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AI > SEC Filings for AI > Form 10-Q on 1-Nov-2013All Recent SEC Filings




Quarterly Report

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Unless the context otherwise requires or provides, references in this Quarterly Report on Form 10-Q to "we," "us," "our" and "our company" refer to Arlington Asset Investment Corp. (Arlington Asset) and its subsidiaries. This discussion and analysis should be read in conjunction with our financial statements and accompanying notes included in Item 1 of this Quarterly Report on Form 10-Q, as well as our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2012.

The discussion of our consolidated financial condition and results of operations below may contain forward-looking statements. These statements, which reflect management's beliefs and expectations, are subject to risks and uncertainties that may cause actual results to differ materially. For a discussion of the risks and uncertainties that may affect our future results, please see "Cautionary Statement About Forward-Looking Statements" immediately following Item 4 of Part I of this Quarterly Report on Form 10-Q and the risk factors included in Item 1A of Part II of this Quarterly Report on Form 10-Q and our Quarterly Report on Form 10-Q for the three months ended June 30, 2013, and in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2012.

Our Company

We are a principal investment firm that currently acquires and holds primarily mortgage-related assets and holds certain other assets. We acquire residential mortgage-backed securities (MBS), either issued by U.S. government agencies or guaranteed as to principal and interest by U.S. government agencies or U.S. government-sponsored entities (agency-backed MBS). We also acquire MBS issued by private organizations (private-label MBS) subject to maintaining our exemption from regulation as an investment company under the Investment Company Act of 1940, as amended (1940 Act). In the future, we may acquire and hold other types of assets, including commercial mortgage-backed securities, asset backed securities, other structured securities, commercial mortgage loans, commercial loans, residential mortgage loans, and other real estate-related loans and securities. In addition, we also may pursue other business activities that will utilize our experience in analyzing investment opportunities and applying similar portfolio management skills. We are a Virginia corporation and taxed as a C corporation for federal income tax purposes. We operate primarily in the United States.

Factors that Affect our Results of Operations and Financial Condition

Our business is materially affected by a variety of industry and economic factors, including:

conditions in the global financial markets and economic conditions;

changes in interest rates and prepayment rates;

actions taken by the U.S. government, U.S. Federal Reserve and the U.S.

changes in laws and regulations and industry practices;

actions taken by ratings agencies with respect to the U.S. credit rating; and

other market developments.

Adverse market conditions and actions by governmental authorities could adversely affect our business in many ways, including but not limited to making it more difficult for us to analyze our investment portfolio, adversely affecting our ability to maintain targeted amounts of leverage on our MBS portfolio and successfully implement our hedging strategy, and limiting our ability to follow our current investment and financing strategies. While uncertain, these potentially adverse market conditions and actions by governmental authorities may adversely affect our liquidity, financial position and results of operations. We have been and will continue to evaluate the potential impact of recent government actions, including developments relating to various state and federal government actions affecting the market price of MBS, related derivative securities, and interest rates. For further discussions on how market conditions and government actions may adversely affect our business, see "Item 1A - Risk Factors" of our Quarterly Report on Form 10-Q for the three months ended June 30, 2013, this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2012.


Our MBS portfolio is affected by general U.S. residential real estate market conditions and the overall U.S. economic environment. In particular, our MBS strategy and the performance of our MBS portfolio is influenced by the specific characteristics of these markets, including prepayment rates, credit losses, interest rates and the interest rate yield curve. Our results of operations with respect to our MBS portfolio primarily depend on, among other things, the level of our interest income and the amount and cost of borrowings we may obtain by pledging our investment portfolio as collateral for the borrowings. Our interest income, which includes the amortization of purchase premiums and accretion of discounts, if any, varies primarily as a result of changes in prepayment speeds of the securities in our MBS portfolio. Our borrowing cost varies based on changes in interest rates and changes in the amount we can borrow, which is generally based on the fair value of the MBS portfolio and the advance rate the lenders are willing to lend against the collateral provided.

The payment of principal and interest on the agency-backed MBS that we acquire and hold is guaranteed by the Federal Home Loan Mortgage Corporation (Freddie Mac) or the Federal National Mortgage Association (Fannie Mae). The payment of principal and interest on agency-backed MBS issued by Freddie Mac or Fannie Mae is not guaranteed by the U.S. government. Any failure to honor its guarantee of agency-backed MBS by Freddie Mac or Fannie Mae or any downgrade of securities issued by Freddie Mac or Fannie Mae by the rating agencies could cause a significant decline in the value of and cash flow from any agency-backed MBS we own that are guaranteed by such entity.

Current Market Conditions and Trends

In September 2012, the U.S. Federal Reserve announced a third round of quantitative easing, known as QE3, pursuant to which it would purchase additional agency-backed MBS at a pace of $40 billion per month until further notice. The Federal Reserve also announced that it would maintain its policy of reinvesting principal payments from its existing holdings of agency-backed MBS into new purchases of agency-backed MBS until the employment rate, among other economic indicators, showed signs of improvement. The Federal Reserve further stated that it would maintain the target range for the Federal Funds Rate between zero and 0.25% through at least mid-2015, which is six months longer than previously announced. The Federal Reserve provided further guidance to the market in December 2012 that it intended to keep the Federal Funds Rate close to zero while the unemployment rate is above 6.5% and as long as inflation does not rise above 2.5%. In December 2012, the Federal Reserve also announced that it would initially begin purchasing $45 billion of long-term Treasury bonds each month and noted that such amount may increase in the future.

The economic news for the third quarter of 2013 was dominated by the effects of the sequester, government shutdown and debt ceiling and the reaction of the market to the Federal Reserve's continuation of QE3, which primarily consists of asset purchases, despite market expectations that tapering its asset purchases would begin in September 2013. While there are signs of the private sector recovering some sustainable growth, inflation continues to be very low and the unemployment rate of approximately 7.2% in September 2013 remains higher than the 6.5% target threshold previously indicated by the Federal Reserve as one of the key drivers of tapering of its asset purchases. Interest rates during the quarter were extremely volatile with the 10-year Treasury Rate starting at 2.52% then reaching close to 3.0% in early September, but then declining to below 2.7% once the Federal Reserve indicated in its September meeting that it was going to postpone the commencement of its tapering. Uncertainty around who would be nominated for the next Fed Chairman magnified the interest rate volatility during the third quarter of 2013, though this has since been resolved with the nomination of Janet Yellen by President Obama on October 9, 2013.

The threat of a government shutdown and debate over the debt ceiling appeared to have been built into the market, as the bond market began to stabilize in the latter part of September and only exhibited a slight reaction when the government shut down commenced on October 1, 2013. Even though a temporary resolution was reached on the debt ceiling on October 16, 2013 and the government reopened on October 17, 2013, we expect the volatility in the bond market may continue until these issues have been resolved.

The Federal Reserve Open Market Committee (the FOMC) meeting minutes released on April 10, 2013 revealed that the FOMC had begun considering when the Federal Reserve should begin tapering the pace of agency-backed MBS purchases set in September 2012. The FOMC meeting minutes released on May 22, 2013 announced that the Federal Reserve was considering beginning to taper such purchases as early as June 2013. In minutes released on June 25, 2013, the FOMC introduced more formal unemployment rate and inflation


targets, stating that the Federal Reserve would begin to scale back agency-backed MBS purchases later in 2013 and that such purchases would cease entirely when the unemployment rate reached 7%. The Federal Reserve's current expectation is that 7% unemployment is achievable by midyear 2014.

At the July 30 - 31, 2013 FOMC meeting, the Committee, despite some improvement in the labor market and modest economic expansion, decided to continue asset purchases. At the September 17 - 18, 2013 FOMC meeting, against many market participants' expectations, the Committee decided to hold back on tapering, causing a rapid move downward in interest rates with the 10-Year Treasury Rate ending the quarter at 2.61%. The Federal Reserve continues to maintain its position that the timing and scope of tapering is dependent upon improving economic indicators. The economic projections of Federal Reserve Board Members included in the minutes of the Federal Reserve's September 2013 meeting show inflation running below the Federal Reserve's target inflation rate of 2% through 2016. In addition, the projections show estimates for real GDP growth at 2.2% to 3.3% for 2014. In the minutes from the October 29 - 30, 2013 FOMC meeting, the Committee maintained this assessment, decided to keep QE3 in place for the time being, and provided no additional guidance as to when tapering QE3 might begin. Given the low inflation projections, monetary policy, including the timing of tapering asset purchases, will likely be dependent on actual growth in employment rather than inflation concerns. It's important to note that over the past several years, actual employment growth has been consistently below the Federal Reserve's projections.

While there are signs of a recovery, uncertainty continues to dominate the market, due to the continued historically low interest rate environment and actions by the Federal Reserve. We believe the general business environment will continue to be challenging in the fourth quarter of 2013 and future periods. Our growth outlook is dependent, in part, on the strength of the financial markets, the impact of fiscal and monetary policy actions by the United States and other countries, the overall market value of U.S. equities and liquidity in the financial system. Depending on recent market developments and movements, we may seek to re-align our strategy and our portfolio. We will continue to closely monitor the developments in the market and evaluate the opportunities across the spectrum in the mortgage industry and other types of assets and seek the highest risk-adjusted returns for our capital.

We believe the limited liquidity and volatility in the credit markets will continue while the markets seek to determine the right equilibrium levels for benchmark interest rates as the Federal Reserve stimulus leaves the market place.

Recent Government Activity

On June 25, 2013, Senators Bob Corker (R-TN) and Mark Warner (D-VA), with Senators Mike Johanns (R-NE), Jon Tester (D-MT), Dean Heller (R-NV), Heidi Heitkamp (D-ND), Jerry Moran (R-KS) and Kay Hagan (D-NC) formally introduced the Housing Finance Reform and Taxpayer Protection Act of 2013 (the Corker-Warner Bill) into the U.S. Senate. While the current draft of the Corker-Warner Bill will likely undergo significant changes as it is debated, it is expected to serve as a basis of discussion for congressional efforts to reform Fannie Mae and Freddie Mac.

As currently drafted, the Corker-Warner Bill has three key provisions:

the establishment of the Federal Mortgage Insurance Corporation (the FMIC);

the creation of a Mortgage Insurance Fund (the Fund); and

the wind-down of Fannie Mae and Freddie Mac.

The FMIC would be a government guarantor modeled after the Federal Deposit Insurance Corporation (the FDIC) in that it would collect insurance premiums and maintain a deposit fund on all outstanding obligations. Every mortgage-backed security issued through the FMIC would have a private investor bearing the first risk of loss and holding at least $0.10 in equity capital for every dollar of risk. This private capital buffer would serve to protect taxpayers from the risk of default on the mortgages underlying securities issued by the FMIC. Thus, the ultimate purpose of the FMIC would be to bring in credit investors to bear the risk of default while providing liquidity, transparency and access to mortgage credit for the housing finance system.

The Federal Housing Finance Authority (the FHFA) would be abolished after the establishment of the FMIC, and all current responsibilities of the FHFA, as well as its resources, would be transferred to the


FMIC. In particular, the Corker-Warner Bill specifies that the FMIC would maintain a database of uniform loan-level information on eligible mortgages, develop standard uniform securitization agreements and oversee the common securitization platform currently being developed by the FHFA.

In the event losses due to default on underlying mortgages exceed the first position losses of private credit investors in securities issued by the FMIC, the FMIC would cover such losses out of the Fund. The Corker-Warner Bill specifies that the FMIC would endeavor to attain a reserve balance of 1.25% of the aggregate outstanding principal balance of covered securities within five years of the establishment of the FMIC and 2.50% of such amount within ten years of the establishment of the FMIC. The Fund would be paid with insurance premiums, akin to user fees, paid by private investors with various reporting and transparency requirements.

As currently proposed, the Corker-Warner Bill would revoke the charters of Fannie Mae and Freddie Mac upon the establishment of the FMIC. Fannie Mae and Freddie Mac would wind down as expeditiously as possible while maximizing returns to taxpayers as their assets are sold off.

On July 11, 2013, U.S. Representatives introduced the Protecting American Taxpayers and Homeowners Act (PATH), a broad financing reform bill that serves as a counterpart to the Corker-Warner Bill. PATH would also revoke the charters of Fannie Mae and Freddie Mac and remove barriers to private investment. However, PATH would maintain the FHFA and give it oversight over a new non-government, not-for-profit National Mortgage Market Utility, the mission of which would be to develop best practices standards for the private origination, servicing, pooling and securitizing of mortgages and operate a publicly accessible securitization outlet to match loan originators with investors. Additional provisions of PATH include the reduction in size and scope of the Federal Housing Administration, tailoring its mission specifically to first-time borrowers and low- and moderate-income borrowers except in periods of significant credit contraction.

There is no way to know if either proposal will become law or should one of the proposals become law if and how the enacted law will differ from the current draft of the bill. It is unclear how this proposal would impact housing finance, and what impact, if any, it would have on companies that invest in MBS. The passage of any new legislation affecting Fannie Mae and Freddie Mac may create market uncertainty and reduce the actual or perceived credit quality of securities issued or guaranteed by the U.S. government through a new or existing successor entity to Fannie Mae and Freddie Mac. If the charters of Fannie Mae and Freddie Mac were revoked, it is unclear what effect, if any, this would have on the value of the existing Fannie Mae and Freddie Mac agency-backed MBS. It is also possible that the above-referenced proposed legislation, if made law, could adversely impact the market for securities issued or guaranteed by the U.S. government and the spreads at which they trade. The foregoing could materially adversely affect the pricing, supply, liquidity and value of our target assets and otherwise materially adversely affect our business, operations and financial condition.

Executive Summary

Given the uncertainty around the Federal Reserve policies and reversal or tapering of QE3, coupled with uncertainly regarding the ability of U.S. lawmakers to reach an agreement on the national debt ceiling or a national budget, the market was characterized by increased market and interest rate volatility. As a result, we experienced increased fluctuations in our asset prices and hedge positions during the quarter ended September 30, 2013. On October 16, 2013, Congress passed legislation to reopen the government through January 15, 2014 and effectively suspend the debt ceiling through February 7, 2014. As the Federal Reserve policy environment regains clarity and the U.S. budget negotiations reach a settlement, we expect less volatility in the market which in turn will diminish the variability in the value of our assets and hedge positions; however, it is difficult to determine the longer term effects of the uncertainty and the volatility existing in the current market.

Based on current economic indicators and trends in underlying credit and housing data, we continue to review the allocation of our available capital to maximize return to our shareholders. As of September 30, 2013, our MBS portfolio consisted of $2.0 billion in fair value, with $1.6 billion of agency-backed MBS and $344.1 million of private-label MBS.


As we previously disclosed in the quarter ended March 31, 2013, we are subject to examination by the U.S. Internal Revenue Service (IRS), and other taxing jurisdictions. In March 2013, an IRS examination of the tax years 2009 and 2010 was completed without any adjustment. As a result, we reversed $3.2 million of unrecognized federal tax benefit related to an uncertain tax position and $0.5 million of related accrued interest as of March 31, 2013. We believe that the statute of limitation on the 2009 state tax return expired as of October 15, 2013. As a result, during the quarter ending December 31, 2013, we expect to reverse $9.6 million of unrecognized state tax benefit related to an uncertain tax position and $2.9 million of related accrued interest.

For the three months ended September 30, 2013, we had net income of $3.1 million, or $0.18 per share (diluted). As of September 30, 2013, our book value per share was $31.77.

In addition to the financial results reported in accordance with generally accepted accounting principles as consistently applied in the United States (GAAP), we calculated non-GAAP core operating income for the three and nine months ended September 30, 2013. Our non-GAAP core operating income for the three and nine months ended September 30, 2013 was $17.3 million and $50.8 million, respectively. In determining core operating income, we excluded certain legacy litigation expenses and the following non-cash expenses: (1) compensation costs associated with stock-based awards, (2) accretion of MBS purchase discounts adjusted for contractual interest and principal repayments in excess of proportionate invested capital, (3) unrealized mark-to-market adjustments on the trading MBS and hedge instruments, (4) other-than-temporary impairment charges recognized, (5) non-cash income tax provisions, and (6) benefit from the reversal of previously accrued federal tax liability and accrued interest related to uncertain tax positions. This non-GAAP measurement is used by management to analyze and assess the operating results and dividends. We believe that this non-GAAP measurement assists investors in understanding the impact of these non-core items and non-cash expenses on our performance and provides additional clarity around our forward earnings capacity and trends. A limitation of utilizing this non-GAAP measure is that the GAAP accounting effects of these events do in fact reflect the underlying financial results of our business and these effects should not be ignored in evaluating and analyzing our financial results. Therefore, we believe net income on a GAAP basis and core operating income on a non-GAAP basis should be considered together.

The following is a reconciliation of GAAP net income to non-GAAP core operating income for the three and nine months ended September 30, 2013 (dollars in thousands):

[[Image Removed]]                            [[Image Removed]]      [[Image Removed]]
                                                         September 30, 2013
                                                 Three Months           Nine Months
                                                    Ended                  Ended
GAAP net income                              $         3,093        $         9,464
Legacy litigation expenses(1)                            (24 )                  551
Stock compensation                                       729                  1,666
Non-cash interest income related to
purchase discount                                     (1,915 )               (3,091 )
Net unrealized mark-to-market loss on                 12,898                 40,221
trading MBS and hedge instruments
Other-than-temporary impairment charges                  380                  1,270
Non-cash income tax provisions                         2,170                  4,469
Benefit from the reversal of federal tax
liability and accrued interest related to                  -                 (3,744 )
uncertain tax position
Non-GAAP core operating income               $        17,331        $        50,806

[[Image Removed]]

(1) Legacy litigation expenses relate to legal matters pertaining to events related to business activities the Company completed or exited in or prior to 2009 - primarily debt extinguishment, sub-prime mortgage origination and securitization and broker/dealer operations.

(2) Non-cash interest income related to purchase discount accretion represents interest income recognized in excess of cash receipts related to contractual interest income and principal repayments in excess of proportionate invested capital.


As of September 30, 2013, our agency-backed MBS consisted of $1.6 billion in face value with a cost basis of $1.7 billion and had a fair value of $1.6 billion. Our agency-backed MBS had a weighted-average coupon of 4.08% and a weighted-average cost of funding of 0.37% at September 30, 2013. During the three months ended September 30, 2013, we received proceeds of $309.5 million from the sale of $297.7 million in face value of our agency-backed MBS, realizing $3.9 million in net losses, or realized net losses of $16.0 million from the acquisition price. During the nine months ended September 30, 2013, we received proceeds of $837.3 million from the sale of $787.6 million in face value of our agency-backed MBS, realizing $25.9 million in net losses, or realized net losses of $16.8 million from the acquisition price.

We have entered into Eurodollar futures and swap futures to mitigate the interest rate sensitivity which directly impacts our cost of borrowing and the market value of our agency-backed MBS. The Eurodollar futures mature through September 30, 2018 and have a lifetime weighted-average rate of 3.08%, as compared to a lifetime weighted-average market rate of 2.10% as of September 30, 2013. The value of these five-year hedge instruments is expected to fluctuate inversely relative to the agency-backed MBS portfolio and decrease in value during periods of declining interest rates and/or widening mortgage spreads. Conversely, during periods of increasing rates and/or tightening mortgage spreads, these instruments are expected to increase in value. The cost of these Eurodollar hedges will increase over their five-year term. The swap futures mature in December 2013 and have a weighted-average rate of 2.89%, as compared to a weighted-average market rate of 2.85% as of September 30, 2013.

As of September 30, 2013, our private-label MBS portfolio consisted of $511.8 million in face value with an amortized cost basis of $287.0 million and had a fair value at $344.1 million. The unamortized net discount on our private-label MBS portfolio was $224.8 million as of September 30, 2013. During the three months ended September 30, 2013, we recognized net interest income of $6.8 million, representing a 9.8% annualized yield, including coupon and accretion of purchase discount based on the current accretable yield rate, from our private-label MBS portfolio. During the three months ended September 30, 2013, we received proceeds of $27.1 million from the sale of $49.0 million in face value of our private-label MBS, realizing $4.8 million in gains. We also recognized $0.4 million in other-than-temporary impairment charges during the three months ended September 30, 2013. This charge does not affect non-GAAP core operating income or book value, but does reduce our net income and lowers the accounting basis used to record future discount accretion.

Our private-label MBS are primarily senior and re-REMIC tranches in securitization trusts issued between 2005 and 2010. The senior securities represent interests in securitizations that have the first right to cash flows and absorb losses last. The re-REMIC securities represent interests in re-securitizations of senior MBS and pro-rata mezzanine securities. For re-REMIC securities, the cash flows from, and any credit losses absorbed by, the underlying MBS are allocated among the re-REMIC securities issued in the re-securitization transactions based on the re-REMIC structure. For example, prime and non-prime residential senior securities have been resecuritized to create a two-tranche structure with a re-REMIC senior security and a re-REMIC subordinated security. In these re-REMIC securities, all principal payments from the underlying securities are directed to the re-REMIC senior security until the face value is fully paid off. Thereafter, all principal payments are directed to the re-REMIC subordinated security. For pro-rata mezzanine securities, principal payments from the underlying MBS are typically allocated concurrently and proportionally to the mezzanine securities along with senior securities. The re-REMIC subordinated and mezzanine securities absorb credit losses, if any, first; however, these credit losses occur only when credit losses exceed the credit protection provided to the underlying securities. Senior, re-REMIC, and . . .

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