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ORC > SEC Filings for ORC > Form 10-K on 22-Mar-2013All Recent SEC Filings

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Form 10-K for ORCHID ISLAND CAPITAL, INC.


22-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and notes to those statements included in Item 8 of this Form 10-K. The discussion may contain certain forward-looking statements that involve risks and uncertainties. Forward-looking statements are those that are not historical in nature. As a result of many factors, such as those set forth under "Risk Factors" in this Form 10-K, our actual results may differ materially from those anticipated in such forward-looking statements.


Overview

We are a specialty finance company that invests in Agency RMBS. Our investment strategy focuses on, and our portfolio consists of, two categories of Agency RMBS: (i) traditional pass-through Agency RMBS and (ii) structured Agency RMBS, such as CMOs, IOs, IIOs and POs, among other types of structured Agency RMBS. From inception through the closing of the initial public offering of our common stock, we were managed by Bimini. After the closing of the offering, we will be externally managed by Bimini Advisors, a registered investment adviser with the Securities and Exchange Commission ("SEC").

We were formed by Bimini in August 2010 and commenced operations on November 24, 2010. At December 31, 2012, Bimini was our sole stockholder. We completed our initial public offering on February 20, 2013. In that offering we raised proceeds of approximately $35.4 million from the sale of 2,360,000 shares of our common stock.

Our business objective is to provide attractive risk-adjusted total returns over the long term through a combination of capital appreciation and the payment of regular monthly distributions. We intend to achieve this objective by investing in and strategically allocating capital between the two categories of Agency RMBS described above. We seek to generate income from (i) the net interest margin on our leveraged pass-through Agency RMBS portfolio and the leveraged portion of our structured Agency RMBS portfolio, and (ii) the interest income we generate from the unleveraged portion of our structured Agency RMBS portfolio. We intend to fund our pass-through Agency RMBS and certain of our structured Agency RMBS, such as fixed and floating rate tranches of CMOs and POs, through short-term borrowings structured as repurchase agreements. However, we do not intend to employ leverage on the securities in our structured Agency RMBS portfolio that have no principal balance, such as IOs and IIOs. We do not intend to use leverage in these instances because the securities contain structural leverage. Pass-through Agency RMBS and structured Agency RMBS typically exhibit materially different sensitivities to movements in interest rates. Declines in the value of one portfolio may be offset by appreciation in the other. The percentage of capital that we allocate to our two Agency RMBS asset categories will vary and will be actively managed in an effort to maintain the level of income generated by the combined portfolios, the stability of that income stream and the stability of the value of the combined portfolios. We believe that this strategy will enhance our liquidity, earnings, book value stability and asset selection opportunities in various interest rate environments.

We intend to qualify and will elect to be taxed as a REIT under the Code commencing with our short taxable year ending December 31, 2013. We generally will not be subject to U.S. federal income tax to the extent that we annually distribute all of our REIT taxable income to our stockholders and qualify as a REIT.

Factors that Affect our Results of Operations and Financial Condition

A variety of industry and economic factors may impact our results of operations and financial condition. These factors include:

interest rate trends;

prepayment rates on mortgages underlying our Agency RMBS, and credit trends insofar as they affect prepayment rates;

the difference between Agency RMBS yields and our funding and hedging costs;

competition for investments in Agency RMBS;

recent actions taken by the Federal Reserve and the U.S. Treasury; and

other market developments.

In addition, a variety of factors relating to our business may also impact our results of operations and financial condition. These factors include:

our degree of leverage;

our access to funding and borrowing capacity;

our borrowing costs;

our hedging activities;

the market value of our investments; and

the requirements to qualify as a REIT and the requirements to qualify for a registration exemption under the Investment Company Act.


We anticipate that, for any period during which changes in the interest rates for our adjustable rate assets do not coincide with interest rate changes on the corresponding liabilities, such assets will re-price more slowly than the corresponding liabilities. Consequently, changes in interest rates, particularly short term interest rates, may significantly influence our net income.

Our net income may be affected by a difference between actual prepayment rates and our projections. Prepayments on loans and securities may be influenced by changes in market interest rates and homeowners' ability and desire to refinance their mortgages.

Results of Operations

Described below are the Company's results of operations for the year ended December 31, 2012, as compared to the Company's results of operations for the year ended December 31, 2011.

Net Income (Loss) Summary

Net income for the year ended December 31, 2012 was $0.5 million, or $0.54 per
share. Net loss for the year ended December 31, 2011 was $1.2 million, or $1.21
per share. The components of net income (loss) for the years ended December 31,
2012 and 2011, along with the changes in those components are presented in the
table below:

(in thousands)
                                           Years Ended December 31,
                                         2012         2011       Change
Interest income                        $  2,698     $  1,771     $   927
Interest expense                           (277 )        (96 )      (181 )
Net interest income                       2,421        1,675         746
Losses on MBS and Eurodollar futures     (1,154 )     (1,273 )       119
Net portfolio income                      1,267          402         865
Expenses                                   (733 )     (1,592 )       859
Net income (loss)                      $    534     $ (1,190 )   $ 1,724

GAAP and Non-GAAP Reconciliation

To date, we have used derivatives, specifically Eurodollar futures contracts, to hedge the interest rate risk on repurchase agreements in a rising rate environment. We have not elected to designate our derivative holdings for hedge accounting treatment under the Financial Accounting Standards Board (the "FASB") Accounting Standards Codification ("ASC") Topic 815, Derivatives and Hedging. Changes in fair value of these instruments are presented in a separate line item in our Statements of Operations. As such, for financial reporting purposes, interest expense and cost of funds are not impacted by the fluctuation in value of the Eurodollar futures contracts. In the future, we may use other derivative instruments to hedge our interest expense and/or elect to designate our derivative holdings for hedge accounting treatment.


For the purpose of computing net interest income and ratios relating to cost of funds measures throughout this Management's Discussion and Analysis of Financial Condition and Results of Operations, interest expense includes gains and losses on a Eurodollar futures contracts. Presenting the effects of the Eurodollar positions with the interest expense on interest-bearing liabilities reflects total economic interest expense on these obligations and the economic effect of our hedging strategy. Interest expense, including gains and losses on Eurodollar futures contracts, is referred to as economic interest expense. Net interest income, including gains and losses on Eurodollar futures contracts, is referred to as economic net interest income.

We believe that 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 or operations.

Our presentation of the economic value of our hedging strategy has important limitations. First, other market participants may calculate economic interest expense and economic net interest income differently than we calculate them. Second, while we believe that the calculation of the economic value of our hedging strategy described above helps to present our financial position and performance, it may be 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 interest expense and net interest income computed in accordance with GAAP.

The following table presents the effect of our hedging strategy on interest expense and net interest income for each quarter in 2012 and 2011 and for the years ended December 31, 2012 and 2011.

(dollars in thousands)

                                     GAAP        Eurodollar       Economic          GAAP             Economic
                                   Interest        Gains /        Interest      Net Interest       Net Interest
                                   Expense        (Losses)        Expense          Income             Income
Three Months Ended,
December 31, 2012                 $       94     $        (1 )   $       95     $         379     $          378
September 30, 2012                        58             (14 )           72               639                625
June 30, 2012                             74              (1 )           75               695                694
March 31, 2012                            51             (24 )           75               708                684
December 31, 2011                         36              27              9               437                464
September 30, 2011                        23             (26 )           49               543                517
June 30, 2011                             18            (151 )          169               406                255
March 31, 2011                            19              11              8               289                300
Years Ended,
December 31, 2012                 $      277     $       (40 )   $      317     $       2,421     $        2,381
December 31, 2011                         96            (139 )          235             1,675              1,536

Net Interest Income

During the year ended December 31, 2012, we generated $2.4 million of economic net interest income, consisting of $2.7 million of interest income from MBS assets offset by $0.3 million of economic interest expense on repurchase liabilities. For the comparable period ended December 31, 2011, we generated $1.5 million of economic net interest income, consisting of $1.8 million of interest income from MBS assets offset by $0.2 million of economic interest expense on repurchase liabilities.


The table below provides information on our portfolio average balances, interest income, yield on assets, average repurchase agreement balances, economic interest expense, economic cost of funds, economic net interest income and economic net interest spread for each quarter in 2012 and 2011 and for the years ended December 31, 2012 and 2011.

(dollars in thousands)
                           Average                         Yield on                                             Average        Economic         Net
                             MBS                           Average            Average           Economic        Economic      Portfolio       Economic
                          Securities       Interest          MBS            Repurchase          Interest        Cost of        Interest       Interest
                           Held(1)        Income(2)       Securities       Agreements(1)       Expense(3)        Funds        Income(3)        Spread
Three Months Ended,
December 31, 2012        $     91,094     $      473             2.08 %   $        80,256     $         95           0.47 %   $      378           1.61 %
September 30, 2012             64,378            697             4.33 %            53,698               72           0.54 %          625           3.79 %
June 30, 2012                  73,559            769             4.18 %            62,407               75           0.48 %          694           3.70 %
March 31, 2012                 70,585            759             4.30 %            59,157               75           0.50 %          684           3.80 %
December 31, 2011              53,522            473             3.53 %            42,390                9           0.08 %          464           3.45 %
September 30, 2011             40,356            566             5.61 %            32,230               49           0.62 %          517           4.99 %
June 30, 2011                  29,286            424             5.79 %            23,267              169           2.90 %          255           2.89 %
March 31, 2011                 27,373            308             4.50 %            22,632                8           0.14 %          300           4.36 %
Years Ended,
December 31, 2012        $     74,904     $    2,698             3.60 %   $        63,880     $        317           0.50 %   $    2,381           3.10 %
December 31, 2011              37,634          1,771             4.71 %            30,130              235           0.78 %        1,536           3.93 %

(1) Portfolio yields and costs of borrowings presented in the table above and the tables on pages 50 and 51 are calculated based on the average balances of the underlying investment portfolio/repurchase agreement balances and are annualized for the quarterly periods presented. Average balances for quarterly periods are calculated using two data points, the beginning and ending balances. Average balances for the year to date periods are calculated as the average of the average quarterly periods.

(2) Interest income presented in the table above includes only interest earned on the Company's MBS investments and excludes interest earned on cash balances, and excludes the impact of discounts or premiums on MBS investments, as discounts or premiums are not amortized under the fair value option. Interest income and net portfolio interest income may not agree with the information presented in the statements of operations.

(3) Economic interest expense and economic net interest income presented in the table above and the table on page 52 includes the effect of our Eurodollar futures positions that were entered into as an economic hedge against the increase in interest on repurchase agreements in a rising rate environment.

Interest Income and Average Earning Asset Yield

Our interest income for the years ended December 31, 2012 and 2011 was $2.7 million and $1.8 million, respectively. We had average MBS holdings of $74.9 million and $37.6 million for the years ended December 31, 2012 and 2011, respectively. The yield on our portfolio was 3.60% and 4.71% for the years ended December 31, 2012 and 2011, respectively. For the year ended December 31, 2012 as compared to the year ended December 31, 2011, there was a $0.9 million increase in interest income due to a $37.3 million increase in average MBS, partially offset by a 111 basis point decrease in the yield on average MBS for the year ended December 31, 2012 when compared to the year ended December 31, 2011.


The table below presents the average portfolio size, income and yields of our respective sub-portfolios, consisting of structured MBS and PT MBS.

(dollars
in
thousands)
                        Average MBS Held                           Interest Income                       Realized Yield on Average MBS
                PT         Structured                      PT        Structured                      PT            Structured
               MBS            MBS           Total         MBS            MBS          Total          MBS               MBS            Total
Three Months Ended,
December
31, 2012     $ 84,617     $      6,477     $ 91,094     $    597     $      (124 )   $    473          2.82 %             (7.66 )%       2.08 %
September
30, 2012       56,519            7,859       64,378          410             287          697          2.90 %             14.59 %        4.33 %
June 30,
2012           65,320            8,239       73,559          593             176          769          3.63 %              8.56 %        4.18 %
March 31,
2012           61,936            8,649       70,585          530             229          759          3.43 %             10.56 %        4.30 %
December
31, 2011       43,917            9,605       53,522          339             134          473          3.09 %              5.56 %        3.53 %
September
30, 2011       33,101            7,255       40,356          283             283          566          3.42 %             15.61 %        5.61 %
June 30,
2011           24,573            4,713       29,286          218             206          424          3.55 %             17.51 %        5.79 %
March 31,
2011           24,280            3,093       27,373          225              83          308          3.70 %             10.75 %        4.50 %
Years Ended,
December
31, 2012     $ 67,098     $      7,806     $ 74,904     $  2,130     $       568     $  2,698          3.17 %              7.27 %        3.60 %
December
31, 2011       31,468            6,166       37,634        1,065             706        1,771          3.38 %             11.45 %        4.71 %

Interest Expense and the Cost of Funds

We had average outstanding repurchase agreements of $63.9 million and $30.1 million and total economic interest expense of $0.3 million and $0.2 million for the years ended December 31, 2012 and 2011, respectively. Our average economic cost of funds was 0.50% and 0.78% for years ended December 31, 2012 and 2011, respectively. There was a 28 basis point decrease in the average economic cost of funds and a $33.7 million increase in average outstanding repurchase agreements during the year ended December 31, 2012 as compared to the year ended December 31, 2011.

Since all of our repurchase agreements are short-term, changes in market rates directly affect our interest expense. Our average economic cost of funds was 25 basis points above average one-month LIBOR and 12 basis points below average six-month LIBOR for the quarter ended December 31, 2012. The average term to maturity of the outstanding repurchase agreements decreased from 27 days at December 31, 2011 to 15 days at December 31, 2012.


The table below presents the average repurchase agreements outstanding, economic interest expense and average economic cost of funds, and average one-month and six-month LIBOR rates for each quarter in 2012 and 2011 and for the years ended December 31, 2012 and 2011.

(dollars in
thousands)
                                                                                                        Average              Average
                                                                                                       Economic             Economic
                  Average                                                                            Cost of Funds        Cost of Funds
                 Balance of       Economic          Average           Average         Average         Relative to          Relative to
                 Repurchase       Interest         Economic          One-Month       Six-Month       Average One-         Average Six-
                 Agreements       Expense        Cost of Funds         LIBOR           LIBOR          Month LIBOR          Month LIBOR
Three Months
Ended,
December 31,
2012            $     80,256     $       95                0.47 %          0.22 %          0.59 %              0.25 %              (0.12 )%
September 30,
2012                  53,698             72                0.54 %          0.23 %          0.70 %              0.31 %              (0.16 )%
June 30, 2012         62,407             75                0.48 %          0.24 %          0.74 %              0.24 %              (0.26 )%
March 31,
2012                  59,157             75                0.50 %          0.26 %          0.76 %              0.24 %              (0.26 )%
December 31,
2011                  42,390              9                0.08 %          0.26 %          0.65 %             (0.18 )%             (0.57 )%
September 30,
2011                  32,230             49                0.62 %          0.21 %          0.46 %              0.41 %               0.16 %
June 30, 2011         23,267            169                2.90 %          0.22 %          0.43 %              2.68 %               2.47 %
March 31,
2011                  22,632              8                0.14 %          0.26 %          0.46 %             (0.12 )%             (0.32 )%
Years Ended,
December 31,
2012            $     63,880     $      317                0.50 %          0.24 %          0.70 %              0.26 %              (0.20 )%
December 31,
2011                  30,130            235                0.78 %          0.24 %          0.50 %              0.54 %               0.28 %

Gains and Losses

The table below presents our gains and losses for the years ended December 31,
2012 and 2011.

(in thousands)
                                               Years Ended December 31,
                                            2012          2011       Change
Realized (losses) gains on sales of MBS   $    (308 )   $    410     $  (718 )
Unrealized losses on MBS                       (806 )     (1,544 )       738
Total losses on MBS                          (1,114 )     (1,134 )        20
Losses on Eurodollar futures                    (40 )       (139 )        99

During the years ended December 31, 2012 and 2011, the Company received proceeds of $129.1 million and $33.5 million, respectively, from the sales of MBS. 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.


Expenses

Total operating expenses were $0.7 million and $1.6 million for the years ended
December 31, 2012 and 2011, respectively. The table below provides a breakdown
of operating expenses for the years ended December 31, 2012 and 2011.

(in thousands)
                                                Years Ended December 31,
                                            2012           2011       Change
Direct REIT operating expenses             $   449       $    345     $   104
Audit, legal and other professional fees       178          1,115        (937 )
Other expenses                                 106            132         (26 )
Total expenses                             $   733       $  1,592        (859 )

Under the terms of the management agreement, the Company paid Bimini a monthly management fee equal to 1/12 of 1.50% per annum of the Stockholders' Equity (as defined in the management agreement) of the Company. In addition, the Company paid Bimini a monthly fee of $7,200, which represents an allocation of overhead expenses for items that include, but are not limited to, occupancy costs, insurance and administrative expenses. These expenses are allocated based on the ratio of the Company's assets and Bimini's consolidated assets. Included in direct REIT operating expenses during each of the years ended December 31, 2012 and 2011 were management fees and allocated expenses of approximately $0.3 million.

During the year ended December 31, 2011, the Company withdrew its Form S-11 Registration Statement related to a proposed initial public offering of its common stock. The Registration Statement was withdrawn due to market conditions. Included in other professional fees for the year ended December 31, 2011 are approximately $1.1 million of expenses related to this attempted initial public offering.

Financial Condition:

Mortgage-Backed Securities

As of December 31, 2012, our MBS portfolio consisted of $115.4 million of agency or government MBS at fair value and had a weighted average coupon on assets of 3.09%. During the year ended December 31, 2012, we received principal repayments of $9.5 million compared to $6.7 million for the year ended December 31, 2011. The average prepayment speeds for the quarters ended December 31, 2012 and 2011 were 28.6% and 29.7%, respectively. (See table below for additional prepayment data).

The following table presents the constant prepayment rate ("CPR") experienced on our structured and PT MBS sub-portfolios, on an annualized basis, for the quarterly periods presented. Assets that were not owned for the entire quarter have been excluded from the calculation. The exclusion of certain assets during periods of high trading activity can create a very high, and often volatile, reliance on a small sample of underlying loans.

                                            Structured
                          PT MBS                MBS                Total
Three Months Ended,    Portfolio (%)       Portfolio (%)       Portfolio (%)
December 31, 2012                 1.1                42.3                28.6
September 30, 2012                4.2                38.7                25.0
June 30, 2012                     0.2                41.4                38.7
March 31, 2012                   11.0                31.2                23.8
December 31, 2011                10.1                33.5                29.7
September 30, 2011               13.1                27.9                21.1
June 30, 2011                     8.1                26.7                18.7
March 31, 2011                    0.5                19.7                 5.7


The following tables summarize certain characteristics of the Company's agency and government mortgage related securities as of December 31, 2012 and 2011:

(in thousands)
                                                   Weighted           Weighted
                               Percentage          Average            Average  Weighted Weighted
                                   of     Weighted Maturity            Coupon  Average  Average
. . .
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