
6.87%
0.39%
0.44%
6.55%
0.35%
0.30%
0.57%
0.77%
(1) Combination of indices that account for less than 0.05% of total or adjust over time, without a reset index.
Borrowings
As of December 31, 2012 and 2011, 99% and 97%, respectively, of our debt consisted of borrowings
collateralized by a pledge of our Investment Securities. These borrowings appear on our Consolidated Statement of
Financial Condition as repurchase agreements. All of our Agency mortgage-backed securities and debentures are
currently accepted as collateral for these borrowings. However, we limit our borrowings, and thus our potential asset
growth, in order to maintain unused borrowing capacity and thus increase the liquidity and strength of our balance
sheet. For the year ended December 31, 2012, the term to maturity of our borrowings ranged from one day to 7 years.
Additionally, we have entered into borrowings giving the counterparty the right to call the balance prior to maturity.
At December 31, 2012 and December 31, 2011, the weighted average cost of funds for all of our borrowings was
1.55% and 1.60%, respectively, including the effect of the interest rate swaps, 4% Convertible Senior Notes due 2015
and 5% Convertible Senior Notes due 2015 (collectively, the “Convertible Senior Notes”), and the weighted average
maturity was 197 days and 110 days, respectively.
The Company did not have an amount at risk greater than 10% of the equity of the Company with any
counterparty as of December 31, 2012 or December 31, 2011.
Liquidity
Liquidity, which is our ability to turn non-cash assets into cash, allows us to purchase additional interest
earning assets and to pledge additional assets to secure existing borrowings should the value of our pledged assets
decline. Potential immediate sources of liquidity for us include cash balances and unused borrowing capacity. Our
non-cash assets are largely actual or implied AAA assets, and accordingly, we have not had, nor do we anticipate
having, difficulty in converting our assets to cash. Our balance sheet also generates liquidity on an on-going basis
through mortgage principal repayments and net earnings held prior to payment as dividends. Should our needs ever
exceed these on-going sources of liquidity plus the immediate sources of liquidity discussed above, we believe that in
71
most circumstances our interest earning assets could be sold to raise cash. The maintenance of liquidity is one of the
goals of our capital investment policy. Under this policy, we limit asset growth in order to preserve unused borrowing
capacity for liquidity management purposes.
We anticipate that, upon repayment of each borrowing under a repurchase agreement, we will use the
collateral immediately for borrowing under a new repurchase agreement. We have not at the present time entered into
any commitment agreements under which the lender would be required to enter into new repurchase agreements
during a specified period of time, nor do we presently plan to have liquidity facilities with commercial banks.
Under our repurchase agreements, we may be required to pledge additional assets to our repurchase
agreement counterparties (i.e., lenders) in the event the estimated fair value of the existing pledged collateral under
such agreements declines and such lenders demand additional collateral (a margin call), which may take the form of
additional securities or cash. Similarly, if the estimated fair value of interest earning assets increases due to changes in
market interest rates or market factors, lenders may release collateral back to us. Specifically, margin calls result from
a decline in the value of our Agency mortgage-backed securities securing our repurchase agreements, prepayments on
the mortgages securing such Agency mortgage-backed securities. Changes in the fair value or changes in market
interest rates and other market factors may result in a margin call. Our repurchase agreements generally provide that
the valuations for the Agency mortgage-backed securities securing our repurchase agreements are to be obtained from
a generally recognized source agreed to by the parties. However, in certain circumstances and under certain of our
repurchase agreements our lenders have the sole discretion to determine the value of the Agency mortgage-backed
securities securing our repurchase agreements. In instances where we have agreed to permit our lenders to make a
determination of the value of the Agency mortgage-backed securities securing our repurchase agreements, such
lenders are required to act in good faith in making such valuation determinations and in certain of these instances are
also required to act reasonably in this determination. Our repurchase agreements generally provide that in the event of
a margin call we must provide additional securities or cash on the same business day that a margin call is made, if the
lender provides us notice prior to the margin notice deadline on such day. Through December 31, 2012, we did not
have any margin calls on our repurchase agreements that we were not able to satisfy with either cash or additional
pledged collateral. However, should prepayment speeds on the mortgages underlying our Agency mortgage-backed
securities and/or market interest rates suddenly increase, margin calls on our repurchase agreements could result,
causing an adverse change in our liquidity position.
At December 31, 2012, we had total pledged collateral for repurchase agreements and interest rate swaps of
$109.2 billion. The weighted average haircut was approximately 5% on repurchase agreements. The excess capital
cushion totaled approximately $9.9 billion. The quality and character of the Agency mortgage-backed securities that
we pledge as collateral under the repurchase agreements and interest rate swaps did not materially change in the
quarter and year ended December 31, 2012, compared to quarter and year ended December 31, 2011, and our
counterparties did not materially alter any requirements, including required haircuts, related to the collateral we pledge
under repurchase agreements and interest rate swaps during the quarter and year ended December 31, 2012.
The following table summarizes the effect on our liquidity and cash flows from contractual obligations for
repurchase agreements, interest expense on repurchase agreements and Convertible Senior Notes, the non-cancelable
office lease and employment agreements as of December 31, 2012. The table does not include the effect of net interest
rate payments under our interest rate swap agreements. The net swap payments will fluctuate based on monthly
changes in the receive rate. As of December 31, 2012, the interest rate swaps had a net negative fair value of $2.6
billion.
72
Contractual Obligations
(dollars in thousands)
Within One
Year
One to Three
Years
Three to Five
Years
More than
Five Years
Repurchase agreements
Interest expense on repurchase agreements,
based on rates at December 31, 2012
Convertible Senior Notes
Interest Expense on Convertible Senior Notes
Long-term operating lease obligations
Employment contracts
Total
$91,403,200
$3,752,497
$7,530,000
297,597
-
41,802
2,632
9,767
$91,754,998
374,658
857,541
56,402
2,899
-
$5,043,997
164,709
-
-
40
-
$7,694,749
$100,000
3,863
-
-
-
-
$103,863
Total
$102,785,697
840,827
857,541
98,204
5,571
9,767
104,597,607
In the coming periods, we expect to continue to finance our activities in a manner that is consistent with our
current operations via repurchase agreements. During the years ended December 31, 2012 and 2011, we received
$35.1 billion and $23.6 billion from principal repayments, and used leverage on our Agency mortgage-backed
securities which provided $12.2 billion and $19.6 billion in cash, respectively. In addition, we may from time to time
sell securities as a source of cash to fund new purchases.
Stockholders’ Equity
During the year ended December 31, 2012, 603,000 options were exercised for an aggregate exercise price of
$8.4 million. During the year ended December 31, 2011, 679,000 options were exercised for an aggregate exercise
price $9.0 million, respectively.
During the year ended December 31, 2012, 1.3 million shares of Series B Preferred Stock were converted into
4.0 million shares of common stock. During the year ended December 31, 2011, 320,000 shares of Series B Preferred
Stock were converted into 906,000 shares of common stock.
During the year ended December 31, 2012, we raised $2.8 million, by issuing 170,000 shares, through the
Direct Purchase and Dividend Reinvestment Program. During the year ended December 31, 2011, we raised $455.5
million by issuing 26.2 million shares through the Direct Purchase and Dividend Reinvestment Program, respectively.
On March 19, 2012, we entered into six separate Distribution Agency Agreements, or Distribution Agency
Agreements, with each of Merrill Lynch, Pierce, Fenner & Smith Incorporated, Credit Suisse Securities (USA) LLC,
Goldman, Sachs & Co., J.P. Morgan Securities LLC, Morgan Stanley & Co. LLC and RCap Securities, Inc. (together,
the Agents). Pursuant to the terms of the Distribution Agency Agreements, we may sell from time to time through the
Agents, as our sales agents, up to 125,000,000 shares of our common stock. We did not make any sales under the
Distribution Agency Agreements during the year ended December 31, 2012.
On October 16, 2012, we announced that our Board of Directors authorized the repurchase of up to $1.5
billion of our outstanding common shares over a 12 month period. All common shares purchased were part of a
publicly announced plan in open-market transactions. During the year ended December 31, 2012, we repurchased
approximately 27.8 million shares of our outstanding common stock for $397.1 million, of which $141.1 million had
not settled at December 31, 2012.
On January 4, 2011, we entered into an agreement pursuant to which we sold 86,250,000 shares of our
common stock for net proceeds following expenses of approximately $1.5 billion. This transaction settled on January
7, 2011.
On February 15, 2011, we entered into an agreement pursuant to which we sold 86,250,000 shares of our
common stock for net proceeds following expenses of approximately $1.5 billion. This transaction settled on February
18, 2011.
73
On July 11, 2011, we entered into an agreement pursuant to which we sold 138,000,000 shares of our
common stock for net proceeds following expenses of approximately $2.4 billion. This transaction settled on July 15,
2011.
On June 23, 2011, we amended our charter to increase the number of authorized shares of capital stock, par
value $0.01 per share, from 1,000,000,000 shares to 2,000,000,000 shares, consisting of 1,987,987,500 shares
classified as Common Stock, 7,412,500 shares classified as 7.875% Series A Cumulative Redeemable Preferred Stock,
and 4,600,000 shares classified as 6.00% Series B Cumulative Convertible Preferred Stock.
On May 16, 2012, we amended our charter through the filing of articles supplementary to our charter to
reclassify 12,650,000 shares of authorized shares of Common Stock as 7.625% Series C Cumulative Redeemable
Preferred Stock.
On September 13, 2012, we amended our charter through the filing of articles supplementary to our charter to
reclassify 18,400,000 shares of authorized shares of Common Stock as 7.50% Series D Cumulative Redeemable
Preferred Stock. Following the effectiveness of the articles supplementary to our charter our authorized shares of
capital stock, par value of $0.01 per share, consists of 1,956,937,500 shares classified as Common Stock, 7,412,500
shares classified as 7.875% Series A Cumulative Redeemable Preferred Stock, 4,600,000 shares classified as 6.00%
Series B Cumulative Convertible Preferred Stock, 12,650,000 shares classified as 7.625% Series C Cumulative
Redeemable Preferred Stock and 18,400,000 shares classified as 7.50% Series D Cumulative Redeemable Preferred
Stock.
Unrealized Gains and Losses
With our “available-for-sale” accounting treatment, unrealized fluctuations in market values of assets do not
impact our GAAP or taxable income but rather are reflected on our balance sheet by changing the carrying value of the
asset and stockholders’ equity under “Accumulated Other Comprehensive Income (Loss).” As a result of this mark-to-
market accounting treatment, our book value and book value per share are likely to fluctuate far more than if we used
historical amortized cost accounting. As a result, comparisons with companies that use historical cost accounting for
some or all of their balance sheet may not be meaningful.
The table below shows unrealized gains and losses reflected in the Consolidated Statement of Comprehensive
Income.
Unrealized Gains and Losses
(dollars in thousands)
Unrealized gain
Unrealized loss
Net unrealized gain (loss)
2012
$3,092,778
(39,536)
$3,053,242
2011
$3,091,152
(82,164)
$3,008,988
2010
$1,764,182
(599,540)
$1,164,642
Unrealized changes in the estimated net fair value of available-for-sale investments may have a direct effect
on our potential earnings and dividends: positive changes will increase our equity base and allow us to increase our
borrowing capacity while negative changes tend to limit borrowing capacity under our capital investment policy. A
very large negative change in the net fair value of our available-for-sale investments securities might impair our
liquidity position, requiring us to sell assets with the likely result of realized losses upon sale.
Leverage
Our debt-to-equity ratio at December 31, 2012, 2011 and 2010 was 6.5:1, 5.4:1 and 6.7:1, respectively. We
generally expect to maintain a ratio of debt-to-equity of less than 12:1. The ratio varies from time to time based upon
various factors, including our management’s opinion of the level of risk of our assets and liabilities, our liquidity
position, our level of unused borrowing capacity, the availability of credit, over-collateralization levels required by
lenders when we pledge assets to secure borrowings and our assessment of domestic and international market
74
conditions. Our debt-to-equity ratios have been below our historical average ratios since the credit crisis of 2008. We
believe that it is prudent to maintain our existing debt-to-equity ratio because there continues to be volatility in the
mortgage and credit markets primarily driven by the uncertainty in Europe and U.S. capital markets.
Our target debt-to-equity ratio is determined under our capital investment policy. Should our actual debt-to-
equity ratio increase above the target level due to asset acquisition or market value fluctuations in assets, we would
cease to acquire new assets. Our management will, at that time, present a plan to our board of directors to bring us
back to our target debt-to-equity ratio; in many circumstances, this would be accomplished over time by the monthly
reduction of the balance of our Agency mortgage-backed securities through principal repayments.
Asset/Liability Management and Effect of Changes in Interest Rates
We regularly review our asset/liability management strategy with respect to interest rate risk, mortgage
prepayment risk, credit risk and the related issues of capital adequacy and liquidity. Our goal is to provide attractive
risk-adjusted stockholder returns while maintaining what we believe is a strong balance sheet.
We seek to manage the extent to which our net income changes as a function of changes in interest rates by
matching adjustable-rate assets with variable-rate borrowings. In addition, we have attempted to mitigate the potential
impact on net income of periodic and lifetime coupon adjustment restrictions in our portfolio of Agency mortgage-
backed securities and Agency debentures by entering into interest rate swaps. At December 31, 2012, we had entered
into swap agreements with a total notional amount of $46.9 billion. We agreed to pay a weighted average pay rate of
2.21% and receive a floating rate based on one month LIBOR. At December 31, 2011, we had entered into swap
agreements with a total notional amount of $40.1 billion. We agreed to pay a weighted average pay rate of 2.55% and
receive a floating rate based on one month LIBOR. The weighted average pay rate declined by 0.34% from December
31, 2011 to December 31, 2012. The decline was the direct result of interest rate swaps maturing or terminated with
higher pay rates being replaced with interest rate swaps with lower pay rates. We believe that for the immediately
foreseeable periods, our weighted average pay rate will continue to decline as a result of interest rate swaps with
higher pay rates maturing or being terminated and the replacement of such swaps with interest rate swaps with lower
pay rates. We may enter into similar derivative transactions in the future by entering into interest rate collars, caps or
floors or purchasing interest only securities. Changes in interest rates may also affect the rate of mortgage principal
prepayments and, as a result, prepayments on mortgage-backed securities. We seek to mitigate the effect of changes in
the mortgage principal repayment rate by balancing assets we purchase at a premium with assets we purchase at a
discount. To date, the aggregate premium exceeds the aggregate discount on our mortgage-backed securities. As a
result, prepayments, which result in the amortization of unamortized premiums, will reduce our net income compared
to what net income would be absent such prepayments.
The following table summarizes certain characteristics of our interest rate swaps as of December 31, 2012:
Maturity of Interest Rate Swaps
(dollars in thousands)
Maturity
0 - 3 years
3 - 6 years
6 - 10 years
Greater than 10 years
Total / Weighted Average
Current
Notional
Weighted Average
Pay Rate
Weighted
Average
Receive Rate
Weighted Average
Years to Maturity
$18,165,800
19,609,500
5,300,000
3,836,500
$46,911,800
2.23%
1.84%
2.66%
3.45%
2.21%
0.24%
0.23%
0.25%
0.24%
0.24%
1.80
3.74
7.76
19.90
4.77
75
Off-Balance Sheet Arrangements
We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which would have been established for the purpose of
facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, we have not
guaranteed any obligations of unconsolidated entities nor do we have any commitment or intent to provide funding to
any such entities. As such, we are not materially exposed to any market, credit, liquidity or financing risk that could
arise if we had engaged in such relationships.
Capital Resources
At December 31, 2012, we had no material commitments for capital expenditures.
Inflation
Virtually all of our assets and liabilities are financial in nature. As a result, interest rates and other factors
drive our performance far more than does inflation. Changes in interest rates do not necessarily correlate with
inflation rates or changes in inflation rates. Our financial statements are prepared in accordance with GAAP and our
dividends are based upon our net income as calculated for tax purposes; in each case, our activities and balance sheet
are measured with reference to historical cost or fair market value without considering inflation.
Other Matters
We calculate that at least 75% of our assets were qualified REIT assets, as defined in the Code for the years
ended December 31, 2012 and 2011. We also calculate that our revenue qualifies for the 75% source of income test
and for the 95% source of income test rules for the years ended December 31, 2012, 2011 and 2010 and for each
quarter therein. Consequently, we met the REIT income and asset tests. We also met all REIT requirements regarding
the ownership of our common stock and the distribution of our net income. Therefore, for the years ended December
31, 2012, 2011 and 2010, we believe that we qualified as a REIT under the Code.
We at all times intend to conduct our business so as not to become regulated as an investment company under
the Investment Company Act of 1940, or the Investment Company Act. If we were to become regulated as an
investment company, then our use of leverage would be substantially reduced.
We currently rely on the exemption from registration provided by Section 3(c)(5)(C) of the Investment
Company Act. Section 3(c)(5)(C) as interpreted by the staff of the Securities and Exchange Commission (or the SEC),
requires us to invest at least 55% of our assets in “mortgages and other liens on and interest in real estate” (or
Qualifying Real Estate Assets) and at least 80% of our assets in Qualifying Real Estate Assets plus real estate related
assets. The assets that we acquire, therefore, are limited by the provisions of the Investment Company Act and the
rules and regulations promulgated under the Investment Company Act.
We rely on an interpretation that “whole pool certificates” that are issued or guaranteed by Fannie Mae,
Freddie Mac or Ginnie Mae (or Agency Whole Pool Certificates) are Qualifying Real Estate Assets under Section
3(c)(5)(C). This interpretation was promulgated by the SEC staff in a no-action letter over 30 years ago, was
reaffirmed by the SEC in 1992 and has been commonly relied on by mortgage REITs.
On August 31, 2011, the SEC issued a concept release titled “Companies Engaged in the Business of
Acquiring Mortgages and Mortgage-Related Instruments” (SEC Release No. IC-29778). Under the concept release,
the SEC is reviewing interpretive issues related to the Section 3(c)(5)(C) exemption. Among other things, the SEC
specifically requested comments on whether it should revisit whether Agency Whole Pool Certificates may be treated
as Qualifying Real Estate Assets and whether entities, such as us, whose primary business consists of investing in
Agency Whole Pool Certificates are the type of entities that Congress intended to be encompassed by the exclusion
provided by Section 3(c)(5)(C). The potential outcomes of the SEC’s actions are unclear as is the SEC’s timetable for
its review and actions.
76
We determined that as of December 31, 2012 and December 31, 2011, we were in compliance with the
exemption from registration provided by Section 3(c)(5)(C) of the Investment Company Act as interpreted by the staff
of the SEC.
As a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the U.S.
Commodity Futures Trading Commission (or CFTC) gained jurisdiction over the regulation of interest rate swaps.
The CFTC has asserted that this causes the operators of mortgage real estate investment trusts that use swaps as part of
their business model to fall within the statutory definition of Commodity Pool Operator (or CPO), and, absent relief
from the Division or the Commission, to register as CPOs. On December 7, 2012, as a result of numerous requests for
no-action relief from the CPO registration requirement for operators of mortgage real estate investment trusts, the
Division of Swap Dealer and Intermediary Oversight of the CFTC issued no-action relief entitled “No-Action Relief
from the Commodity Pool Operator Registration Requirement for Commodity Pool Operators of Certain Pooled
Investment Vehicles Organized as Mortgage Real Estate Investment Trusts” that permits a CPO to receive relief by
filing a claim to perfect the use of the relief. A claim submitted by a CPO will be effective upon filing, so long as the
claim is materially complete. The conditions that must be met to claim the relief are that the mortgage real estate
investment trust must:
• Limit the initial margin and premiums required to establish its commodity interest positions to no more
than 5 percent of the fair market value of the mortgage real estate investment trust’s total assets;
• Limit the net income derived annually from its commodity interest positions that are not qualifying
hedging transactions to less than five percent of the mortgage real estate investment trust’s gross income;
• Ensure that interests in the mortgage real estate investment trust are not marketed to the public as or in a
commodity pool or otherwise as or in a vehicle for trading in the commodity futures, commodity options,
or swaps markets; and
• Either:
o
o
identify itself as a “mortgage REIT” in Item G of its last U.S. income tax return on Form 1120-
REIT; or
if it has not yet filed its first U.S. income tax return on Form 1120-REIT, but has disclosed to its
shareholders that it intends to identify itself as a “mortgage REIT” in its first U.S. income tax
return on Form 1120-REIT.
While we disagree that the CFTC’s position that mortgage real estate investment trusts that use swaps as part of their
business model fall within the statutory definition of a CPO, we have submitted a claim for the relief set forth in the
no-action relief entitled “No-Action Relief from the Commodity Pool Operator Registration Requirement for
Commodity Pool Operators of Certain Pooled Investment Vehicles Organized as Mortgage Real Estate Investment
Trusts” and believe we meet the criteria for such relief set forth therein.
ITEM 7A
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
Market risk is the exposure to loss resulting from changes in interest rates, foreign currency exchange rates,
commodity prices and equity prices. The primary market risk to which we are exposed is interest rate risk, which is
highly sensitive to many factors, including governmental monetary and tax policies, domestic and international
economic and political considerations and other factors beyond our control. Changes in the general level of interest
rates can affect our net interest income, which is the difference between the interest income earned on interest-earning
assets and the interest expense incurred in connection with our interest-bearing liabilities, by affecting the spread
between our interest-earning assets and interest-bearing liabilities. Changes in the level of interest rates also can affect
the value of our Agency mortgage-backed securities and our ability to realize gains from the sale of these assets. We
77
may utilize a variety of financial instruments, including interest rate swaps, caps, floors, inverse floaters and other
interest rate exchange contracts, in order to limit the effects of interest rates on our operations. When we use these
types of derivatives to hedge the risk of interest-earning assets or interest-bearing liabilities, we may be subject to
certain risks, including the risk that losses on a hedge position will reduce the funds available for payments to holders
of securities and that the losses may exceed the amount we invested in the instruments.
Our profitability and the value of our portfolio (including interest rate swaps) may be adversely affected
during any period as a result of changing interest rates. The following table quantifies the potential changes in
economic net interest income and portfolio value, should interest rates go up or down 25, 50 and 75 basis points,
assuming the yield curves of the rate shocks will be parallel to each other and the current yield curve. All changes in
income and value are measured as percentage changes from the projected net interest income and portfolio value at the
base interest rate scenario. The base interest rate scenario assumes interest rates at December 31, 2012 and various
estimates regarding prepayment and all activities are made at each level of rate shock. Actual results could differ
significantly from these estimates.
Change in Interest Rate
Projected Percentage Change in
Economic Net Interest Income(1)
Projected Percentage Change in
Portfolio Value, with Effect of
Interest Rate Swaps
-75 Basis Points
-50 Basis Points
-25 Basis Points
Base Interest Rate
+25 Basis Points
+50 Basis Points
+75 Basis Points
(0.69%)
(1.64%)
(2.68%)
-
3.27%
8.83%
13.08%
(0.12%)
(0.01%)
0.09%
-
(0.18%)
(0.45%)
(0.81%)
(1) Economic net interest income includes interest expense on interest rate swaps.
ASSET AND LIABILITY MANAGEMENT
Asset and liability management is concerned with the timing and magnitude of the repricing of assets and
liabilities. We attempt to control risks associated with interest rate movements. Methods for evaluating interest rate
risk include an analysis of our interest rate sensitivity "gap," which is the difference between interest-earning assets
and interest-bearing liabilities maturing or repricing within a given time period. A gap is considered positive when the
amount of interest-rate sensitive assets exceeds the amount of interest-rate sensitive liabilities. A gap is considered
negative when the amount of interest-rate sensitive liabilities exceeds interest-rate sensitive assets. During a period of
rising interest rates, a negative gap would tend to adversely affect net interest income, while a positive gap would tend
to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to
result in an increase in net interest income, while a positive gap would tend to affect net interest income
adversely. Because different types of assets and liabilities with the same or similar maturities may react differently to
changes in overall market rates or conditions, changes in interest rates may affect net interest income positively or
negatively even if an institution were perfectly matched in each maturity category.
The following table sets forth the estimated maturity or repricing of our interest-earning assets and interest-
bearing liabilities at December 31, 2012. The amounts of assets and liabilities shown within a particular period were
determined in accordance with the contractual terms of the assets and liabilities, except adjustable-rate loans, and
securities are included in the period in which their interest rates are first scheduled to adjust and not in the period in
which they mature and does include the effect of the interest rate swaps. The interest rate sensitivity of our assets and
liabilities in the table could vary substantially based on actual prepayment experience.
78
Within 3
Months
4-12 Months
More than 1 Year
to 3 Years
3 Years and
Over
Total
(dollars in thousands)
Rate Sensitive Assets:
Cash and cash equivalents
Reverse repurchase agreements
U.S. Treasury securities
Securities borrowed
Agency Mortgage-backed securities (principal)
Agency debentures (principal)
Corporate debt
Total Rate Sensitive Assets
$ 615,789
1,811,095
-
2,160,942
642,494
-
64,393
5,294,713
$ -
-
-
-
2,136,177
-
-
2,136,177
Rate Sensitive Liabilities:
U.S. Treasury Securities sold, not yet purchased
Repurchase agreements, with the effect of interest
rate swaps
Securities loaned
Convertible Senior Notes (principal)
Total Rate Sensitive Liabilities
-
28,989,850
-
15,669,640
1,808,315
-
30,798,165
-
-
15,669,640
$ -
-
-
-
734,399
461,005
-
1,195,404
-
22,167,127
-
857,541
23,024,668
$ -
-
752,076
-
111,706,934
2,545,683
-
115,004,693
495,437
35,959,080
-
-
36,454,517
$ 615,789
1,811,095
752,076
2,160,942
115,220,004
3,006,688
64,393
123,630,987
495,437
102,785,697
1,808,315
857,541
105,946,990
Interest rate sensitivity gap
($25,503,452)
($13,533,463)
($21,829,264)
$78,550,176
17,683,997
Cumulative rate sensitivity gap
($25,503,452)
($39,036,915)
($60,866,179)
$17,683,997
Cumulative interest rate sensitivity gap as a
percentage of total rate-sensitive assets
(21%)
(32%)
(49%)
14%
Our analysis of risks is based on management’s experience, estimates, models and assumptions. These
analyses rely on models which utilize estimates of fair value and interest rate sensitivity. Actual economic conditions
or implementation of investment decisions by our management may produce results that differ significantly from the
estimates and assumptions used in our models and the projected results shown in the above tables and in this
report. These analyses contain certain forward-looking statements and are subject to the safe harbor statement set
forth under the heading, “Special Note Regarding Forward-Looking Statements.”
ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our financial statements and the related notes, together with the Report of Independent Registered Public
Accounting Firm thereon, are set forth beginning on page F-1 of this Form 10-K.
ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A CONTROLS AND PROCEDURES
Our management, including our Chief Executive Officer (the CEO) and Chief Financial Officer (the CFO),
reviewed and evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as
defined in Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act) as of the end of the period covered by this
quarterly report. Based on that review and evaluation, the CEO and CFO have concluded that our current disclosure
controls and procedures, as designed and implemented, (1) were effective in ensuring that information regarding the
Company and its subsidiaries is accumulated and communicated to our management, including our CEO and CFO, by
our employees, as appropriate to allow timely decisions regarding required disclosure and (2) were effective in
providing reasonable assurance that information the Company must disclose in its periodic reports under the Securities
Exchange Act is recorded, processed, summarized and reported within the time periods prescribed by the SEC’s rules
and forms.
79
There have been no changes in our internal controls over financial reporting that occurred during the quarter
ended December 31, 2012 that have materially affected, or are reasonably likely to materially affect our internal
control over financial reporting.
Management Report On Internal Control Over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over
financial reporting. Internal control over financial reporting is defined in Rules 13a-15(f) under the Securities
Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal
financial officers and effected by the Company’s board of directors, management and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting principles and includes those policies and
procedures that:
•
•
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and
dispositions of the assets of the Company;
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles, and that receipts and expenditures of
the Company are being made only in accordance with authorizations of management and directors of the
Company; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or
disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect
misstatements. As a result, even systems determined to be effective can provide only reasonable assurance regarding
the preparation and presentation of financial statements. Moreover, projections of any evaluation of effectiveness to
future periods are subject to the risks that controls may become inadequate because of changes in conditions or that the
degree of compliance with the policies or procedures may deteriorate.
The Company’s management assessed the effectiveness of the Company’s internal control over financial
reporting as of December 31, 2012. In making this assessment, the Company’s management used criteria set forth by
the Committee of Sponsoring Organizations of the Treadway Commission (or COSO) in Internal Control-Integrated
Framework.
Based on management’s assessment, the Company’s management believes that, as of December 31, 2012, the
Company’s internal control over financial reporting was effective based on those criteria. The Company’s
independent registered public accounting firm, Ernst and Young LLP, has issued an attestation report on the
Company’s internal control over financial reporting. Ernst & Young LLP, an independent registered public
accounting firm, has issued an attestation report on the Company’s internal control over financial reporting, which is
included herein.
80
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of
Annaly Capital Management, Inc. and Subsidiaries
We have audited Annaly Capital Management, Inc. and Subsidiaries’ internal control over financial reporting as of December 31,
2012, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (the COSO criteria). Annaly Capital Management, Inc. and Subsidiaries’ management
is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of
internal control over financial reporting included in the accompanying Management Report on Internal Control Over Financial
Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control
over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control
over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating
effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability
of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted
accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain
to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of
the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable
assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that
could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also,
projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Annaly Capital Management, Inc. and Subsidiaries maintained, in all material respects, effective internal control
over financial reporting as of December 31, 2012, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated statement of financial condition of Annaly Capital Management, Inc. and Subsidiaries as of December 31, 2012 and
the related consolidated statements of operations and comprehensive income (loss), stockholders’ equity and cash flows for the year
ended December 31, 2012 of Annaly Capital Management, Inc. and Subsidiaries and our report dated February 26, 2013 expressed
an unqualified opinion thereon.
/s/Ernst & Young LLP
New York, New York
February 26, 2013
81
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by Item 10 as to our directors is incorporated herein by reference to the proxy
statement to be filed with the SEC within 120 days after December 31, 2012. The information regarding our executive
officers required by Item 10 appears in Part I of this Form 10-K. The information required by Item 10 as to our
compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference to the proxy
statement to be filed with the SEC within 120 days after December 31, 2012.
We have adopted a Code of Business Conduct and Ethics within the meaning of Item 406(b) of Regulation S-
K. This Code of Business Conduct and Ethics applies to our principal executive officer, principal financial officer and
principal accounting officer. This Code of Business Conduct and Ethics is publicly available on our website at
www.annaly.com. If we make substantive amendments to this Code of Business Conduct and Ethics or grant any
waiver, including any implicit waiver, we intend to disclose these events on our website.
The information regarding certain matters pertaining to our corporate governance required by Item 407(c)(3),
(d)(4) and (d)(5) of Regulation S-K is incorporated by reference to the Proxy Statement to be filed with the SEC
within 120 days after December 31, 2012.
ITEM 11
EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated herein by reference to the proxy statement to be filed
with the SEC within 120 days after December 31, 2012.
ITEM 12
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information required by Item 12 is incorporated herein by reference to the proxy statement to be filed
with the SEC within 120 days after December 31, 2012.
ITEM 13
INDEPENDENCE
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
The information required by Item 13 is incorporated herein by reference to the proxy statement to be filed
with the SEC within 120 days after December 31, 2012.
ITEM 14
PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by Item 14 is incorporated herein by reference to the proxy statement to be filed
with the SEC within 120 days after December 31, 2012.
82
ITEM 15
EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
PART IV
(a) Documents filed as part of this report:
1.
2.
Financial Statements.
Schedules to Financial Statements:
All financial statement schedules not included have been omitted because they are either inapplicable or the
information required is provided in our Financial Statements and Notes thereto, included in Part II, Item 8, of this
Annual Report on Form 10-K.
3.
Exhibits:
Exhibit
Number
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
3.9
3.10
3.11
Exhibit Description
EXHIBIT INDEX
Articles of Amendment and Restatement of the Articles of Incorporation of the Registrant
(incorporated by reference to Exhibit 3.2 to the Registrant’s Registration Statement on Form S-
11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on
August 5, 1997).
Articles of Amendment of the Articles of Incorporation of the Registrant (incorporated by
reference to Exhibit 3.1 of the Registrant’s Registration Statement on Form S-3 (Registration
Statement 333-74618) filed with the Securities and Exchange Commission on June 12, 2002).
Articles of Amendment of the Articles of Incorporation of the Registrant (incorporated by
reference to Exhibit 3.1 of the Registrant's Form 8-K (filed with the Securities and Exchange
Commission on August 3, 2006)).
Articles of Amendment of the Articles of Incorporation of the Registrant (incorporated by
reference to Exhibit 3.4 of the Registrant's Form 10-Q (filed with the Securities and Exchange
Commission on May 7, 2008)).
Articles of Amendment of the Articles of Incorporation of the Registrant (incorporated by
reference to Exhibit 3.1 of the Registrant's Form 8-K (filed with the Securities and Exchange
Commission on June 23, 2011)).
Form of Articles Supplementary designating the Registrant’s 7.875% Series A Cumulative
Redeemable Preferred Stock, liquidation preference $25.00 per share (incorporated by
reference to Exhibit 3.3 to the Registrant’s 8-A filed April 1, 2004).
Articles Supplementary of the Registrant’s designating an additional 2,750,000 shares of the
Company’s 7.875% Series A Cumulative Redeemable Preferred Stock, as filed with the State
Department of Assessments and Taxation of Maryland on October 15, 2004 (incorporated by
reference to Exhibit 3.2 to the Registrant’s 8-K filed October 4, 2004).
Articles Supplementary designating the Registrant’s 6% Series B Cumulative Convertible
Preferred Stock, liquidation preference $25.00 per share (incorporated by reference to Exhibit
3.1 to the Registrant’s 8-K filed April 10, 2006).
Articles Supplementary designating the Registrant’s 7.625% Series C Cumulative Redeemable
Preferred Stock, liquidation preference $25.00 per share (incorporated by reference to Exhibit
3.1 to the Registrant’s Current Report on Form 8-K filed May 16, 2012).
Articles Supplementary designating the Registrant’s 7.50% Series D Cumulative Redeemable
Preferred Stock, liquidation preference $25.00 per share (incorporated by reference to Exhibit
3.1 to the Registrant’s Current Report on Form 8-K filed September 13, 2012).
Bylaws of the Registrant, as amended (incorporated by reference to Exhibit 3.1 of the
Registrant’s form 8-K (filed with the Securities and Exchange Commission on March 22,
2011)).
83
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
4.10
4.11
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
10.9
Specimen Common Stock Certificate (incorporated by reference to Exhibit 4.1 to Amendment
No. 1 to the Registrant’s Registration Statement on Form S-11 (Registration No. 333-32913)
filed with the Securities and Exchange Commission on September 17, 1997).
Specimen Preferred Stock Certificate (incorporated by reference to Exhibit 4.2 to the
Registrant’s Registration Statement on Form S-3 (Registration No. 333-74618) filed with the
Securities and Exchange Commission on December 5, 2001).
Specimen Series A Preferred Stock Certificate (incorporated by reference to Exhibit 4.1 of the
Registrant's Registration Statement on Form 8-A filed with the SEC on April 1, 2004).
Specimen Series B Preferred Stock Certificate (incorporated by reference to Exhibit 4.1 to the
Registrant’s Form 8-K filed with the Securities and Exchange Commission on April 10, 2006).
Specimen Series C Preferred Stock Certificate (incorporated by reference to Exhibit 4.1 to the
Registrant’s Form 8-K filed with the Securities and Exchange Commission on May 16, 2012).
Specimen Series D Preferred Stock Certificate (incorporated by reference to Exhibit 4.1 to the
Registrant’s Form 8-K filed with the Securities and Exchange Commission on September 13,
2012).
Indenture, dated as of February 12, 2010, between the Registrant and Wells Fargo Bank,
National Association (incorporated by reference to Exhibit 4.1 to the Registrant’s Form 8-K
filed with the Securities and Exchange Commission on February 12, 2010).
Supplemental Indenture, dated as of February 12, 2010, between the Registrant and Wells
Fargo Bank, National Association (incorporated by reference to Exhibit 4.2 to the Registrant’s
Form 8-K filed with the Securities and Exchange Commission on February 12, 2010).
Form of 4.00% Convertible Senior Note due 2015 (included in Exhibit 4.8).
Second Supplemental Indenture, dated as of May 14, 2012, between the Registrant and Wells
Fargo Bank, National Association (incorporated by reference to Exhibit 4.2 to the Registrant’s
Form 8-K filed with the Securities and Exchange Commission on May 14, 2012).
Form of 5.00% Convertible Senior Note due 2015 (included in Exhibit 4.10).
Long-Term Stock Incentive Plan (incorporated by reference to Exhibit 10.3 to the Registrant’s
Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities
and Exchange Commission on August 5, 1997).*
Form of Master Repurchase Agreement (incorporated by reference to Exhibit 10.7 to the
Registrant’s Registration Statement on Form S-11 (Registration No. 333-32913) filed with the
Securities and Exchange Commission on August 5, 1997).
Amended and Restated Employment Agreement, dated as of February 25, 2008, between the
Registrant and Wellington J. Denahan (incorporated by reference to Exhibit 10.4 of the
Registrant’s Form 10-K filed with the Securities and Exchange Commission on February 26,
2008).*
Amended and Restated Employment Agreement, effective as of June 4, 2004,between the
Registrant and Kathryn F. Fagan (incorporated by reference to Exhibit 10.5 of the Registrant’s
Form 10-K filed with the Securities and Exchange Commission on March 10, 2005).*
Amended and Restated Employment Agreement, effective as of June 4, 2004, between the
Registrant and James P. Fortescue (incorporated by reference to Exhibit 10.7 of the Registrant’s
Form 10-K filed with the Securities and Exchange Commission on March 10, 2005).*
Amended and Restated Employment Agreement, dated as of April 21, 2006, between the
Registrant and Rose-Marie Lyght (incorporated by reference to Exhibit 10.9 of the Registrant’s
Form 10-Q filed with the Securities and Exchange Commission on May 9, 2006).*
Amended and Restated Employment Agreement, effective as of June 4, 2004, between the
Registrant and Kristopher R. Konrad (incorporated by reference to Exhibit 10.11 of the
Registrant’s Form 10-K filed with the Securities and Exchange Commission on March 10,
2005).*
Amended and Restated Employment Agreement, dated January 23, 2006, between the
Registrant and R. Nicholas Singh (incorporated by reference to Exhibit 10.7 of the Registrant’s
Form 10-K filed with the Securities and Exchange Commission on March 13, 2006).*
Employment Agreement, dated July 1, 2010, between the Registrant and Kevin Keyes
(incorporated by reference to Exhibit 10.13 of the Registrant’s Form 10-K filed with the
Securities and Exchange Commission February 25, 2011).*
84
31.2
32.1
12. 1
10.10
21.1
23.1
23.2
31.1
Registrant’s 2010 Equity Incentive Plan (incorporated by reference to Exhibit 10.1 to the
Registrant’s Current Report Form 8-K filed with the SEC on June 1, 2010).*
Computation of ratio of earnings to combined fixed charges and preferred stock dividends and
ratio of earnings to fixed charges.
Subsidiaries of Registrant.
Consent of Ernst & Young LLP.
Consent of Deloitte & Touche LLP.
Certification of Wellington Denahan, Chairman and Chief Executive Officer of the Registrant,
pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
Certification of Kathryn F. Fagan, Chief Financial Officer and Treasurer of the Registrant,
pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
Certification of Wellington Denahan, Chairman and Chief Executive Officer of the Registrant,
pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
Certification of Kathryn F. Fagan, Chief Financial Officer and Treasurer of the Registrant,
pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
Exhibit 101.INS XBRL
Exhibit 101.SCH XBRL Taxonomy Extension Schema Document †
Exhibit 101.CAL XBRL Taxonomy Extension Calculation Linkbase Document †
Exhibit 101.DEF XBRL Additional Taxonomy Extension Definition Linkbase Document Created†
Exhibit 101.LAB XBRL Taxonomy Extension Label Linkbase Document †
Exhibit 101.PRE XBRL Taxonomy Extension Presentation Linkbase Document †
*
Exhibits to this Form 10-K.
Instance Document †
32.2
Exhibit Numbers 10.1 and 10.3-10.14 are management contracts or compensatory plans required to be filed as
Submitted electronically herewith. Attached as Exhibit 101 to this report are the following documents
†
formatted in XBRL (Extensible Business Reporting Language): (i) Consolidated Statements of Financial Condition at
December 31, 2012 and December 31, 2011; (ii) Consolidated Statements of Operations and Comprehensive Income
(Loss) for the years ended December 31, 2012, 2011 and 2010; (iii) Consolidated Statement of Stockholders' Equity
for the years ended December 31, 2012, 2011 and 2010; (iv) Consolidated Statements of Cash Flows for the years
ended December 31, 2012, 2011 and 2010; and (v) Notes to Consolidated Financial Statements. Users of this data are
advised pursuant to Rule 406T of Regulation S-T that this interactive data file is deemed not filed or part of a
registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, is deemed not filed
for purposes of section 18 of the Securities and Exchange Act of 1934, and otherwise is not subject to liability under
these sections.
85
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
FINANCIAL STATEMENTS
REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMS
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
DECEMBER 31, 2012, 2011, AND 2010
Consolidated Statements of Financial Condition
Consolidated Statements of Operations and Comprehensive Income (Loss)
Consolidated Statements of Stockholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Page
F-1
F-3
F-4
F-6
F-8
F-10
86
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Annaly Capital Management, Inc. and Subsidiaries
We have audited the accompanying consolidated statement of financial condition of Annaly Capital Management, Inc. and
Subsidiaries (the "Company") as of December 31, 2012, and the related consolidated statements of operations and comprehensive
income (loss), stockholders’ equity and cash flows for the year ended December 31, 2012. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our
audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial
position of Annaly Capital Management, Inc. and Subsidiaries at December 31, 2012, and the consolidated results of their operations
and their cash flows for the year ended December 31, 2012, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Annaly
Capital Management, Inc. and Subsidiaries' internal control over financial reporting as of December 31, 2012, based on criteria
established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission and our report dated February 26, 2013 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
New York, New York
February 26, 2013
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Annaly Capital Management, Inc. and Subsidiaries
New York, New York
We have audited the accompanying consolidated statement of financial condition of Annaly Capital Management, Inc. and
Subsidiaries (the "Company") as of December 31, 2011, and the related consolidated statements of operations and comprehensive
income (loss), stockholders' equity, and cash flows for each of the two years in the period ended December 31, 2011. Our
responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a reasonable basis for our opinions.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of
Annaly Capital Management, Inc. and Subsidiaries as of December 31, 2011, and the results of their operations and their cash flows
for each of the two years in the period ended December 31, 2011, in conformity with accounting principles generally accepted in the
United States of America.
/s/ Deloitte & Touche LLP
New York, New York
February 28, 2012
F-2
Part I
Item1. Financial Statements
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31, 2012 AND 2011
(dollars in thousands, except per share amounts)
ASSETS
Cash and cash equivalents
Reverse repurchase agreements
Investments, at fair value:
U.S. Treasury Securities (including pledged assets of $752,076 and $352,820,
respectively)
Securities borrowed
Agency mortgage-backed securities (including pledged assets of $107,466,084 and
$90,406,535, respectively)
Agency debentures (including pledged assets of $981,727 and $567,383, respectively)
Investments in affiliates
Equity securities
Corporate debt, held for investment
Receivable for investments sold
Accrued interest and dividends receivable
Receivable from Prime Broker
Receivable for advisory and service fees (including from affiliates of $14,077 and
$16,245, respectively)
Intangible for customer relationships (net of accumulated amortization of $5,779 and
$5,432, respectively)
Goodwill
Other derivative contracts, at fair value
Other assets
Total Assets
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
U.S. Treasury Securities sold, not yet purchased, at fair value
Repurchase agreements
Securities loaned, at fair value
Payable for investments purchased
Payable for share buyback program
Convertible Senior Notes
Accrued interest payable
Dividends payable
Interest rate swaps, at fair value
Accounts payable and other liabilities
Total Liabilities
6.00% Series B Cumulative Convertible Preferred Stock:
4,600,000 shares authorized, 0 and 1,331,849 shares issued and
outstanding, respectively
Stockholders’ Equity:
7.875% Series A Cumulative Redeemable Preferred Stock: 7,412,500 authorized,
issued and outstanding
7.625% Series C Cumulative Redeemable Preferred Stock: 12,650,000 and 0
authorized, respectively, 12,000,000 and 0 issued and outstanding, respectively
7.50% Series D Cumulative Redeemable Preferred Stock: 18,400,000 and 0
authorized, issued and outstanding, respectively
Common stock, par value $0.01 per share, 1,956,937,500 and 1,987,987,500
authorized, respectively, 947,213,204 and 970,161,647 issued and outstanding,
respectively
Additional paid-in capital
Accumulated other comprehensive income (loss)
Accumulated deficit
Total Stockholders’ Equity
Total Liabilities, Series B Cumulative Convertible Preferred Stock and
Stockholders’ Equity
See notes to consolidated financial statements.
F-3
December 31, 2012
December 31, 2011
$ 615,789
1,811,095
$ 994,198
860,866
752,076
2,160,942
123,963,207
3,009,568
234,120
-
63,944
290,722
419,259
-
928,547
928,732
104,251,055
889,580
211,970
3,891
52,073
-
409,023
3,272
17,730
19,550
6,989
55,417
9,830
41,607
$133,452,295
10,807
42,030
113
24,295
$109,630,002
$ 495,437
102,785,697
1,808,315
8,256,957
141,149
825,541
186,896
432,154
2,584,907
10,798
117,527,851
$ 826,912
84,097,885
804,901
4,315,796
-
539,913
138,965
552,806
2,552,687
7,223
93,837,088
-
32,272
177,088
290,514
445,457
9,472
14,740,774
3,053,242
(2,792,103)
15,924,444
177,088
-
-
9,702
15,068,870
3,008,988
(2,504,006)
15,760,642
$133,452,295
$109,630,002
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
YEARS ENDED DECEMBER 31, 2012, 2011, AND 2010
(dollars in thousands, except per share amounts)
Interest income:
Investments
U.S. Treasury Securities
Securities loaned
Total interest income
Interest expense:
Repurchase agreements
Convertible Senior Notes
U.S. Treasury Securities sold, not yet purchased
Securities borrowed
Total interest expense
Net interest income
Other income (loss):
Investment advisory and other fee income
Net gains (losses) on disposition of investments
Net loss on extinguishment of 4% Convertible Senior Notes
Dividend income from affiliates
Net gains (losses) on trading assets
Net unrealized gain (losses) on Agency interest-only mortgage-backed securities
Income from underwriting
Subtotal
Realized gains (losses) on interest rate swaps(1)
Realized gains (losses) on termination of interest rate swaps
Unrealized gains (losses) on interest rate swaps
Subtotal
Total other income (loss)
Expenses:
Distribution fees
Compensation expense
Other general and administrative expenses
Total expenses
Income (loss) before income taxes and income from equity method investment in
affiliate
Income taxes
For the Years ended December 31,
2012
2011
2010
$3,232,020
17,222
9,903
3,259,145
$3,558,015
14,706
6,897
3,579,618
$2,676,307
2,830
3,997
2,683,134
577,243
67,221
15,114
7,594
667,172
426,769
35,017
13,081
5,459
480,326
397,971
24,228
2,649
3,377
428,225
2,591,973
3,099,292
2,254,909
82,663
432,139
(162,340)
28,336
22,910
(59,937)
-
343,771
(893,769)
(2,385)
(32,219)
(928,373)
(584,602)
-
190,702
44,857
235,559
79,205
206,846
-
31,516
21,398
(106,657)
5,618
237,926
(882,395)
-
(1,815,107)
(2,697,502)
(2,459,576)
-
206,251
31,093
237,344
58,073
181,791
-
31,038
(2,351)
-
2,095
270,646
(735,107)
-
(318,832)
(1,053,939)
(783,293)
360
146,958
24,529
171,847
1,771,812
402,372
1,299,769
(35,912)
(59,051)
(35,434)
Income (loss) on equity method investment in affiliate
-
1,140
2,945
Net income (loss)
Dividends on preferred stock
1,735,900
344,461
1,267,280
39,530
16,854
18,033
Net income (loss) available (related) to common shareholders
$1,696,370
$327,607
$1,249,247
Net income (loss) per share available (related) to common shareholders:
Basic
Diluted
$1.74
$1.71
$0.37
$0.37
$2.12
$2.04
Weighted average number of common shares outstanding:
Basic
Diluted
972,902,459
1,005,755,057
874,212,039
874,518,938
588,192,659
625,307,174
Dividends Declared Per Share of Common Stock
$2.05
$2.44
$2.65
Statement continued on following page
F-4
Statement continued from previous page.
Net income (loss)
Other comprehensive income (loss):
Unrealized gains (losses) on available-for-sale securities
Unrealized loss on interest rate swaps
Reclassification adjustment for net (gains) losses included in net income (loss)
Other comprehensive income (loss)
Comprehensive income (loss)
$1,735,900
$344,461
$1,267,280
482,765
-
(438,511)
2,036,894
14,298
(206,846)
$44,254
$1,844,346
$1,780,154
$2,188,807
(639,783)
94,899
(181,791)
(726,675)
$540,605
(1)
Interest expense related to the Company’s interest rate swaps is recorded in Realized losses on interest rate swaps on the Consolidated Statements of Operations
and Comprehensive Income (Loss).
See notes to consolidated financial statements.
F-5
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F-7
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2012, 2011, AND 2010
(dollars in thousands)
Cash flows from operating activities:
Net income (loss)
Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities:
Amortization of Investment premiums and discounts, net
Amortization of intangibles
Amortization of deferred expenses
Amortization of contingent beneficial conversion feature and equity
component on Convertible Senior Notes
(Gains) losses on disposal of investments
Net loss on extinguishment of 4% Convertible Senior Notes
Stock option and long-term compensation expense
Non-cash component of disposal of subsidiary
Unrealized (gains) losses on interest rate swaps
Net unrealized (gains) losses on interest-only Agency mortgage-backed
securities
Net (gains) losses on trading assets
(Gain) loss on investment with affiliate, equity method
Unrealized (gains) losses on equity securities
Proceeds from repurchase agreements from RCap
Payments on repurchase agreements from RCap
Proceeds from reverse repurchase agreements to RCap
Payments on reverse repurchase agreements to RCap
Proceeds from reverse repurchase agreements to Shannon
Payments on reverse repurchase agreements to Shannon
Proceeds from securities borrowed
Payments on securities borrowed
Proceeds from securities loaned
Payments on securities loaned
Proceeds from U.S. Treasury Securities
Payments on U.S. Treasury Securities
Net payments on derivatives
Net change in:
Other assets
Accrued interest and dividends receivable
Advisory and service fees receivable
Receivable from Prime Broker
Accrued interest payable
Accounts payable and other liabilities
Net cash provided by (used in) operating activities
Cash flows from investing activities:
Payments on purchases of Agency mortgage-backed securities and debentures
Proceeds from sales of Agency mortgage-backed securities and debentures
Principal payments on Agency mortgage-backed securities
Proceeds from Agency debentures called
Payments on purchase of corporate debt
Proceeds from corporate debt called
Principal payments on corporate debt
Net gains (losses) on other derivative securities
Earn out payment
Purchase of investment in affiliate
Purchase of customer relationships
Purchase of equity securities
Proceeds from sale of equity securities
Proceeds from reverse repurchase agreements
Payments on reverse repurchase agreements
Payment on disposal of subsidiary
Net cash provided by (used in) investing activities
Cash flows from financing activities:
Proceeds from repurchase agreements
Principal payments on repurchase agreements
Proceeds from exercise of stock options
Net proceeds from Series C Preferred offering
F-8
For the Years Ended December 31,
2012
2011
2010
$1,735,900
$344,461
$ 1,267,280
1,470,801
4,080
6,965
794,205
2,300
3,600
664,429
1,600
3,150
18,017
7,550
-
(432,139)
162,340
5,584
(1,177)
32,219
(206,846)
-
5,269
-
1,815,107
(181,791)
-
4,757
-
318,832
59,937
106,657
-
(20,525)
-
-
733,739,097
(727,275,192)
401,926,011
(402,805,044)
680,525
(751,721)
74,361,498
(75,593,708)
185,657,591
(184,654,177)
64,028,348
(64,746,420)
(10,173)
(9,243)
(6,151)
1,820
3,272
47,931
3,241
7,639,507
(86,161,777)
30,542,875
35,133,544
1,801,283
(81,090)
67,649
4,247
10,379
(13,387)
-
-
-
4,048
-
-
(800)
(18,693,029)
352,497,651
(340,273,744)
8,438
290,514
(21,398)
(98)
100
877,734,065
(878,806,056)
156,659,365
(156,502,577)
166,354
(177,845)
27,261,366
(27,973,422)
54,126,121
(53,539,061)
29,168,074
(28,490,573)
(7,158)
(3,258)
(64,362)
(3,378)
-
23,199
(1,698)
2,420,063
(69,065,069)
19,337,053
23,565,709
1,124,000
(31,675)
-
1,375
13,965
-
(57,500)
(3,555)
(3,990)
-
-
-
-
(25,119,687)
273,023,622
(253,387,283)
8,953
-
2,351
(318)
-
1,268,429,168
(1,258,941,064)
87,968,002
(88,479,412)
-
-
2,924,082
(3,111,681)
3,231,198
(3,042,414)
9,331,089
(9,521,134)
(3,455)
3,950
(27,125)
(3,606)
-
26,306
(1,084)
10,863,110
(54,424,951)
9,262,772
28,961,203
2,132,002
(21,670)
-
-
-
(14,113)
-
-
-
-
4,291,430
(4,032,426)
-
(13,845,753)
224,789,731
(223,342,427)
4,598
-
Net proceeds from Series D Preferred offering
Net proceeds from issuance of 5% Convertible Senior Notes
Net proceeds from issuance of 4% Convertible Senior Notes
Net payment on extinguishment of 4% Convertible Senior Notes
Net proceeds from direct purchases and dividend reinvestments
Net proceeds from common stock follow-on offerings
Net payment on share repurchase
Dividends paid
Net cash provided by (used in) financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents, beginning of period
445,457
727,500
-
(617,476)
2,794
(248)
(255,901)
(2,149,872)
10,675,113
(378,409)
994,198
-
-
-
-
455,547
5,351,846
-
(2,041,489)
23,411,196
-
-
582,000
-
278,784
1,047,354
-
(1,599,339)
1,760,701
711,572
282,626
(1,221,942)
1,504,568
Cash and cash equivalents, end of period
$615,789
$994,198
$282,626
Supplemental disclosure of cash flow information:
Interest received
Dividends received
Fees received
Interest paid (excluding interest paid on interest rate swaps)
Net interest paid on interest rate swaps
Taxes paid
Noncash investing activities:
Receivable for Investments sold
Payable for Investments purchased
Net change in unrealized gains (losses) on available-for-sale securities and
interest rate swaps, net of reclassification adjustment
Noncash financing activities:
Dividends declared, not yet paid
Conversion of Series B Cumulative Convertible preferred stock
Contingent beneficial conversion feature on 4% Convertible Senior Notes
Equity component of 5% Convertible Senior Notes
See notes to consolidated financial statements.
$4,718,524
$29,522
$84,483
$595,152
$892,656
$52,590
$4,309,690
$31,876
$75,827
$455,873
$876,099
$61,045
$3,322,228
$30,042
$54,467
$411,608
$725,418
$36,742
$290,722
$8,256,957
-
$4,315,796
$151,460
$4,575,026
$44,254
$1,844,346
($726,675)
$432,154
$32,272
$61,725
$11,717
$552,806
$7,759
$60,087
-
$404,220
$23,081
-
-
F-9
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2012, 2011 AND 2010
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Annaly Capital Management, Inc. (“Annaly” or the “Company”) was incorporated in Maryland on
November 25, 1996. The Company commenced its operations of purchasing and managing an investment portfolio of
mortgage-backed securities on February 18, 1997, upon receipt of the net proceeds from the private placement of
equity capital, and completed its initial public offering on October 14, 1997. The Company is a real estate investment
trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). On June 4, 2004, the Company
acquired Fixed Income Discount Advisory Company (“FIDAC”). FIDAC is a registered investment advisor and is a
wholly owned taxable REIT subsidiary of the Company. On June 27, 2006, the Company made a majority equity
investment in an affiliated investment fund (the “Fund”), which is now wholly owned by the Company. During the
third quarter of 2008, the Company formed RCap Securities, Inc. (“RCap”). RCap was granted membership in the
Financial Industry Regulatory Authority (“FINRA”) on January 26, 2009, and operates as a broker-dealer. RCap is a
wholly owned taxable REIT subsidiary of the Company. On October 31, 2008, the Company acquired Merganser
Capital Management, Inc. (“Merganser”). Merganser is a registered investment advisor and is a wholly owned taxable
REIT subsidiary of the Company. In 2010, the Company established Shannon Funding LLC (“Shannon”), which
provides warehouse financing to residential mortgage originators in the United States. In 2010, the Company also
established Charlesfort Capital Management LLC (“Charlesfort”), which engages in corporate middle market lending
transactions. In 2011, FIDAC established FIDAC Europe Limited (“FIDAC Europe”), which the Company sold in
December 2012. In 2011, the Company established FIDAC FSI LLC (“FIDAC FSI”), which invested in trading
securities. FIDAC FSI was liquidated in August 2012.
A summary of the Company’s significant accounting policies follows:
Basis of Accounting
The accompanying consolidated financial statements and related notes of the Company have been prepared in
accordance with accounting principles generally accepted in the United States ("U.S. GAAP").
Principles of Consolidation
The consolidated financial statements include the accounts of the Company, FIDAC, FIDAC FSI, FIDAC
Europe, Merganser, RCap, Shannon and Charlesfort. All intercompany balances and transactions have been
eliminated in consolidation. Cash flows from RCap are reported as operating activities in the Consolidated Statements
of Cash Flows.
Cash and Cash Equivalents - Cash and cash equivalents include cash on hand and cash held in money market
funds on an overnight basis. RCap is a member of various clearing organizations with which it maintains cash
required for the conduct of its day-to-day clearance activities. Cash and securities deposited with clearing
organizations are carried at cost, which approximates fair value, which was $424.6 million at December 31,
2012. The Company also maintains collateral in the form of cash on margin with a counterparty to its interest rate
swaps of $102.9 million at December 31, 2012
Reverse Repurchase Agreements – The Company through RCap enters into reverse repurchase agreements as
part of RCap’s matched book trading activity. Reverse repurchase agreements are recorded on trade date at the
contract amount and are collateralized by mortgage-backed or other securities. Margin calls are made by RCap as
necessary based on the daily valuation of the underlying collateral as compared to the contract price. RCap generates
income from the spread between what is earned on the reverse repurchase agreements and what is paid on the matched
repurchase agreements. RCap’s policy is to obtain possession of collateral with a market value in excess of the
principal amount loaned under reverse repurchase agreements. To ensure that the market value of the underlying
collateral remains sufficient, collateral is valued daily, and RCap will require counterparties to deposit additional
F-10
collateral, when necessary. All reverse repurchase activities are transacted under master repurchase agreements that
give the Company the right, in the event of default, to liquidate collateral held and to offset receivables and payables
with the same counterparty.
Securities Borrowed and Loaned Transactions — RCap records securities borrowed and loaned transactions
as collateralized financings. Securities borrowed transactions require the Company to provide the counterparty with
collateral in the form of cash, or other securities. The Company receives collateral in the form of cash or other
securities for securities loaned transactions in an amount generally in excess of the fair value of the securities loaned.
RCap monitors the fair value of the securities borrowed and loaned on a daily basis, with additional collateral obtained
or refunded as necessary. Securities borrowed and securities loaned transactions are recorded contract value. For
these transactions, the rebates accrued by the Company are recorded as interest revenue or expense.
U.S. Treasury Securities — RCap’s trades in U.S. Treasury securities consist of long and short positions on
U.S Treasury notes and bonds. U.S. Treasury securities are classified as trading investments and are recorded on the
trade date. Changes in fair value are reflected in the Company’s Consolidated Statement of Comprehensive Income.
Generally RCap does not hold the U.S. Treasury bills, notes and bonds to maturity and realizes gains and losses from
trading those positions. Interest income or expense on U.S Treasury notes and bonds is accrued based on the
outstanding principal amount of those investments and their stated terms.
Investment Securities –Agency mortgage-backed securities, Agency debentures, and corporate debt are
referred to herein as “Investment Securities.” Although the Company generally intends to hold most of its Investment
Securities until maturity, it may, from time to time, sell any of its Investment Securities as part of its overall
management of its portfolio. Investment Securities classified as available-for-sale are reported at fair values estimated
by management that are compared to independent sources for reasonableness, with unrealized gains and losses
reported as a component of stockholders’ equity. Investment Securities transactions are recorded on the trade date.
Realized gains and losses on sales of Investment Securities are determined using the average cost method. The
Company’s investments in corporate debt are designated as held for investment, and are carried at their principal
balance outstanding plus any premiums or discounts less allowances for loan losses. No allowance for loan losses was
deemed necessary as of December 31, 2012 and 2011.
On April 1, 2011, the Company elected the fair value option for Agency interest-only mortgage-backed
securities acquired on or after such date. Interest-only securities and inverse interest-only securities are collectively
referred to as “interest-only securities.” These Agency interest-only mortgage-backed securities represent the
Company’s right to receive a specified proportion of the contractual interest flows of specific Agency mortgage-
backed securities. Agency interest-only mortgage-backed securities acquired on or after April 1, 2011 are measured at
fair value through earnings in the Company’s Consolidated Statements of Comprehensive Income. The interest-only
securities are included in Agency mortgage-backed securities at fair value on the accompanying Consolidated
Statements of Financial Condition.
Agency Mortgage-Backed Securities and Agency Debentures – The Company invests primarily in mortgage
pass-through certificates, collateralized mortgage obligations and other mortgage-backed securities representing
interests in or obligations backed by pools of mortgage loans, and certificates guaranteed by Ginnie Mae, Freddie Mac
or Fannie Mae (collectively, “Agency mortgage-backed securities”). The Company also invests in Agency debentures
issued by Federal Home Loan Bank (“FHLB”), Freddie Mac, and Fannie Mae.
Interest income from coupon payments is accrued based on the outstanding principal amount of the
Investment Securities and their contractual terms. Premiums and discounts associated with the purchase of the
Investment Securities are amortized into interest income over the projected lives of the securities using the interest
method. The Company’s policy for estimating prepayment speeds for calculating the effective yield is to evaluate
historical performance, consensus prepayment speeds, and current market conditions. Adjustments are made for actual
prepayment activity.
Equity Securities – The Company invests in equity securities that are classified as available-for-sale or
trading. Equity securities classified as available-for-sale are reported at fair value, based on market quotes, with
unrealized gains and losses reported as a component of stockholders’ equity. Equity securities classified as trading are
reported at fair value, based on market quotes, with unrealized gains and losses reported in the Consolidated Statement
of Comprehensive Income. Dividends are recorded in earnings based on the declaration date.
F-11
Other-Than-Temporary Impairment – Management evaluates available-for-sale securities for other-than-
temporary impairment at least quarterly, and more frequently when economic or market concerns warrant such
evaluation. The Company determines if it (1) has the intent to sell the securities, (2) is more likely than not that it will
be required to sell the securities before recovery, or (3) does not expect to recover the entire amortized cost basis of the
securities. Further, the security is analyzed for credit loss (the difference between the present value of cash flows
expected to be collected and the amortized cost basis). The credit loss, if any, will then be recognized in the
Consolidated Statements of Comprehensive Income, while the balance of losses related to other factors will be
recognized as a component of stockholders’ equity. There was no other-than-temporary impairment for the years
ended December 31, 2012, 2011 and 2010.
Derivative Instruments – The Company accounts for interest rate swaps at fair value as either assets or
liabilities on the Consolidated Statements of Financial Condition. Changes in the fair value of interest rate swaps are
recognized in earnings. The Company uses interest rate swaps to manage its exposure to changing interest rates on its
repurchase agreements. Net payments on interest rate swaps are included in the Consolidated Statements of Cash
Flows as a component of operating activities.
The Company elected to net, by counterparty, the fair value of interest rate swap contracts. These contracts
contain legally enforceable provisions that allow for netting or setting off swap receivables and payables with each
counterparty and, therefore, the fair value of those swap contracts are netted by counterparty. The credit support annex
provisions of the Company’s interest rate swap contracts allow the parties to mitigate their credit risk by requiring the
party which is out of the money to post collateral. As the Company elected to net by counterparty the fair value of
interest rate swap contracts, it also nets by counterparty any collateral exchanged as part of the interest rate swap
contracts. Substantially all collateral is non-cash collateral under these contracts. In addition, the Company’s
agreements with certain of its counterparties with whom it has both interest rate swap contracts and master repurchase
agreements contain legally enforceable provisions that allow for netting or setting off, on an aggregate basis, all
receivables, payables and collateral postings required under both the interest rate swap contract and the master
repurchase agreement with respect to each such counterparty.
The Company may from time to time also use a variety of derivative instruments to economically hedge some
of its exposure to market risks, including interest rate and prepayment risk. Any such hedging transactions could take
a variety of forms, including the use of derivative instruments such as interest rate swap agreements, interest rate
swaptions or forward contracts. The Company may also purchase or short To-Be-Announced (“TBA”) securities,
purchase or write put or call options on TBA securities or invest in other types of mortgage derivative securities.
RCap enters primarily into U.S. Treasury, Eurodollar, federal funds, U.S. equity index and currency futures
and options contracts. The Company maintains a margin account which is settled daily with futures and options
commission merchants. Changes in the unrealized gains or losses on the futures and options contracts as well as any
foreign exchange gains and losses are reflected in the Company’s Consolidated Statements of Comprehensive
Income. Unrealized gains (losses) are excluded from net income (loss) in arriving at cash flows from operating
activities in the Consolidated Statements of Cash Flows.
Credit Risk – The Company has limited its exposure to credit losses on its portfolio of Agency mortgage-
backed securities by only purchasing securities issued by Freddie Mac, Fannie Mae or Ginnie Mae and Agency
debentures issued by the FHLB, Freddie Mac and Fannie Mae. The payment of principal and interest on the Freddie
Mac and Fannie Mae Agency mortgage-backed securities are guaranteed by those respective agencies, and the
payment of principal and interest on Ginnie Mae Agency mortgage-backed securities are backed by the full faith and
credit of the U.S. government. Principal and interest on Agency debentures are guaranteed by the agency issuing the
debenture. Substantially all of the Company’s Investment Securities have an actual or implied “AAA” rating. The
Company faces credit risk on the portions of its portfolio which are not Agency mortgage-backed securities and
Agency debentures.
F-12
Market Risk - Weakness in the mortgage market may adversely affect the performance and market value of
the Company’s investments. This could negatively impact the Company’s net book value. Furthermore, if many of
the Company’s lenders are unwilling or unable to provide additional financing, the Company could be forced to sell
its Investment Securities at an inopportune time when prices are depressed. The Company does not anticipate having
difficulty converting its assets to cash or extending financing terms due to the fact that its Agency mortgage-backed
securities and Agency debentures have an actual or implied “AAA” rating and principal payment is guaranteed by
Freddie Mac, Fannie Mae, or Ginnie Mae.
Counterparty Credit Risk – The Company is exposed to risk of loss if an issuer or a counterparty fails to
perform its obligations under contractual terms.
The Company has established policies and procedures for mitigating credit risk, including reviewing and
establishing limits for credit exposure, limiting transactions with specific counterparties, maintaining qualifying
collateral and continually assessing the creditworthiness of counterparties.
Repurchase Agreements - The Company finances the acquisition of a significant portion of its Agency
mortgage-backed securities with repurchase agreements. The Company examines each of the specified criteria in
Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 860, Transfers and
Servicing, at the inception of each transaction and has determined that each of the financings meet the specified criteria
in this guidance. None of the Company’s repurchase agreements are accounted for as components of linked
transactions. As a result, the Company separately accounts for the financial assets and related repurchase financings in
the accompanying consolidated financial statements.
Reverse repurchase agreements and repurchase agreements with the same counterparty and the same maturity
are presented net in the Consolidated Statements of Financial Condition when the terms of the agreements permit
netting. The Company reports cash flows on repurchase agreements as financing activities in the Consolidated
Statements of Cash Flows. The Company reports the net cash flows on repurchase agreements entered into by RCap
and Shannon as operating activities in the Consolidated Statements of Cash Flows.
Convertible Senior Notes – The Company records the 4% Convertible Senior Notes and 5% Convertible
Senior Notes (collectively, the “Convertible Senior Notes”) at their contractual amounts, adjusted by the effects of a
beneficial conversion feature and a contingent beneficial conversion feature. This intrinsic value is included in
“Additional paid-in capital” on the Company’s Consolidated Statements of Financial Condition and reduces the
liability associated with the Convertible Senior Notes.
The Convertible Senior Notes have a conversion price adjustment feature that is evaluated at the time of the
conversion price adjustment. A contingent beneficial conversion feature may be recognized as a result of adjustments
to the conversion price for dividends declared. The Company determined the intrinsic value of a contingent beneficial
conversion feature on its 4% Convertible Senior Notes.
Cumulative Convertible Preferred Stock - The Series B Cumulative Convertible Preferred Stock (the “Series
B Preferred Stock”) contains fundamental change provisions that allow the holder to redeem the Series B Preferred
Stock for cash if certain events occur. As redemption under these provisions is not solely within the Company’s
control, for the periods that the Company had Series B Preferred Stock issued and outstanding, the Company classified
the Series B Preferred Stock as temporary equity in the accompanying Consolidated Statements of Financial
Condition. As of December 31, 2012, there were no shares outstanding of Series B Preferred Stock.
Income Taxes - The Company has elected to be taxed as a REIT and intends to comply with the provisions of
the Code, with respect thereto. Accordingly, the Company will not be subjected to federal income tax to the extent of
its distributions to shareholders and as long as certain asset, income and stock ownership tests are met. The Company
and its direct and indirect subsidiaries, FIDAC, Merganser and RCap, have made separate joint elections to treat these
subsidiaries as taxable REIT subsidiaries. As such, each of the taxable REIT subsidiaries are taxable as a domestic C
corporation and subject to federal, state, and local income taxes based upon their taxable income. FIDAC Europe is
located in Europe and is not currently required to pay United States income taxes. FIDAC Europe was sold by the
Company in December 2012.
F-13
The provisions of ASC 740, Income Taxes (“ASC 740”), clarify the accounting for uncertainty in income
taxes recognized in financial statements and prescribe a recognition threshold and measurement attribute for tax
positions taken or expected to be taken on a tax return. ASC 740 also requires that interest and penalties related to
unrecognized tax benefits be recognized in the financial statements. The Company does not have any unrecognized tax
benefits that would affect its financial position. Thus, no accruals for penalties and interest were necessary as of
December 31, 2012 and 2011.
Goodwill and Intangible Assets - The Company’s acquisitions of FIDAC and Merganser and FIDAC
Europe’s acquisition of certain assets were accounted for using the acquisition method. Under the acquisition method,
net assets and results of operations of acquired companies are included in the consolidated financial statements from
the date of acquisition. The costs of FIDAC and Merganser were allocated to the assets acquired, including identifiable
intangible assets, and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess
of purchase price over the fair value of the net assets acquired was recognized as goodwill. In addition, FIDAC
Europe acquired a customer relationship after its formation. Goodwill and intangible assets are periodically (but not
less frequently than annually) reviewed for potential impairment. Intangible assets with an estimated useful life are
amortized over the expected life. During the years ended December 31, 2012, 2011 and 2010, there were no
impairment losses recognized related to goodwill and intangible assets.
Stock-Based Compensation - The Company is required to measure and recognize in the consolidated financial
statements the compensation cost relating to share-based payment transactions. The Company recognizes
compensation expense on a straight-line basis over the requisite service period for the entire award.
Use of Estimates - The preparation of the consolidated financial statements in conformity with U.S. GAAP
requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. All assets classified as trading or available-for-sale and interest
rate swaps are reported at their estimated fair value, based on market prices. The Company’s policy is to obtain fair
values from one or more independent sources to compare to internal prices for reasonableness. Actual results could
differ from those estimates.
A Summary of Recent Accounting Pronouncements Follows:
Presentation
Balance Sheet (ASC 210)
On December 23, 2011, FASB released ASU 2011-11 Balance Sheet: Disclosures about Offsetting Assets
and Liabilities. Under this update, the Company will be required to disclose both gross information and net
information about both instruments and transactions eligible for offset in the statement of financial position and
transactions subject to an agreement similar to a master netting arrangement. The scope would include derivatives,
sale and repurchase agreements and reverse sale and repurchase agreements and securities borrowing and securities
lending arrangements. This disclosure is intended to enable financial statement users to understand the effect of such
arrangements on the Company’s financial position. In January 2013, FASB released ASU 2013-01 Balance Sheet:
Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities, which served solely to clarify the scope of
financial instruments included in ASU 2011-11 as there was concern about diversity in practice. The objective of
these updates is to support further convergence of US GAAP and IFRS requirements. The updates are effective for
annual reporting periods beginning on or after January 1, 2013 and may result in additional disclosures for the
Company.
Comprehensive Income (ASC 220)
In June 2011, FASB released Accounting Standards Update (“ASU”) 2011-05, which attempts to improve
the comparability, consistency, and transparency of financial reporting and increase the prominence of items reported
in other comprehensive income (“OCI”). The amendment requires that all non-owner changes in stockholders’ equity
be presented either in a single continuous statement of net income and comprehensive income or two separate
consecutive statements. Either presentation requires the presentation on the face of the financial statements any
F-14
reclassification adjustments for items that are reclassified from OCI to net income in the statements. There is no
change in what must be reported in OCI or when an item of OCI must be reclassified to net income. This update was
effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. This update
resulted in additional disclosure, but did not have a material effect on the Company’s consolidated financial
statements.
On December 23, 2011, the FASB issued ASU 2011-12, Comprehensive Income: Deferral of Effective Date
for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income In
ASU No. 2011-05, which defers those changes in ASU 2011-05 that relate to the presentation of reclassification
adjustments out of accumulated OCI. This was done to allow the FASB time to re-deliberate the presentation on the
face of the financial statements the effects of reclassifications out of accumulated OCI on the components of net
income and OCI. No other requirements under ASU 2011-05 are affected by ASU 2011-12. FASB tentatively
decided not to require presentation of reclassification adjustments out of accumulated other comprehensive income on
the face of the financial statements and to propose new disclosures instead.
In February 2013, the FASB issued ASU 2013-02 Comprehensive Income: Reporting of Amounts
Reclassified Out of Accumulated Other Comprehensive Income. This update addresses the disclosure issue left open at
the deferral under ASU 2011-12. This update requires the provision of information about the amounts reclassified out
of accumulated OCI by component. In addition, it requires presentation, either on the face of the statement where net
income is presented or in the notes, significant amounts reclassified out of accumulated OCI by the respective line
items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in
its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in
their entirety to net income, a cross-reference must be provided to other disclosures required under U.S. GAAP that
provide additional detail about those amounts. This update, which will increase disclosures for the Company as
outlined above, is effective for reporting periods beginning after December 15, 2012 with early adoption permitted.
The Company has not elected early adoption.
Assets
Intangibles – Goodwill and Other (ASC 350)
In September 2011, FASB released ASU 2011-08, which allows an entity to first assess qualitative factors to
determine whether it is necessary to perform the two-step quantitative goodwill impairment test. The objective of the
update is to simplify how entities test goodwill for impairment. Under this update, an entity is not required to
calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is
less than its carrying amount. This update if effective for annual and interim goodwill impairment tests performed for
fiscal years beginning after December 15, 2011. The Company was not eligible to elect early adoption. This update
has no material effect on the Company’s consolidated financial statements.
Broad Transactions
Transfers and Servicing (ASC 860)
In April 2011, the FASB issued ASU 2011-03, Transfers and Servicing: Reconsideration of Effective Control
for Repurchase Agreements. In a typical repurchase agreement transaction, an entity transfers financial assets to the
counterparty in exchange for cash with an agreement for the counterparty to return the same or equivalent financial
assets for a fixed price in the future. Previous to this update, one of the factors in determining whether sale treatment
could be used was whether the transferor maintained effective control of the transferred assets and in order to do so,
the transferor must have the ability to repurchase such assets. In connection with the issuance of ASU 2011-03, the
FASB concluded that the assessment of effective control should focus on a transferor’s contractual rights and
obligations with respect to transferred financial assets, rather than whether the transferor has the practical ability to
perform in accordance with those rights or obligations. ASU 2011-03 removes the transferor’s ability criterion from
consideration of effective control. This update is effective for the first interim or annual period beginning on or after
December 15, 2011. As the Company records repurchase agreements as secured borrowings and not sales, this update
has no significant effect on the Company’s consolidated financial statements.
F-15
Financial Services – Investment Companies (ASC 946)
In October 2011, the FASB issued a proposed ASU 2011-20, Financial Services-Investment Companies:
Amendments to the Scope, Measurement, and Disclosure Requirements, which would amend the criteria in Topic 946
for determining whether an entity qualifies as an investment company for reporting purposes. As proposed, this ASU
would affect the measurement, presentation and disclosure requirements for Investment Companies, as defined, amend
the investment company definition in ASC 946, and remove the current exemption for Real Estate Investment Trusts
from this topic. If promulgated in its current form, this proposal may result in a material modification to the
presentation of the Company’s consolidated financial statements.
On December 12, 2012, the FASB agreed that the accounting for real estate investments should be considered in a
second phase of the Investment Companies project and that all REITs should be exempted from conclusions reached in
phase I of the project. The Board has not yet agreed on the scope of phase II of the project.
The Company is monitoring developments related to this proposal and is evaluating the effects it would have on the
Company’s consolidated financial statements.
F-16
2.
AGENCY MORTGAGE-BACKED SECURITIES
The following tables present the Company’s available-for-sale Agency mortgage-backed securities portfolio
as of December 31, 2012 and 2011 which were carried at their fair value:
December 31, 2012
Freddie Mac
Fannie Mae
Ginnie Mae
(dollars in thousands)
Total Mortgage-
Backed Securities
Agency mortgage-backed securities,
par value
Unamortized discount
Unamortized premium
Amortized cost
Gross unrealized gains
Gross unrealized losses
$44,296,234
(9,515)
2,121,478
46,408,197
1,166,299
(36,890)
$70,649,782
(12,315)
3,695,381
74,332,848
$273,988
(389)
39,348
312,947
$115,220,004
(22,219)
5,856,207
121,053,992
1,913,334
(146,533)
17,583
(4,578)
3,097,216
(188,001)
Estimated fair value
$47,537,606
$76,099,649
$325,952
$123,963,207
Adjustable rate
Fixed rate
Total
Amortized Cost
Gross Unrealized
Gain
Gross Unrealized
Loss
Estimated Fair
Value
(dollars in thousands)
$5,786,718
115,267,274
$259,013
2,838,203
($4,613)
(183,388)
$6,041,118
117,922,089
$121,053,992
$3,097,216
($188,001)
$123,963,207
December 31, 2011
Freddie Mac
Fannie Mae
Ginnie Mae
(dollars in thousands)
Total Mortgage-
Backed Securities
Agency mortgage-backed securities,
par value
Unamortized discount
Unamortized premium
Amortized cost
Gross unrealized gains
Gross unrealized losses
$34,395,542
(9,874)
1,139,881
35,525,549
$63,066,372
(13,632)
2,205,138
65,257,878
973,476
(15,243)
2,081,282
(118,871)
$500,968
(399)
15,949
516,518
31,474
(1,008)
$97,962,882
(23,905)
3,360,968
101,299,945
3,086,232
(135,122)
Estimated fair value
$36,483,782
$67,220,289
$546,984
$104,251,055
Adjustable rate
Fixed rate
Total
Amortized Cost
Gross Unrealized
Gain
(dollars in thousands)
Gross Unrealized
Loss
Estimated Fair
Value
$8,698,746
92,601,199
$345,642
2,740,590
($3,188)
(131,934)
$9,041,200
95,209,855
$101,299,945
$3,086,232
($135,122)
$104,251,055
Actual maturities of Agency Mortgage-Backed Securities are generally shorter than stated contractual
maturities because actual maturities of Agency Mortgage-Backed Securities are affected by the contractual lives of the
underlying mortgages, periodic payments of principal, and prepayments of principal. The following table summarizes
F-17
the Company’s Agency Mortgage-Backed Securities on December 31, 2012 and 2011, according to their estimated
weighted-average life classifications:
Weighted-Average Life
Fair Value
Amortized
Cost
(dollars in thousands)
Fair Value
Amortized
Cost
December 31, 2012
December 31, 2011
Less than one year
Greater than one year through five years
Greater than five years through ten years
Greater than ten years
$ 1,264,094 $ 1,250,405
116,510,310
2,992,054
301,223
119,288,168
3,104,073
306,872
$ 1,715,530
97,344,791
4,447,540
743,194
$ 1,697,101
94,534,782
4,348,841
719,221
Total
$123,963,207
$121,053,992
$104,251,055
$101,299,945
The weighted-average lives of the Agency mortgage-backed securities at December 31, 2012 and 2011 in the
table above are based upon data provided through subscription-based financial information services, assuming
constant principal prepayment rates to the reset date of each security. The prepayment model considers current yield,
forward yield, steepness of the yield curve, current mortgage rates, mortgage rate of the outstanding loans, loan age,
margin, volatility, and other factors. The actual weighted average lives of the Agency mortgage-backed securities
could be longer or shorter than estimated.
The following table presents the gross unrealized losses and estimated fair value of the Company’s Agency
mortgage-backed securities by length of time that such securities have been in a continuous unrealized loss position at
December 31, 2012 and December 31, 2011.
Unrealized Loss Position For:
(dollars in thousands)
Less than 12 Months
December 31,
Estimated
Fair Value
Unrealized
Losses
Number
of
Securities
Estimated
Fair Value
12 Months or More
Unrealized
Losses
Number
of
Securities
Estimated
Fair Value
Total
Unrealized
Losses
2012
2011
$11,220,514
($82,721)
187
$147,775
($105,280)
$1,087,552
($118,593)
71
$883,143
($16,529)
39
36
$11,368,289
($188,001)
$1,970,695
($135,122)
Number
of
Securities
226
107
The decline in value of these securities is solely due to market conditions and not the credit quality of the
assets. Substantially all of the Company’s Investment Securities are Agency mortgage-backed securities that are
“AAA” rated or carry an implied “AAA” rating. The investments are not considered to be other-than-temporarily
impaired because the Company currently has the ability and intent to hold the investments to maturity or for a period
of time sufficient for a forecasted market price recovery up to or beyond the cost of the investments, and it is not more
likely than not that the Company will be required to sell the investments before recovery of the amortized cost bases,
which may be maturity. Also, the Company is guaranteed payment of the principal amount of the securities by the
respective issuing agency.
During the year ended December 31, 2012, the Company sold $30.4 billion of Agency mortgage-backed
securities, resulting in a realized gain of $438.5 million. During the year ended December 31, 2011, the Company sold
$18.7 billion of Agency mortgage-backed securities, resulting in a realized gain of $199.2 million. During the year
ended December 31, 2010, the Company sold $7.8 billion of Agency Mortgage-Backed Securities, resulting in a
realized gain of $171.6 million. Average cost is used as the basis on which the realized gain or loss on sale is
determined.
Agency interest-only mortgage-backed securities represent the right to receive a specified portion of the
contractual interest flows of the underlying unamortized principal balance of specific Agency mortgage-backed
securities. As of December 31, 2012 and 2011, Agency interest-only mortgage-backed securities had net unrealized
losses of $141.1 and $123.1 million and an amortized cost of $797.1 million and $405.1 million, respectively.
F-18
3.
INVESTMENT IN AFFILIATES, AVAILABLE-FOR-SALE EQUITY SECURITIES
Substantially all of the Company’s available-for-sale equity securities are shares of Chimera Investment
Corporation (“Chimera”) and CreXus Investment Corp. (“CreXus”) and are reported at fair value. The Company
owned approximately 45.0 million shares of Chimera at a fair value of approximately $117.4 million at December 31,
2012 and approximately 45.0 million shares of Chimera at a fair value of approximately $112.9 million at December
31, 2011. At December 31, 2012, the investment in Chimera had an unrealized loss of $21.5 million. The Company
owned approximately 9.5 million shares of CreXus at a fair value of approximately $116.7 million at December 31,
2012 and approximately 9.5 million shares of CreXus at a fair value of approximately $98.9 million at December 31,
2011. At December 31, 2012, the investment in CreXus had an unrealized loss of $8.7 million.
The Company has evaluated the near-term prospects of its investment in affiliates in relation to the severity
and length of time of the impairment. Based on this evaluation, management has determined that its investment in
affiliates is not considered to be other-than-temporarily impaired as of December 31, 2012 and December 31, 2011 as
the Company has the intent and ability to retain its investments for a period of time sufficient to allow for any
anticipated recovery in market value.
On November 9, 2012, the Company announced that it had proposed to the Board of Directors of CreXus that
the Company acquire for cash all of the shares of CreXus that the Company does not currently own.
4.
GOODWILL
At December 31, 2012 and 2011 goodwill totaled $55.4 million and $42.0 million, respectively. There was
no impairment for the years ended December 31, 2012 and 2011. Merganser’s prior owners received an additional
payment of $13.4 million during the year ended December 31, 2012 relating to earn-out provisions in the merger
agreement. This amount was recorded as additional goodwill.
5.
FAIR VALUE MEASUREMENTS
The Company follows fair value guidance in accordance with U.S. GAAP to account for its financial
instruments. The Company categorizes its financial instruments, based on the priority of the inputs to the valuation
technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in
active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If
the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is
based on the lowest level input that is significant to the fair value measurement of the instrument. Financial assets and
liabilities recorded at fair value on the consolidated statements of financial condition or disclosed in the related notes
are categorized based on the inputs to the valuation techniques as follows:
Level 1– inputs to the valuation methodology are quoted prices (unadjusted) for identical assets and liabilities
in active markets.
Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active
markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially
the full term of the financial instrument.
Level 3 – inputs to the valuation methodology are unobservable and significant to overall fair value.
Agency mortgage-backed securities, Agency debentures and interest rate swaps are valued using quoted
prices, including dealer quotes, or internally estimated prices for similar assets. The Company incorporates common
market pricing methods, including a spread measurement to the Treasury curve as well as underlying characteristics of
the particular security including coupon, periodic and life caps, rate reset period and expected life of the security in its
estimates of fair value. Management reviews the fair values generated by the model to determine whether prices are
reflective of the current market. Management indirectly corroborates its estimates of the fair value using pricing
models by comparing its results to independent prices provided by dealers in the securities and/or third party pricing
F-19
services. Certain liquid asset classes, such as Agency fixed-rate pass-throughs, may be priced using independent
sources such as quoted prices for To-Be-Announced (“TBA”) securities.
The Agency mortgage-backed securities market is considered to be an active market such that participants
transact with sufficient frequency and volume to provide transparent pricing information on an ongoing basis. The
liquidity of the Agency mortgage-backed securities market and the similarity of the Company’s securities to those
actively traded enable the Company to observe quoted prices in the market and utilize those prices as a basis for
formulating fair value measurements. Consequently, the Company has classified Agency mortgage-backed securities
as Level 2 inputs in the fair value hierarchy.
The fair value of U.S. Treasury securities, securities borrowed and loaned, investments in affiliates and equity
investments are based on quoted prices in active markets.
At December 31, 2012
Assets:
U.S. Treasury Securities
Agency mortgage-backed securities
Agency debentures
Investment in affiliates
Other derivative contracts
Liabilities:
U.S. Treasury securities sold, not yet purchased
Interest rate swaps
Level 1
Level 2
Level 3
(dollars in thousands)
$752,076
-
-
234,120
7,955
495,437
-
$ -
123,963,207
3,009,568
-
1,875
-
2,584,907
At December 31, 2011
(dollars in thousands)
Level 1
Level 2
Level 3
Assets:
U.S. Treasury Securities
Agency mortgage-backed securities
Agency debentures
Investment in affiliates
Equity securities
Other derivative contracts
Liabilities:
U.S. Treasury securities sold, not yet purchased
Interest rate swaps
$928,547
-
-
211,970
3,891
113
826,912
-
$ -
104,251,055
889,580
-
-
-
-
2,552,687
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
F-20
The following table summarizes the estimated fair value for all financial assets and liabilities as of December 31,
2012 and December 31, 2011.
Level in
Fair Value
Hierarchy
for 2012
Financial assets:
Cash and cash equivalents(1)
Reverse repurchase
agreements(1)
U.S. Treasury Securities(2)
Securities borrowed(2)
Agency mortgage-backed
securities
Agency debentures
Investment in affiliates(2)
Equity securities(2)
Corporate debt(3)
Other derivatives(2)
Financial liabilities:
U.S. Treasury Securities sold,
not yet purchased(2)
Repurchase agreements(1)(4)
Securities loaned(2)
Convertible Senior Notes(2)
Interest rate swaps
1
1
1
2
2
2
1
1
2
1,2
1
1,2
2
1
2
December 31, 2012
December 31, 2011
Carrying
Value
Fair Value
Carrying
Value
Fair Value
(dollars in thousands)
$ 615,789 $ 615,789
$ 994,198
$ 994,198
1,811,095
752,076
2,160,942
1,811,095
752,076
2,160,942
123,963,207
3,009,568
234,120
-
63,944
9,830
123,963,207
3,009,568
234,120
-
64,271
9,830
860,866
928,547
928,732
104,251,055
889,580
211,970
3,891
52,073
113
860,866
928,547
928,732
104,251,055
889,580
211,970
3,891
52,628
113
$ 495,437
102,785,697
1,808,315
825,541
2,584,907
$ 495,437
103,332,832
1,808,315
899,192
2,584,907
$ 826,912
84,097,885
804,901
539,913
2,552,687
$826,912
84,369,817
804,901
685,500
2,552,687
(1) The fair value of cash accounts and repurchase agreements with maturities less than one year approximates carrying value due to the
short-term maturities of these items.
(2) Fair value is determined using end of day quoted prices in active markets.
(3) The carrying value of the corporate debt is based on amortized cost. Estimates of fair value of corporate debt require the use of
significant judgments and inputs including, but not limited to, the enterprise value of the borrower (i.e., an estimate of the total fair value
of the borrower's debt and equity), the nature and realizable value of any collateral, the borrower’s ability to make payments when due
and its earnings history. Management also considers factors that affect the macro and local economic markets in which the borrower
operates.
(4) The fair value of repurchase agreements with maturities greater than one year are valued as pay fixed versus receive floating interest rate
swaps.
F-21
6.
REPURCHASE AGREEMENTS
The Company had outstanding $102.8 billion and $84.1 billion of repurchase agreements with weighted
average borrowing rates of 1.53% and 1.59%, after giving effect to the Company’s interest rate swaps, and weighted
average remaining maturities of 191 days and 103 days as of December 31, 2012 and December 31, 2011,
respectively. Investment Securities and U.S. Treasury Securities pledged as collateral under these repurchase
agreements and interest rate swaps had an estimated fair value and accrued interest of $109.2 billion and $363.8
million at December 31, 2012, respectively, and $91.3 billion and $337.0 million at December 31, 2011, respectively.
At December 31, 2012 and 2011, the repurchase agreements had the following remaining maturities:
December 31, 2012
December 31, 2011
Repurchase
Agreements
Weighted Average
Rate
Repurchase
Agreements
Weighted Average
Rate
1 day
2 to 29 days
30 to 59 days
60 to 89 days
90 to 119 days
Over 120 days
Total
$ -
33,191,448
28,383,851
8,602,680
4,804,671
27,803,047
$102,785,697
7. DERIVATIVE INSTRUMENTS
(dollars in thousands)
-
0. 50%
0.45%
0.42%
0.57%
1.03%
0.63%
$ 508,647
33,780,070
28,346,380
3,699,425
6,781,137
10,982,226
$84,097,885
0.50%
0.37%
0.37%
0.93%
0.37%
1.39%
0.53%
In connection with the Company’s interest rate risk management strategy, the Company economically hedges a
portion of its interest rate risk by entering into derivative financial instrument contracts. As of December 31, 2012,
such instruments are comprised of interest rate swaps, which in effect modify the cash flows on repurchase
agreements, or convert floating rate liabilities to fixed rates. The purpose of the swaps is to mitigate the risk of rising
interest rates that affect the Company’s cost of funds. The use of interest rate swaps creates exposure to credit risk
relating to potential losses that could be recognized if the counterparties to these instruments fail to perform their
obligations under the contracts. In the event of a default by the counterparty, the Company could have difficulty
obtaining its Investment Securities pledged as collateral for swaps. The Company’s interest rate swaps have not been
designated as hedging instruments for accounting purposes.
The location and fair value of interest rate swaps reported in the Consolidated Statements of Financial Condition
as of December 31, 2012 and December 31, 2011 are as follows:
Location on Consolidated Statements of
Financial Condition
Notional
Amount
Net Estimated Fair
Value
(dollars in thousands)
December 31, 2012
December 31, 2012
December 31, 2011
December 31, 2011
Assets: Interest rate swaps, at fair value
Liabilities: Interest rate swaps, at fair value
Assets: Interest rate swaps, at fair value
Liabilities: Interest rate swaps, at fair value
-
$46,911,800
-
$40,109,880
-
($2,584,907)
-
($2,552,687)
F-22
The effect of interest rate swaps on the Consolidated Statements of Comprehensive Income is as follows:
Location on Statement of Operations and Comprehensive Income
Realized Gains
(Losses) on
Interest Rate Swaps(1)
Gain (loss) on
Termination of
Interest Rate Swaps
(dollars in thousands)
Unrealized Gains
(Losses) on Interest
Rate Swaps
For the Year Ended December 31, 2012
For the Year Ended December 31, 2011
For the Year Ended December 31, 2010
($893,769)
($882,395)
($735,107)
($2,385)
-
-
($32,219)
($1,815,107)
($318,832)
(1) Net interest payments on interest rate swaps is presented in the Company’s Consolidated Statements of Operations and Comprehensive Income
(Loss) as realized gains (losses) on interest rate swaps.
The Company’s interest rate swap weighted average pay rate at December 31, 2012 was 2.21% and the
weighted average receive rate was 0.24%. The weighted average pay rate at December 31, 2011 was 2.55% and the
weighted average receive rate was 0.33%. Without netting the market value of the swaps by dealer at December 31,
2012, the gross unrealized losses on interest rate swaps was $2.6 billion, with a notional amount of $45.8 billion and
the gross unrealized gains on interest rate swaps was $26.0 million with a notional amount of $1.1 billion. Without
netting the market value of the swaps by dealer at December 31, 2011, the gross unrealized losses on interest rate
swaps was $2.6 billion, with a notional amount of $40.1 billion.
Certain of the Company’s derivative contracts are subject to International Swaps and Derivatives Association
Master Agreements (“ISDA”) which contain provisions that grant counterparties certain rights with respect to the
applicable ISDA upon the occurrence of (i) negative performance that results in a decline in net assets in excess of
specified thresholds or dollar amounts over set periods of time, (ii) the Company’s failure to maintain its REIT status,
(iii) the Company’s failure to comply with limits on the amount of leverage, and (iv) the Company’s stock being
delisted from the New York Stock Exchange (NYSE). Upon the occurrence of items (i) through (iv), the counterparty
to the applicable ISDA has a right to terminate the ISDA in accordance with its provisions. The aggregate fair value of
all derivative instruments with credit-risk-related contingent features that are in a net liability position at December 31,
2012 is approximately $2.6 billion, including accrued interest, which represents the maximum amount the Company
would be required to pay upon termination, which is fully collateralized.
In connection with RCap’s proprietary trading activities, it enters primarily into U.S. Treasury, Eurodollar,
federal funds and German government and U.S. equity index futures and options contracts. RCap invests in futures
and options contracts for economic hedging purposes to reduce exposure to changes in yields of its U.S. Treasury
securities and for speculative purposes to achieve capital appreciation. The use of futures and options contracts creates
exposure to credit risk relating to potential loses that could be recognized if the counterparties to these instruments fail
to perform their obligations under the contracts. RCap executes these trades as a customer of an appropriately licensed
futures and options broker dealer. RCap’s derivative contracts are presented in the Consolidated Statements of
Financial Condition as Other derivatives.
8. CONVERTIBLE SENIOR NOTES
In 2010, the Company issued $600.0 million in aggregate principal amount of its 4% convertible senior notes
due 2015 (“4% Convertible Senior Notes”) for net proceeds of approximately $582.0 million. Interest on the 4%
Convertible Senior Notes is paid semi-annually at a rate of 4% per year and the 4% Convertible Senior Notes will
mature on February 15, 2015 unless repurchased or converted earlier. The 4% Convertible Senior Notes are
convertible into shares of Common Stock at a conversion rate for each $1,000 principal amount of 4% Convertible
Senior Notes. The initial conversion rate was 46.6070, which was equivalent to an initial conversion price of
approximately $21.4560 per share of Common Stock. The conversion rate at December 31, 2012 was 70.6980, which
is equivalent to a conversion price of approximately $14.1447 per share of Common Stock. The conversion rate is
subject to adjustment in certain circumstances. There is no limit on the total number of shares of Common Stock that
the Company would be required to issue upon a conversion.
F-23
The intrinsic value of the contingent beneficial conversion feature was $75.8 million and $60.1 million,
respectively, at December 31, 2012 and December 31, 2011, which is reflected in Additional paid in capital on the
Company’s Consolidated Statements of Financial Condition, and serves to reduce the 4% Convertible Senior Notes
liability. The discount to the principal amount of the 4% Convertible Senior Notes at December 31, 2012 and
December 31, 2011 of $22.7 million and $60.1 million, respectively, is recognized in interest expense over the
remaining life of the notes.
During the year ended December 31, 2012, the Company repurchased approximately $492.5 million of the
outstanding $600.0 million of our 4% Convertible Senior Notes for $617.5 million, resulting in a loss on
extinguishment of debt of $162.3 million.
In May 2012, the Company issued $750.0 million in aggregate principal amount of its 5% convertible senior
notes due 2015 (“5% Convertible Senior Notes”) for net proceeds of approximately $727.5 million. Interest on the 5%
Convertible Senior Notes is paid semi-annually at a rate of 5% per year and the 5% Convertible Senior Notes will
mature on May 15, 2015 unless repurchased or converted earlier. The 5% Convertible Senior Notes are convertible
into shares of Common Stock at a conversion rate for each $1,000 principal amount of 5% Convertible Senior Notes.
The initial conversion rate and conversion rate at December 31, 2012 is 52.7969, which is equivalent to an initial
conversion price of approximately $18.94 per share of Common Stock, subject to adjustment in certain circumstances.
Upon conversion, the Company will pay or deliver, as the case may be, cash, shares of Common Stock or a
combination of cash and shares of Common Stock, at the Company’s sole discretion. There is no limit on the total
number of shares of Common Stock that the Company would be required to issue upon a conversion.
At issuance, the Company determined that the 5% Convertible Senior Notes included an equity component of
$11.7 million, which is reflected in Additional paid in capital on the Company’s Consolidated Statements of Financial
Condition, and serves to reduce the 5% Convertible Senior Notes liability. The $11.7 million discount to the principal
amount of the Convertible Senior Notes is recognized in interest expense over the remaining life of the notes using the
effective yield method. At December 31, 2012, $9.3 million of the discount had not been reflected in interest expense.
The 4% Convertible Senior Notes due 2015 and the 5% Convertible Senior Notes due 2015 rank pari passu
with each other. They are each general corporate obligations and therefore rank junior to collateralized debt of the
company with respect to secured collateral.
The 4% Convertible Senior Notes due 2015 and the 5% Convertible Senior Notes due 2015 rank senior to the
7.875% Series A Cumulative Redeemable Preferred Stock, 7.625% Series C Cumulative Redeemable Preferred Stock
and 7.50% Series D Cumulative Redeemable Preferred Stock. The 7.875% Series A Cumulative Redeemable
Preferred Stock, 7.625% Series C Cumulative Redeemable Preferred Stock and 7.50% Series D Cumulative
Redeemable Preferred Stock rank pari passu with each other.
The 7.875% Series A Cumulative Redeemable Preferred Stock, 7.625% Series C Cumulative Redeemable
Preferred Stock and 7.50% Series D Cumulative Redeemable Preferred Stock rank senior to the common stock of the
company.
9. COMMON STOCK AND PREFERRED STOCK
(A) Common Stock
During the year ended December 31, 2012, 603,000 options were exercised for an aggregate exercise price of
$8.4 million. During the year ended December 31, 2011, 679,000 options were exercised for an aggregate exercise
price $9.0 million, respectively.
During the year ended December 31, 2012, 1.3 million shares of Series B Preferred Stock were converted into
4.0 million shares of common stock. During the year ended December 31, 2011, 320,000 shares of Series B Preferred
Stock were converted into 906,000 shares of common stock.
F-24
During the year ended December 31, 2012, we raised $2.8 million, by issuing 170,000 shares, through the
Direct Purchase and Dividend Reinvestment Program. During the year ended December 31, 2011, we raised $455.5
million by issuing 26.2 million shares through the Direct Purchase and Dividend Reinvestment Program, respectively.
On March 19, 2012, we entered into six separate Distribution Agency Agreements (or Distribution Agency
Agreements) with each of Merrill Lynch, Pierce, Fenner & Smith Incorporated, Credit Suisse Securities (USA) LLC,
Goldman, Sachs & Co., J.P. Morgan Securities LLC, Morgan Stanley & Co. LLC and RCap Securities, Inc. (together,
the Agents). Pursuant to the terms of the Distribution Agency Agreements, we may sell from time to time through the
Agents, as our sales agents, up to 125,000,000 shares of our common stock. We did not make any sales under the
Distribution Agency Agreements during the year ended December 31, 2012.
On October 16, 2012, the Company announced that its Board of Directors has authorized the repurchase of up
to $1.5 billion of its outstanding common shares over a 12 month period. All common shares purchased were part of a
publicly announced plan in open-market transactions. During the year December 31, 2012, the Company repurchased
approximately 27.8 million shares of its outstanding common stock for $397.1 million, of which $141.1 million had
not settled at December 31, 2012.
On January 4, 2011, the Company entered into an agreement pursuant to which it sold 86,250,000 shares of
its common stock for net proceeds following expenses of approximately $1.5 billion. This transaction settled on
January 7, 2011.
On February 15, 2011, the Company entered into an agreement pursuant to which it sold 86,250,000 shares of
its common stock for net proceeds following expenses of approximately $1.5 billion. This transaction settled on
February 18, 2011.
On July 11, 2011, the Company entered into an agreement pursuant to which it sold 138,000,000 shares of its
common stock for net proceeds following expenses of approximately $2.4 billion. This transaction settled on July 15,
2011.
On June 23, 2011, the Company amended its charter to increase the number of authorized shares of capital
stock, par value $0.01 per share, from 1,000,000,000 shares to 2,000,000,000 shares, consisting of 1,987,987,500
shares classified as Common Stock, 7,412,500 shares classified as 7.875% Series A Cumulative Redeemable Preferred
Stock, and 4,600,000 shares classified as 6.00% Series B Cumulative Convertible Preferred Stock.
On May 16, 2012, the Company amended its charter through the filing of articles supplementary to its charter
to reclassify 12,650,000 shares of authorized shares of Common Stock as 7.625% Series C Cumulative Redeemable
Preferred Stock.
On September 13, 2012, the Company amended its charter through the filing of articles supplementary to its
charter to reclassify 18,400,000 shares of authorized shares of Common Stock as 7.50% Series D Cumulative
Redeemable Preferred Stock. Following the effectiveness of the articles supplementary to its charter the Company’s
authorized shares of capital stock, par value of $0.01 per share, consists of 1,956,937,500 shares classified as Common
Stock, 7,412,500 shares classified as 7.875% Series A Cumulative Redeemable Preferred Stock, 4,600,000 shares
classified as 6.00% Series B Cumulative Convertible Preferred Stock, 12,650,000 shares classified as 7.625% Series C
Cumulative Redeemable Preferred Stock and 18,400,000 shares classified as 7.50% Series D Cumulative Redeemable
Preferred Stock.
(B) Preferred Stock
At December 31, 2012 and December 31, 2011, the Company had issued and outstanding 7,412,500 shares of
Series A Cumulative Redeemable Preferred Stock (“Series A Preferred Stock”), with a par value of $0.01 per share
and a liquidation preference of $25.00 per share plus accrued and unpaid dividends (whether or not declared). The
Series A Preferred Stock is entitled to a dividend at a rate of 7.875% per year based on the $25.00 liquidation
preference before the common stock is entitled to receive any dividends. The Series A Preferred Stock is redeemable
at $25.00 per share plus accrued and unpaid dividends (whether or not declared) exclusively at the Company's option
commencing on April 5, 2009 (subject to the Company's right under limited circumstances to redeem the Series A
Preferred Stock earlier in order to preserve its qualification as a REIT). The Series A Preferred Stock is senior to the
F-25
Company's common stock and is on parity with the Series C Preferred Stock and Series D Preferred Stock with respect
to dividends and distributions, including distributions upon liquidation, dissolution or winding up. The Series A
Preferred Stock generally does not have any voting rights, except if the Company fails to pay dividends on the Series
A Preferred Stock for six or more quarterly periods (whether or not consecutive). Under such circumstances, the Series
A Preferred Stock, together with the Series C Preferred Stock and Series D Preferred Stock, will be entitled to vote to
elect two additional directors to the Board, until all unpaid dividends have been paid or declared and restricted for
payment. In addition, certain material and adverse changes to the terms of the Series A Preferred Stock cannot be
made without the affirmative vote of holders of at least two-thirds of the outstanding shares of Series A Preferred
Stock, Series C Preferred Stock and Series D Preferred Stock. Through December 31, 2012, the Company had
declared and paid all required quarterly dividends on the Series A Preferred Stock.
In May 2012, the Company issued 12,000,000 shares of Series C Cumulative Redeemable Preferred Stock
(“Series C Preferred Stock”), with a par value of $0.01 per share and a liquidation preference of $25.00 per share plus
accrued and unpaid dividends (whether or not declared). The Series C Preferred Stock is entitled to a dividend at a rate
of 7.625% per year based on the $25.00 liquidation preference before the common stock is entitled to receive any
dividends. The Series C Preferred Stock is redeemable at $25.00 per share plus accrued and unpaid dividends (whether
or not declared) exclusively at the Company’s option commencing on May 16, 2017 (subject to the Company’s right
under limited circumstances to redeem the Series C Preferred Stock earlier in order to preserve its qualification as a
REIT or under limited circumstances related to a change of control of the Company). The Series C Preferred Stock is
senior to the Company’s common stock and is on parity with the Series A Preferred Stock and Series D Preferred
Stock with respect to dividends and distributions, including distributions upon liquidation, dissolution or winding up.
The Series C Preferred Stock generally does not have any voting rights, except if the Company fails to pay dividends
on the Series C Preferred Stock for six or more quarterly periods (whether or not consecutive). Under such
circumstances, the Series C Preferred Stock, together with the Series A Preferred Stock and Series D Preferred Stock,
will be entitled to vote to elect two additional directors to the Board, until all unpaid dividends have been paid or
declared and restricted for payment. In addition, certain material and adverse changes to the terms of the Series C
Preferred Stock cannot be made without the affirmative vote of holders of at least two-thirds of the outstanding shares
of Series C Preferred Stock and Series A Preferred Stock and Series D Preferred Stock. Through December 31, 2012,
the Company had declared and paid all required quarterly dividends on the Series C Preferred Stock.
In September 2012, the Company issued 18,400,000 shares of Series D Cumulative Redeemable Preferred
Stock (“Series D Preferred Stock”), with a par value of $0.01 per share and a liquidation preference of $25.00 per
share plus accrued and unpaid dividends (whether or not declared). The Series D Preferred Stock is entitled to a
dividend at a rate of 7.50% per year based on the $25.00 liquidation preference before the common stock is entitled to
receive any dividends. The Series D Preferred Stock is redeemable at $25.00 per share plus accrued and unpaid
dividends (whether or not declared) exclusively at the Company’s option commencing on September 13, 2017 (subject
to the Company’s right under limited circumstances to redeem the Series D Preferred Stock earlier in order to preserve
its qualification as a REIT or under limited circumstances related to a change of control of the Company). The Series
D Preferred Stock is senior to the Company’s common stock and is on parity with the Series A Preferred Stock and
Series C Preferred Stock with respect to dividends and distributions, including distributions upon liquidation,
dissolution or winding up. The Series D Preferred Stock generally does not have any voting rights, except if the
Company fails to pay dividends on the Series D Preferred Stock for six or more quarterly periods (whether or not
consecutive). Under such circumstances, the Series D Preferred Stock, together with the Series A Preferred Stock and
Series C Preferred Stock, will be entitled to vote to elect two additional directors to the Board, until all unpaid
dividends have been paid or declared and restricted for payment. In addition, certain material and adverse changes to
the terms of the Series D Preferred Stock cannot be made without the affirmative vote of holders of at least two-thirds
of the outstanding shares of Series D Preferred Stock. Through December 31, 2012, the Company had declared and
paid all required quarterly dividends on the Series D Preferred Stock.
At December 31, 2011, the Company had issued and outstanding 1,331,849 shares of Series B Preferred
Stock, with a par value $0.01 per share and a liquidation preference of $25.00 per share plus accrued and unpaid
dividends (whether or not declared). On March 27, 2012, the Company announced that it elected to convert all
outstanding shares of Series B Preferred Stock into shares of common stock. In this conversion, the Company
converted 772,000 shares of Series B Preferred Stock into 2.4 million shares of common stock and the Company had
no shares of Series B Preferred Stock outstanding at December 31, 2012.
F-26
The Series B Preferred Stock was paid a dividend at a rate of 6% per year on the $25.00 liquidation
preference before the common stock received any dividends. The Series B Preferred Stock was not redeemable. The
Series B Preferred Stock was convertible into shares of common stock at a conversion rate that adjusted from time to
time upon the occurrence of certain events, including when the Company distributed to its common shareholders in
any calendar quarter cash dividends in excess of $0.11 per share. Initially, the conversion rate was 1.7730 shares of
common shares per $25 liquidation preference, and the Series B Preferred Stock was converted into common stock at a
conversion ratio of 3.0614 shares of common stock for each share of Series B Preferred Stock. The Series B Preferred
Stock was also convertible into common shares at the option of the Series B preferred shareholder anytime at the then
prevailing conversion rate. The Series B Preferred Stock was senior to the Company’s common stock and on parity
with the Series A Preferred Stock with respect to dividends and distributions, including distributions upon liquidation,
dissolution or winding up. The Series B Preferred Stock generally did not have any voting rights, except if the
Company failed to pay dividends on the Series B Preferred Stock for six or more quarterly periods (whether or not
consecutive). Under such circumstances, the Series B Preferred Stock, together with the Series A Preferred Stock,
would be entitled to vote to elect two additional directors to the Board, until all unpaid dividends have been paid or
declared and restricted for payment. In addition, certain material and adverse changes to the terms of the Series B
Preferred Stock could not be made without the affirmative vote of holders of at least two-thirds of the outstanding
shares of Series B Preferred Stock and Series A Preferred Stock. Through December 31, 2012, the Company had
declared and paid all required quarterly dividends on the Series B Preferred Stock. During the year ended December
31, 2011, 320,000 shares of Series B Preferred Stock were converted into 906,000 shares of common stock. During
the year ended December 31, 2010, 953,000 shares of Series B Preferred Stock were converted into 2.4 million shares
of common stock. As of December 31, 2012, there were no shares outstanding of Series B Preferred Stock.
(C) Distributions to Shareholders
During the year ended December 31, 2012, the Company declared dividends to common shareholders totaling
$2.0 billion or $2.05 per share, of which $432.2 million were paid to shareholders on January 29, 2013. Dividend
distributions for the year ended December 31, 2012, were characterized, for Federal income tax purposes, as 89.3%
ordinary income, 10.7% long-term capital gains. During the year ended December 31, 2012, the Company declared
dividends to Series A Preferred shareholders totaling approximately $14.6 million or $1.97 per share, Series B
Preferred shareholders totaling approximately $289,000 or $0.375 per share, Series C Preferred shareholders totaling
approximately $14.3 million or $1.19 per share, Series D Preferred shareholders totaling approximately $10.4 million
or $0.56 per share.
During the year ended December 31, 2011, the Company declared dividends to common shareholders totaling
$2.2 billion or $2.44 per share, of which $552.8 million were paid to shareholders on January 27, 2012. Dividend
distributions for the year ended December 31, 2011, were characterized, for Federal income tax purposes, as 95.1%
ordinary income, 4.9% long-term capital gains. During the year ended December 31, 2011, the Company declared
dividends to Series A Preferred shareholders totaling approximately $14.6 million or $1.97 per share, and Series B
Preferred shareholders totaling approximately $2.3 million or $1.50 per share, which were paid to shareholders on
January 3, 2012.
F-27
10.
NET INCOME PER COMMON SHARE
The following table presents a reconciliation of net income and shares used in calculating basic and diluted
earnings per share for the years ended December 31, 2012, 2011, and 2010.
Net income
Less: Preferred stock dividends
Net income (loss) available to common shareholders, prior to
adjustment for dilutive potential common shares, if necessary
Add: Preferred Series B dividends, if dilutive
Add: Interest on Convertible Senior Notes, if dilutive
Net income available to common shareholders, as adjusted
Weighted average shares of common stock
outstanding-basic
Add: Effect of dilutive stock options, Series B Preferred Stock and
Convertible Senior Notes, if dilutive
Weighted average shares of common stock outstanding-diluted
For the years ended
(amounts in thousands)
December 31,
2011
December 31,
2012
$1,735,900
39,530
1,696,370
-
27,843
$1,724,213
972,902
32,853
1,005,755
December 31,
2010
$1,267,280
18,033
1,249,247
3,440
21,333
$1,274,020
588,193
37,114
625,307
$344,461
16,854
327,607
-
-
$327,607
874,212
307
874,519
Options to purchase 2,756,000 shares of common stock were outstanding and considered anti-dilutive as their
exercise price and option expense exceeded the average stock price for the year ended December 31, 2012. Options to
purchase 572,000 shares of common stock, were outstanding and considered anti-dilutive as their exercise price and
option expense exceeded the average stock price for the year ended December 31, 2011. Options to purchase 565,000
shares of common stock, were outstanding and considered anti-dilutive as their exercise price and option expense
exceeded the average stock price for the year ended December 31, 2010.
11.
LONG-TERM STOCK INCENTIVE PLAN
The Company has adopted the 2010 Equity Incentive Plan, which authorizes the Compensation Committee of
the board of directors to grant options, stock appreciation rights, dividend equivalent rights, or other share-based
awards, including restricted shares up to an aggregate of 25,000,000 shares, subject to adjustments as provided in the
2010 Equity Incentive Plan. The Company had adopted a long term stock incentive plan for executive officers, key
employees and non-employee directors (the “Prior Plan”). The Prior Plan authorized the Compensation Committee of
the board of directors to grant awards, including non-qualified options as well as incentive stock options as defined
under Section 422 of the Code. The Prior Plan authorized the granting of options or other awards for an aggregate of
the greater of 500,000 shares or 9.5% of the diluted outstanding shares of the Company’s common stock, up to a
ceiling of 8,932,921 shares. No further awards will be made under the Prior Plan, although existing awards remain
effective.
Stock options were issued at the market price on the date of grant, subject to an immediate or four year
vesting in four equal installments with a contractual term of 5 or 10 years.
F-28
The Company has issued and outstanding the following stock options as of December 31, 2012 and 2011:
For the year ended
December 31, 2012
December 31, 2011
Number of
Shares
Weighted
Average
Exercise Price
Number of
Shares
Options outstanding at the beginning of year
Granted
Exercised
Forfeited
Expired
Options outstanding at the end of period
Options exercisable at the end of the period
6,216,805
7,500
(603,169)
(2,450)
-
5,618,686
4,988,124
$15.57
17.11
13.98
16.15
-
$15.74
$16.06
6,891,975
7,500
(678,920)
-
(3,750)
6,216,805
4,451,693
Weighted
Average
Exercise Price
$15.33
18.67
13.19
-
12.15
$15.57
$16.17
The weighted average remaining contractual term was approximately 4.3 years for stock options outstanding
and approximately 4.0 years for stock options exercisable as of December 31, 2012. As of December 31, 2012, there
was approximately $679,000 of total unrecognized compensation cost related to nonvested share-based compensation
awards. That cost is expected to be recognized over a weighted average period of 3 months.
The weighted average remaining contractual term was approximately 5.5 years for stock options outstanding
and approximately 4.8 years for stock options exercisable as of December 31, 2011. As of December 31, 2011, there
was approximately $4.2 million of total unrecognized compensation cost related to nonvested share-based
compensation awards. That cost is expected to be recognized over a weighted average period of 1.1 years.
12.
INCOME TAXES
For the year ended December 31, 2012 the Company is qualified to be taxed as a REIT. As a REIT, the
Company is not subject to federal income tax to the extent that it distributes its taxable income to its shareholders. To
maintain qualification as a REIT, the Company must distribute at least 90% of its annual REIT taxable income to its
shareholders and meet certain other requirements. It is generally the Company’s policy to distribute to its shareholders
all of the Company’s taxable income except for the amount of taxable income attributable to certain employee
remuneration deductions disallowed for tax purposes pursuant to Internal Revenue Code Section 162(m).
Accordingly, in general, the Company is subject to federal, state and local income taxes on taxable income
attributable to the Section 162(m) disallowance. It is assumed that the Company intends to retain its REIT status by
complying with the REIT regulations and its distribution policy in the future. The state and city tax jurisdictions for
which the Company is subject to tax filing obligations recognized the Company’s status as a REIT.
During the year ended December 31, 2012, the Company’s taxable REIT subsidiaries recorded $13.8 million
of income tax expense for income attributable to those subsidiaries, and the portion of earnings retained based on Code
Section 162(m) limitations. During the year ended December 31, 2012, the Company recorded $22.1 million of
income tax expense for a portion of earnings retained based on Section 162(m) limitations.
During the year ended December 31, 2011, the Company’s taxable REIT subsidiaries recorded $14.9 million
of income tax expense for income attributable to those subsidiaries, and the portion of earnings retained based on Code
Section 162(m) limitations. During the year ended December 31, 2011, the Company recorded $44.1 million of
income tax expense for a portion of earnings retained based on Section 162(m) limitations.
During the year ended December 31, 2010, the Company’s taxable REIT subsidiaries recorded $6.8 million
of income tax expense for income attributable to those subsidiaries, and the portion of earnings retained based on Code
Section 162(m) limitations. During the year ended December 31, 2010, the Company recorded $28.6 million of
income tax expense for a portion of earnings retained based on Section 162(m) limitations
F-29
The Company’s effective tax rate was 51%, 52%, and 53%, for the years ended December 31, 2012, 2011,
and 2010, respectively. The Company’s effective tax rate differs from its combined federal, state, and city corporate
statutory tax rate primarily due to the deduction of dividend distributions and Sec 162(m) limitations.
The Company’s 2009, 2010 and 2011 federal and state tax returns remain open for examination.
13.
LEASE COMMITMENTS AND CONTINGENCIES
Commitments
The Company has a non-cancelable lease for office space which commenced in May 2002 and expires in
December 2014. Merganser has a non-cancelable lease for office space, which commenced on May 2003 and expires
in May 2014. Merganser subleases a portion of its leased space to a subtenant. FIDAC has a lease for office space
which commenced in October 2010 and expires in February 2016. The lease expense for the years ended December
31, 2012, 2011, and 2010 were $2.5 million, $1.9 million, and $1.8 million, respectively. The Company’s aggregate
future minimum lease payments total $5.6 million. The following table details the lease payments.
Year Ending December
Lease Commitment
Sublease Income
(dollars in thousands)
60
-
-
-
-
$60
2,937
2,509
159
26
-
$5,631
Net Amount
2,877
2,509
159
26
-
$5,571
2013
2014
2015
2016
Later years
Contingencies
From time to time, the Company is involved in various claims and legal actions arising in the ordinary course
of business. In the opinion of management, the ultimate disposition of these matters will not have a material effect on
the Company’s consolidated financial statements and therefore no accrual is required as of December 31, 2012 and
2011.
14. INTEREST RATE RISK
The primary market risk to the Company is interest rate risk. Interest rates are highly sensitive to many factors,
including governmental monetary and tax policies, domestic and international economic and political considerations
and other factors beyond the Company’s control. Changes in the general level of interest rates can affect net interest
income, which is the difference between the interest income earned on interest-earning assets and the interest expense
incurred in connection with the interest-bearing liabilities, by affecting the spread between the interest-earning assets
and interest-bearing liabilities. Changes in the level of interest rates also can affect the value of the Interest Earning
Assets and the Company’s ability to realize gains from the sale of these assets. A decline in the value of the Interest
Earning Assets pledged as collateral for borrowings under repurchase agreements could result in the counterparties
demanding additional collateral pledges or liquidation of some of the existing collateral to reduce borrowing levels.
The Company seeks to manage the extent to which net income changes as a function of changes in interest
rates by matching adjustable-rate assets with variable-rate borrowings. The Company may seek to mitigate the
potential impact on net income of periodic and lifetime coupon adjustment restrictions in the portfolio of Interest
Earning Assets by entering into interest rate agreements such as interest rate caps and interest rate swaps. As of
December 31, 2012 and 2011, the Company entered into interest rate swaps to pay a fixed rate and receive a floating
rate of interest, with a total notional amount of $46.9 billion and $40.1 billion, respectively.
Changes in interest rates may also have an effect on the rate of mortgage principal prepayments and, as a
result, prepayments on Agency mortgage-backed securities. The Company will seek to mitigate the effect of changes
in the mortgage principal repayment rate by balancing assets purchased at a premium with assets purchased at a
discount. To date, the aggregate premium exceeds the aggregate discount on the Agency mortgage-backed securities.
F-30
As a result, prepayments, which result in the expensing of unamortized premium, will reduce net income compared to
what net income would be absent such prepayments.
15. RCAP REGULATORY REQUIREMENTS
RCap is subject to regulations of the securities business that include but are not limited to trade practices, use
and safekeeping of funds and securities, capital structure, recordkeeping, and conduct of directors, officers and
employees.
As a self clearing, registered broker dealer, RCap is required to maintain minimum net capital by the
Financial Industry Regulatory Authority (“FINRA”). As of December 31, 2012 RCap had a minimum net capital
requirement of $253,850. RCap consistently operates with capital significantly in excess of its regulatory capital
requirements. RCap’s regulatory net capital as defined by SEC Rule 15c3-1, as of December 31, 2012 was $297.9
million with excess net capital of $297.6 million.
16.
RELATED PARTY TRANSACTIONS
For the years ended December 31, 2012 and 2011 the Company recorded advisory fees from Chimera and
CreXus totaling $64.5 million and $62.8 million, respectively At December 31, 2012 and 2011, the Company had
amounts receivable from Chimera and CreXus of $14.1 million and $16.3 million, respectively.
17.
SUBSEQUENT EVENTS
On January 30, 2013, the Company entered into an Agreement and Plan of Merger (the “Merger
Agreement”), among the Company, CXS Acquisition Corporation, a Maryland corporation and a wholly-owned
subsidiary of the Company (“Acquisition”), and CreXus Investment Corp., a Maryland corporation (“CreXus”),
pursuant to which, among other things, Acquisition will commence a tender offer (the “Offer”) to purchase all of the
outstanding shares of CreXus’ common stock, par value $0.01 per share (the “Shares”), that neither the Company nor
Acquisition own at a price per share of $13.00 in cash, plus a cash payment to reflect a pro-rated quarterly dividend for
the quarter in which the tender offer is closed, subject to the terms and conditions set forth in the Merger Agreement.
If at least 51% of the Shares not owned by the Company or any of its subsidiaries, officers or directors are tendered
and purchased by Acquisition in the tender offer, and subject to the satisfaction or waiver of certain limited conditions
set forth in the Merger Agreement (including, if required, receipt of approval by CreXus’ stockholders), Acquisition
will merge with and into CreXus, with CreXus surviving as a wholly-owned subsidiary of the Company (the
“Merger”). In the Merger, each outstanding Share, other than Shares owned by Acquisition and the Company, will be
converted into the right to receive the same cash consideration paid in the Offer.
Under the terms of the Merger Agreement, CreXus may solicit, receive, evaluate and enter into negotiations
with respect to alternative proposals from third parties for a period of 45 calendar days continuing through March 16,
2013 (the “Transaction Solicitation Period”). CreXus may continue discussions after the Transaction Solicitation
Period with parties who made acquisition proposals during the Transaction Solicitation Period, or who made
unsolicited acquisition proposals after the Transaction Solicitation Period, in either case that CreXus determines, in
good faith, would result in, or is reasonably likely to result in, a superior proposal. If CreXus receives a superior
proposal, the Company and Acquisition have the right to increase its offer price one time to a price that is at least
$0.10 per share greater than the value per share stockholders would receive as a result of the superior proposal and
thereafter CreXus may terminate after providing two business days’ notice. If CreXus terminates the Merger
Agreement during the Transaction Solicitation Period or during the 10-day period following its expiration to enter into
a superior proposal with a party who delivered a written acquisition proposal during the Transaction Solicitation
Period, CreXus will be required to pay to the Company a termination fee of $15 million. If CreXus terminates the
Merger Agreement thereafter in connection with a superior proposal, the termination fee will be $25 million. If the
Merger Agreement is terminated in either circumstance, CreXus will also be required to reimburse the Company’s
documented out-of-pocket expenses, up to $5 million. In all cases, the termination fee and expense reimbursement
will be credited against the termination fee payable by CreXus under its management agreement with Fixed Income
Discount Advisory Company (the “Manager”), which is a wholly owned subsidiary of the Company.
F-31
The Merger Agreement includes customary representations, warranties and covenants of CreXus, the
Company and Acquisition. CreXus has agreed to operate its business in the ordinary course consistent with past
practice until the effective time of the Merger. The Company has separately agreed to not purchase any Shares in
excess of the approximately 12.4% of the outstanding that it currently owns.
Consummation of the Offer is subject to various conditions, including (1) the valid tender of the number of
Shares that would represent at least 51% of the Shares not owned by the Company or any of its subsidiaries, officers or
directors, (2) the consummation of the Offer or the Merger not being unlawful under any applicable statute, rule or
regulation, (3) the consummation of the Offer or the Merger not being enjoined by order of any court or other
governmental authority, (4) the absence of a Company Material Adverse Effect (as defined in the Merger Agreement),
(5) neither CreXus’ board of directors nor its special committee of independent directors having withdrawn its
recommendation of the Offer or Merger to CreXus’ stockholders, and (6) the satisfaction of certain other customary
closing conditions. Neither the Offer nor the Merger is subject to a financing condition. The Company plans to
finance the transaction with cash on hand.
If, after completion of the Offer, the Company and Acquisition hold at least 90% of the outstanding Shares,
the Merger will be consummated in accordance with the short-form merger provisions under Maryland law without the
approval of the Merger by CreXus’ stockholders. If, after completion of the Offer, the Company and Acquisition hold
less than 90% of the outstanding Shares, Acquisition will have the right to exercise an irrevocable option (the
“Percentage Increase Option”) granted to it by CreXus under the Merger Agreement to purchase from CreXus that
number of additional Shares that will increase the percentage of outstanding Shares owned by the Company and its
subsidiaries to one share more than 90% of the outstanding Shares (after giving effect to the issuance of shares
pursuant to the Percentage Increase Option). Upon exercise of the Percentage Increase Option, the Merger will be
consummated in accordance with the short-form merger provisions under Maryland law without approval of the
Merger by CreXus’ stockholders.
CreXus’ board of directors, upon the unanimous recommendation and approval of a special committee
consisting of three independent directors (the “Special Committee”), adopted resolutions (i) determining and declaring
advisable the Merger Agreement and the Offer, the Merger, the Percentage Increase Option and the other transactions
contemplated by the Merger Agreement, (ii) determining that the terms of the Offer, the Merger Agreement, the
Merger and the other transactions contemplated by the Merger Agreement are in the best interests of, and fair to,
CreXus’ stockholders other than the Company and its affiliates, and (iii) recommending that CreXus’ stockholders
(other than the Company and its affiliates) accept the Offer, tender their Shares into the Offer and, to the extent
required by applicable law to consummate the Merger, vote their Shares in favor of approving the Merger.
F-32
18.
SUMMARIZED QUARTERLY RESULTS (UNAUDITED)
The following is a presentation of summarized quarterly results of operations for the years ended December 31, 2012
and 2011.
For the Quarters Ended
March 31,
June 30,
September 30,
December 31,
2012
2012
2012
2012
(dollars in thousands, expect per share amounts)
Total interest income
Less: Total interest expense
Net interest income
Total other income (loss)
Less: Total general and administrative expenses
Income before income taxes
Less: Income taxes
Net income (loss)
Less: Dividends on preferred stock
Net income (loss) available (related) to common shareholders
Net income (loss) available (related) per share to common shareholders:
Basic
Diluted
$854,895
133,345
721,550
264,633
67,915
918,268
16,462
901,806
3,938
$897,868
$0.92
$0.89
$886,324
166,443
719,881
(734,828)
64,556
(79,503)
11,656
(91,159)
6,508
($97,667)
($0.10)
($0.10)
$761,265
181,893
579,372
(277,689)
63,004
238,679
13,921
224,758
9,367
$215,391
$0.22
$0.22
$756,661
185,491
571,170
163,282
40,084
694,368
(6,127)
700,495
19,717
$680,778
$0.70
$0.68
For the Quarters Ended
March 31,
June 30,
September 30,
December 31,
2011
2011
2011
2011
(dollars in thousands, except per share amounts)
Total interest income
Less: Total interest expense
Net interest income
Total other income (loss)
Less: Total general and administrative expenses
Income (loss) before income taxes and income from equity method
investment in affiliate
Less: Income taxes
Income from equity method investment in affiliate
Net income (loss)
Less: Dividends on preferred stock
Net income (loss) available (related) to common shareholders
Net income (loss) available (related) per share to common shareholders:
Basic
Diluted
$844,048
115,456
728,592
35,565
51,827
712,330
13,575
1,140
699,895
4,267
$695,628
$0.92
$0.89
$957,068
113,320
843,748
(652,940)
57,229
133,579
12,762
-
120,817
4,267
$116,550
$0.14
$0.14
$930,802
121,417
809,385
(1,650,587)
65,194
(906,396)
15,417
-
(921,813)
4,172
($925,985)
($0.98)
($0.98)
$847,700
130,133
717,567
(191,614)
63,094
462,859
17,297
-
445,562
4,148
$441,414
$0.46
$0.44
F-33
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the city of New York,
State of New York.
Date: February 26, 2013
By: /s/ Wellington J. Denahan
ANNALY CAPITAL MANAGEMENT, INC.
Wellington J. Denahan
(Chief Executive Officer, and authorized officer of
registrant)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the date indicated.
Signature
/s/ KEVIN P. BRADY
Kevin P. Brady
/s/ KATHRYN F. FAGAN
Kathryn F. Fagan
Title
Director
Chief Financial Officer and Treasurer
(principal financial and accounting
officer)
Date
February 26, 2013
February 26, 2013
/s/ JONATHAN D. GREEN
Director
February 26, 2013
Jonathan D. Green
/s/ KEVIN G. KEYES
Kevin G. Keyes
President and Director
February 26, 2013
/s/ MICHAEL E. HAYLON
Director
February 26, 2013
Michael E. Haylon
/s/ JOHN A. LAMBIASE
John A. Lambiase
Director
February 26, 2013
/s/ E. WAYNE NORDBERG
Director
February 26, 2013
E. Wayne Nordberg
/s/ DONNELL A. SEGALAS
Director
February 26, 2013
Donnell A. Segalas
/s/ WELLINGTON J. DENAHAN
Wellington J. Denahan
Chairman of the Board of Directors and
Chief Executive Officer
(principal executive officer)
February 26, 2013
II-1
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Exhibit 12.1
Ratio of Earnings To Combined Fixed Charges And Preferred Stock Dividends and Ratio of Earnings To Fixed
Charges (Unaudited)
The following table sets forth the calculation of our ratio of earnings to combined fixed charges and preferred stock
dividends for the years shown (dollars in thousands):
For the Years Ended December 31,
2012
2011
2010
2009
2008
Net income before income taxes and
noncontrolling interest
1,771,812
402,372
1,299,769
1,996,104
372,157
Add: Fixed charges (Interest expense)
1,560,941
1,362,721
1,163,332
1,295,762
1,888,912
Earnings as adjusted
3,332,753
1,765,093
2,463,101
3,291,866
2,261,069
Fixed charges (interest expense) + preferred
stock dividend
Ratio of earnings to combined fixed charges
and preferred stock dividends
Ratio of earnings to fixed charges
1,600,471
1,379,575
1,181,365
1,314,263
1,910,089
2.08
2.14
1.28
1.30
2.08
2.12
2.50
2.54
1.18
1.20
Subsidiaries of Registrant
Exhibit 21.1
Fixed Income Discount Advisory Company, Delaware corporation
RCap Securities, Inc., Maryland corporation
Merganser Capital Management, Inc., Delaware corporation
FIDAC Housing Cycle Fund, LLC, Delaware limited liability company
FHC Master Fund, Ltd., a Cayman Islands exempted company (wholly owned subsidiary of FIDAC Housing Cycle
Fund, LLC)
Shannon Funding LLC, Delaware limited liability company
Charlesfort Capital Management LLC, Delaware limited liability company
FIDAC FSI LLC, Delaware limited liability company
CXS Acquisition Corporation, a Maryland corporation
Exhibit 23.1
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
We consent to the incorporation by reference in the Registration Statements No. 333-178214 and No. 333-186465 on Forms S-
3 and Registration Statement No. 333-169923 on Form S-8 of our report dated February 26, 2013, with respect to the
consolidated financial statements of Annaly Capital Management, Inc. and Subsidiaries and the effectiveness of internal
control over financial reporting of Annaly Capital Management, Inc. and Subsidiaries included in this Annual Report (Form
10-K) of Annaly Capital Management, Inc. and Subsidiaries for the year ended December 31, 2012.
/s/ Ernst and Young LLP
New York, New York
February 26, 2013
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
We consent to the incorporation by reference in the Registration Statements No. 333-178214 and No. 333-186465 on Forms S-
3 and Registration Statement No. 333-169923 on Form S-8 of our report dated February 28, 2012, relating to the consolidated
financial statements of Annaly Capital Management, Inc., appearing in this Annual Report on Form 10-K of Annaly Capital
Management, Inc. for the year ended December 31, 2012.
Exhibit 23.2
/s/ Deloitte & Touche LLP
New York, New York
February 26, 2013
CERTIFICATIONS
Exhibit 31.1
I, Wellington J. Denahan, certify that:
1.
I have reviewed this annual report on Form 10-K of Annaly Capital Management, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to
state a material fact necessary to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report,
fairly present in all material respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control
over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and
have:
a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to
be designed under our supervision, to ensure that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us by others within those entities, particularly
during the period in which this report is being prepared;
b) Designed such internal control over financial reporting, or caused such internal control over financial
reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability
of financial reporting and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles;
c)
d)
Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this
report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of
the period covered by this report based on such evaluation; and
Disclosed in this report any change in the registrant’s internal control over financial reporting that
occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the
case of an annual report) that has materially affected, or is reasonably likely to materially affect, the
registrant’s internal control over financial reporting; and
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of
internal control over financial reporting, to the registrant’s auditors and the audit committee of the
registrant’s board of directors (or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design or operation of internal control over
financial reporting which are reasonably likely to adversely affect the registrant’s ability to record,
process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other employees who have a
significant role in the registrant’s internal control over financial reporting.
Date: February 26, 2013
/s/Wellington J. Denahan
Chairman and Chief Executive Officer
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CERTIFICATIONS
Exhibit 31.2
I, Kathryn F. Fagan, certify that:
1.
I have reviewed this annual report on Form 10-K of Annaly Capital Management, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to
state a material fact necessary to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report,
fairly present in all material respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control
over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and
have:
a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to
be designed under our supervision, to ensure that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us by others within those entities, particularly
during the period in which this report is being prepared;
b) Designed such internal control over financial reporting, or caused such internal control over financial
reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability
of financial reporting and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles;
c)
d)
Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this
report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of
the period covered by this report based on such evaluation; and
Disclosed in this report any change in the registrant’s internal control over financial reporting that
occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the
case of an annual report) that has materially affected, or is reasonably likely to materially affect, the
registrant’s internal control over financial reporting; and
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of
internal control over financial reporting, to the registrant’s auditors and the audit committee of the
registrant’s board of directors (or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design or operation of internal control over
financial reporting which are reasonably likely to adversely affect the registrant’s ability to record,
process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other employees who have a
significant role in the registrant’s internal control over financial reporting.
Date: February 26, 2013
/s/Kathryn F. Fagan
Chief Financial Officer and Treasurer
Exhibit 32.1
ANNALY CAPITAL MANAGEMENT, INC.
1211 AVENUE OF THE AMERICAS
SUITE 2902
NEW YORK, NEW YORK 10036
CERTIFICATION
PURSUANT TO SECTION 906 OF THE
SARBANES-OXLEY ACT OF 2002, 10 U.S.C. SECTION 1350
In connection with the annual report on Form 10-K of Annaly Capital Management, Inc. (the “Company”) for the
period ended December 31, 2012 to be filed with Securities and Exchange Commission on or about the date
hereof (the “Report”), I, Wellington J. Denahan, Chief Executive Officer of the Company, certify, pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, that:
1.
2.
The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities
Exchange Act of 1934; and
The information contained in the Report fairly presents, in all material respects, the financial
condition and results of operations of the Company at the dates of, and for the periods covered
by, the Report.
It is not intended that this statement be deemed to be filed for purposes of the Securities Exchange Act of 1934.
/s/ Wellington J. Denahan
Wellington J. Denahan
Chairman and Chief Executive Officer
February 26, 2013
Exhibit 32.2
ANNALY CAPITAL MANAGEMENT, INC.
1211 AVENUE OF THE AMERICAS
SUITE 2902
NEW YORK, NEW YORK 10036
CERTIFICATION
PURSUANT TO SECTION 906 OF THE
SARBANES-OXLEY ACT OF 2002, 10 U.S.C. SECTION 1350
In connection with the annual report on Form 10-K of Annaly Capital Management, Inc. (the “Company”) for the
period ended December 31, 2012 to be filed Kathryn F. Fagan, Chief Financial Officer of the Company, certify,
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, that:
1.
2.
The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities
Exchange Act of 1934; and
The information contained in the Report fairly presents, in all material respects, the financial
condition and results of operations of the Company at the dates of, and for the periods covered
by, the Report.
It is not intended that this statement be deemed to be filed for purposes of the Securities Exchange Act of 1934.
/s/ Kathryn F. Fagan
Kathryn F. Fagan
Chief Financial Officer and Treasurer
February 26,2013
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Corporate officers
Wellington J. Denahan
Kevin g. Keyes
Kathryn F. Fagan
James P. Fortescue
Chairman and Chief Executive
Officer
President
Chief Financial Officer and
Treasurer
Chief Operating Officer
KristoPher r. KonraD
rose-marie lyght
r. nicholas singh
Co-Chief Investment Officer
Co-Chief Investment Officer
Chief Legal Officer and
Secretary
Board of directors
Wellington J. Denahan
Kevin g. Keyes
Kevin P. BraDy
Jonathan D. green
Chairman and Chief Executive
Officer
President
Chief Executive Officer
ARMtech, LLC
Former Vice Chairman, President
and CEO Rockefeller Group
International, Inc.
michael e. haylon
John a. lamBiase
e. Wayne norDBerg
Donnell a. segalas
Managing Director Conning
Asset Management
Former Managing Director
Salomon Brothers, Inc.
Chairman Hollow Brook
Wealth Management, LLC
Managing Partner and Chief
Executive Officer Pinnacle Asset
Management, L.P.
Corporate information
corPorate heaDquarters
transFer agent
corPorate counsel
inDePenDent accountants
Annaly Capital Management, Inc.
Computershare
K&L Gates LLP
Ernst & Young LLP
1211 Avenue of the Americas
480 Washington Boulevard
1601 K Street, N.W.
5 Times Square
New York, NY 10036
Jersey City, NJ 07310
Washington, DC 20006
New York, NY 10036
Material Request
Copies of the Company’s Annual Report and 2012 Form 10-K may be obtained by writing the Secretary, by calling the investor relations
hotline at 1–888–826-6259, sending an email to investor@annaly.com, or by visiting our website at www.annaly.com.
Stock exchange listing
The common stock is listed on the New York Stock Exchange (symbol: NLY). The Series A preferred stock is listed on the New York
Stock Exchange (symbol: NLY-A). The Series C preferred stock is listed on the New York Stock Exchange (symbol: NLYPrC). The Series D
preferred stock is listed on the New York Stock Exchange (symbol: NLYPrD).
Additional information
The Company has included as exhibits to its Annual Report on Form 10-K for fiscal year ended 2012 certificates of the Company’s Chief
Executive Officer and Chief Financial Officer certifying the quality of the Company’s public disclosure controls, and the Company has
submitted to the New York Stock Exchange (NYSE) in 2012 a certificate of the Company’s Chief Executive Officer certifying that she is
not aware of any violations by the Company of the NYSE corporate governance listing standards.
AnnAly CApitAl MAnAgeMent, inC.
1211 Avenue of the AMeRiCAS, new yoRk, ny 10036
www.AnnAly.CoM