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IVR > SEC Filings for IVR > Form 10-Q on 6-Aug-2014All Recent SEC Filings

Show all filings for INVESCO MORTGAGE CAPITAL INC.

Form 10-Q for INVESCO MORTGAGE CAPITAL INC.


6-Aug-2014

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.

In this quarterly report on Form 10-Q, or this "Report," we refer to Invesco Mortgage Capital Inc. and its consolidated subsidiaries as "we," "us," "our Company," or "our," unless we specifically state otherwise or the context indicates otherwise. We refer to our external manager, Invesco Advisers, Inc., as our "Manager," and we refer to the indirect parent company of our Manager, Invesco Ltd. (NYSE:IVZ) together with its consolidated subsidiaries (which does not include us), as "Invesco."
The following discussion should be read in conjunction with our consolidated financial statements and the accompanying notes to our consolidated financial statements, which are included in Item 1 of this Report, as well as the information contained in our most recent Form 10-K filed with the Securities and Exchange Commission (the "SEC").

Forward-Looking Statements
We make forward-looking statements in this Report and other filings we make with the SEC 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 (the "Exchange Act"), and such statements are intended to be covered by the safe harbor provided by the same. Forward-looking statements are subject to substantial risks and uncertainties, many of which are difficult to predict and are generally beyond our control. These forward-looking statements include information about possible or assumed future results of our business, investment strategies, financial condition, liquidity, results of operations, plans and objectives. When we use the words "believe," "expect," "anticipate," "estimate," "plan," "continue," "intend," "should," "may" or similar expressions and future or conditional verbs such as "will," "may," "could," "should," and "would," and any other statement that necessarily depends on future events, we intend to identify forward-looking statements. Factors that could cause actual results to differ from those expressed in our forward-looking statements include, but are not limited to:
our business and investment strategy;

our investment portfolio;

our projected operating results;

actions and initiatives of the U.S. governmental agencies and changes to U.S. government policies, including the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), mortgage loan modification programs and the reduction of the Federal Reserve long-term asset purchases (quantitative easing or "QE") and our ability to respond to and comply with such actions, initiatives and changes;

the availability of financing sources, including our ability to obtain additional financing arrangements and the terms of such arrangements;

financing and advance rates for our target assets;

changes to our expected leverage;

general volatility of the markets in which we invest;

general volatility of foreign financial markets and their governments' responses;

our expected investments;

our expected book value per share of common stock;

interest rate mismatches between our target assets and our borrowings used to fund such investments;

the adequacy of our cash flow from operations and borrowings to meet our short-term liquidity needs;

our ability to maintain sufficient liquidity to meet any margin calls;

changes in the credit rating of the U.S. government;

changes in interest rates and interest rate spreads and the market value of our target assets;

changes in prepayment rates on our target assets;

the impact of any deficiencies in foreclosure practices of third parties and related uncertainty in the timing of collateral disposition;

our reliance on third parties in connection with services related to our target assets;


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effects of hedging instruments on our target assets;

rates of default or decreased recovery rates on our target assets;

modifications to whole loans or loans underlying securities;

the degree to which our hedging strategies may or may not protect us from interest rate volatility;

the degree to which derivative contracts expose us to contingent liabilities;

counterparty defaults;

changes in governmental regulations, tax law and rates, and similar matters and our ability to respond to such changes;

our ability to maintain our qualification as a real estate investment trust for U.S. federal income tax purposes;

our ability to maintain our exception from the definition of "investment company" under the Investment Company Act of 1940, as amended (the "1940 Act");

availability of investment opportunities in mortgage-related, real estate-related and other securities;

availability of U.S. Government Agency guarantees with regard to payments of principal and interest on securities;

the market price and trading volume of our capital stock;

availability of qualified personnel;

the relationship with our Manager;

estimates relating to taxable income and our ability to continue to make distributions to our shareholders in the future;

estimates relating to fair value of our target assets and loan loss reserves;

our understanding of our competition;

changes to generally accepted accounting principles in the United States of America ("U.S. GAAP"); and

market trends in our industry, interest rates, real estate values, the debt securities markets or the general economy.

These forward-looking statements are based upon information presently available to our management and are inherently subjective, uncertain and subject to change. There can be no assurance that actual results will not differ materially from our expectations. We caution investors not to rely unduly on any forward-looking statements and urge you to carefully consider the risks identified under the captions "Risk Factors," "Forward-Looking Statements" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Report and our most recent Form 10-K and subsequent Form 10-Qs, which are available on the SEC's website at www.sec.gov. All written or oral forward-looking statements that we make, or that are attributable to us, are expressly qualified by this cautionary notice. We expressly disclaim any obligation to update the information in any public disclosure if any forward-looking statement later turns out to be inaccurate, except as may otherwise be required by law.
The following discussion should be read in conjunction with our consolidated financial statements and the accompanying notes to our consolidated financial statements, which are included in this Report. Overview
We are a Maryland corporation primarily focused on investing in, financing and managing residential and commercial mortgage-backed securities ("MBS") and mortgage loans. We are externally managed and advised by Invesco Advisers, Inc., our Manager, which is an indirect, wholly-owned subsidiary of Invesco Ltd. We elected to be taxed as a real estate investment trust ("REIT") for U.S. federal income tax purposes under the provisions of the Internal Revenue Code of 1986, as amended ("Code"), commencing with our taxable year ended December 31, 2009. To maintain our REIT qualification, we are generally required to distribute at least 90% of our taxable income to our shareholders annually. We operate our business in a manner that permits our exclusion from the definition of "Investment Company" under the 1940 Act.
Our objective is to provide attractive risk-adjusted returns to our investors, primarily through dividends and secondarily through capital appreciation. To achieve this objective, we primarily invest in the following:
Agency residential mortgage-backed securities ("RMBS"), for which a U.S. government agency such as the Government National Mortgage Association ("Ginnie Mae") or a federally chartered corporation such as the Federal National Mortgage Association ("Fannie Mae") or the Federal Home Loan Mortgage Corporation ("Freddie Mac") guarantees payments of principal and interest on the securities;


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Non-Agency RMBS, which are RMBS that are not guaranteed by a U.S. government agency or a federally chartered corporation;

Credit risk transfer securities issued by government-sponsored enterprise ("GSE CRT"), which are general obligations of Fannie Mae or Freddie Mac that are structured to provide credit protection to the GSE issuer with respect to defaults and other credit events within reference pools of residential mortgage loans that collateralize MBS issued and guaranteed by such GSE;

Commercial mortgage-backed securities ("CMBS");

Residential and commercial mortgage loans; and

Other real estate-related financing arrangements.

We finance our investments in Agency RMBS, non-Agency RMBS, GSE CRT and CMBS primarily through short-term borrowings structured as repurchase agreements, secured loans, committed facilities and other forms of private financing. We finance our residential loans held-for-investment through asset-backed securities ("ABS") issued by securitization trusts for which we have determined we are the primary beneficiary. We have also issued exchangeable notes to finance investments in our target assets. Capital Activities
On June 16, 2014, we declared a dividend of $0.50 per share of common stock. The dividend was paid on July 28, 2014 to shareholders of record as of the close of business on June 27, 2014.
On June 16, 2014, we declared a dividend of $0.4844 per share of Series A Preferred Stock. The dividend was paid on July 25, 2014 to shareholders of record as of the close of business on July 1, 2014.
During the three months ended June 30, 2014, we did not repurchase any shares of our common stock. During the six months ended June 30, 2014, we repurchased 1,438,213 shares of our common stock at an average repurchase price of $14.69 per share for a net cost of $21.1 million, including acquisition expenses. On December 2, 2013, our board of directors authorized the repurchase of an additional 20,000,000 shares of our common stock with no stated expiration date. Our board of directors has approved an aggregate repurchase of 27,000,000 shares of our common stock to date. As of June 30, 2014, we had authority to purchase 14,841,784 additional shares of our common stock through this program. Factors Impacting Our Operating Results
Our operating results can be affected by a number of factors and primarily depend on, among other things, the level of our net interest income, the market value of our assets and the supply of, and demand for, the target assets in which we invest. Our net interest income, which includes the amortization of purchase premiums and accretion of purchase discounts, varies primarily as a result of changes in market interest rates and prepayment speeds, as measured by the constant prepayment rate ("CPR") on our target assets. Interest rates and prepayment speeds vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty.
Market Conditions
Macroeconomics factors that affect our business include credit spread premiums, market interest rates, Federal Reserve policy initiatives, residential and commercial real estate prices, employment and inflation. There are a number of reasons to believe the U.S. economy is improving despite a meager 1.5% year-over-year increase in real gross domestic product ("GDP"). Year-over-year GDP has dropped given the -2.9% real growth rate in the first quarter of 2014, causing the Federal Open Market Committee and the consensus of private economists to lower their full year 2014 GDP forecast to 2.2% and 1.7%, respectively. In addition, interest rates have continued to fall since the first quarter of 2014.
For the second quarter of 2014, the unemployment rate fell to 6.1% and monthly payrolls increased by 272,000 jobs per month. Home and automobile sales during the second quarter each made strong increases. The low interest rate environment should be stimulative to economic growth since current policy rates are much lower than that which would be indicated by unemployment and inflation indicators alone. Households are once again increasing their debt levels, albeit at a low rate, which increases their ability to consume goods and services. Inflation data has recently been higher than expected with core personal consumption expenditures prices having increased 1.5% year-over-year and 1.7% over the past three months.
Despite these indicators of apparent strength describe above, including surprisingly robust employment data, interest rates fell in the second quarter of 2014. Underlying this decline is the notion that economic growth is likely to disappoint and that the Federal Reserve is likely to keep the funds rate near 0% for the next year, and be very gradual in raising rates when they do. Factors that seem to support this view include: the U.S. and other large countries must overcome a heavy debt burden such that


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fiscal policies in the U.S. and abroad will be a drag on economic growth; companies are more focused on margins and stock repurchases than on growth strategies; disinflation is entrenched in the collective psyche of consumers; there is risk of deflation in Europe; China is a concern for global growth; and geo-political concerns seem to be on the rise.
In this environment the 10-year U.S. Treasury note yield has moved in an extraordinarily tight band, generally hovering between 2.5% and 2.7%. Actual interest rate volatility has continued to decline in the second quarter of 2014, as has the volatility implied by interest rate options. U.S. Treasury interest rates ended the second quarter lower, with the 10-year note lower by about 19 basis points and longer maturities declined by more than shorter maturities. This has been supportive for the Agency RMBS market generally as the prepayment option embedded in MBS is less onerous given lower expected interest rate volatility. Further, MBS investors seem much less concerned over the market impact from Federal Reserve tapering of MBS purchases. There has been adequate demand from investors and limited supply of new MBS to offset the decline in demand from the Federal Reserve. The environment has also been supportive of credit spreads (i.e. the additional yield premium earned by investors over risk-free term interest rates for accepting credit risk in non-government guaranteed bonds). In the second quarter of 2014, yields required by investors on CMBS and non-Agency RMBS fell by more than similar duration U.S. Treasury notes and U.S. interest rate swaps. This had a beneficial impact on the prices of our holdings and caused our book value to increase.
We believe we have reduced the interest rate sensitivity of our investment portfolio, resulting in greater book value stability. The driving force behind the 6.9% increase in book value in the second quarter was the improvement in credit spread premiums, as described above. Our core earnings benefited from slow prepayment rates. It is possible that we may realize losses on the sale of assets in future periods and these losses may cause our GAAP earnings to be negative. In addition, as of December 31, 2013 we elected to discontinue hedge accounting for our portfolio of interest rate swaps. As a result of discontinuing hedge accounting, beginning January 1, 2014, changes in the fair value of the interest rate swap agreements are recorded in gain (loss) on interest rate derivative instruments, net in our consolidated statements of operations, rather than in accumulated other comprehensive income (loss) ("AOCI"). This change will cause our net income to be more volatile in future periods and could contribute to us recording a net loss in future periods. Refer to Note 9 - "Derivatives and Hedging Activities" for further information. The impact of regulatory initiatives on the economy may also affect our business and our financial results. The Dodd-Frank Act, enacted in July 2010, contains numerous provisions affecting the financial and mortgage industries, many of which may have an impact on our operating environment and the target assets in which we invest. Consequently, the Dodd-Frank Act may affect our cost of doing business, may limit our investment opportunities and may affect the competitive balance within our industry and market areas. Under the Dodd-Frank Act, new underwriting requirements for residential mortgage loans have been adopted. The Ability-to-Repay ("ATR") rule requires lenders to make a reasonable, good-faith determination that the borrower has a reasonable ability to repay the loan. In addition to the ATR rule, the Consumer Financial Protection Bureau adopted a Qualified Mortgage ("QM") framework that provides certain legal protections to lenders related to residential mortgage loans that meet the QM criteria, which include restrictions on loan features and borrower debt-to-income ratios. While we are not directly subject to compliance with the implementation of rules regarding the origination of residential mortgage loans, the effect of these regulations and others could affect our ability to securitize or invest in newly originated loans in the future.
There are also a number of pending legislative proposals related to the eventual wind-down or phase out of the GSEs, including the Corker-Warner and Johnson-Crapo bills, which would replace the GSEs with a new government agency, the Federal Mortgage Insurance Corporation. In the second quarter there was a bi-partisan effort in the U.S. Senate to bring about mortgage finance reform via the Johnson-Crapo bill. The bill did not receive enough votes in committee to get to the floor for a vote. At this point it seems unlikely there will be mortgage finance reform legislation in 2014. A meaningful resurrection of a fully functioning primary market for private label securitizations is unlikely to occur in the near term. We have been successful in participating in securitizations despite the environment, having consolidated in our financial statements an additional prime jumbo securitization in each of the first two quarters of 2014. We expect to close and consolidate at least one additional prime jumbo securitization in the third quarter of 2014. The high credit quality of the loans underlying these securitizations is showing through in strong monthly performance data.
In addition, the regulatory landscape for our repurchase agreement counterparties continues to evolve following the adoption of new capital rules which generally affects the manner in which banks lend. Regulators are also focused on liquidity requirements which will likely affect how banks fund themselves. While we are not directly subject to compliance with the implementation of rules regarding financial institutions, the effect of these regulations and others could affect our ability to finance our assets in the future.
Investment Activities
In the second quarter of 2014, we continued to position the investment portfolio to take advantage of opportunities created by an improving housing market and the availability of high credit quality, newly originated residential mortgage loans.


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During 2013 and 2014, we participated in seven residential loan securitizations that are consolidated on our balance sheet, and have participated in GSE CRT transactions issued by both Fannie Mae and Freddie Mac at a fair value of $506.6 million compared to $0 one year ago. In addition, during the second quarter of 2014, we committed to purchase securities in an additional residential loan securitization, and upon settlement, we anticipate the residential loan securitization to be consolidated on our balance sheet. During 2013, we also began a commercial real estate lending program. Since its inception, we have purchased or originated five loans in addition to investing in securitized mezzanine loans. We expect to continue to pursue opportunities to increase the percentage of our equity invested in each of these three areas during 2014:
commercial mortgage loans, subordinate interests in residential loan securitizations and GSE CRT transactions.
To provide economic stimulus, the Federal Reserve has been purchasing Agency RMBS through its QE program which has had the effect of holding mortgage interest rates low. In 2014, the Federal Reserve has reduced purchases under their QE program of U.S. Treasuries and Agency RMBS, but they have continued buying a large percentage of issuance, which has also declined. The interest rate and credit spread premium environment and our views on how they will change have a significant impact on our portfolio decisions. We have taken the opportunity to reduce our lower coupon 30 year Agency RMBS positions by nearly 50% from $12.2 billion at March 31, 2013 to $6.2 billion at June 30, 2014. We reinvested proceeds of sales and prepayments in part into agency hybrid ARM assets. We have also reduced our repurchase agreement debt from 6.4 times equity at June 30, 2013 to 5.6 times equity at June 30, 2014. In addition, we increased the notional amount of our interest rate swaps from $12.2 billion at June 30, 2013 to $12.8 billion at June 30, 2014, or by 4.9%. We also entered into payer swaptions to further reduce interest rate risk in the second quarter. As a result of all of these actions, we believe we have reduced interest rate and funding risk relative to the prior quarter and the prior year.
The table below shows the allocation of our equity as of June 30, 2014 and 2013:

                            As of June 30,
                            2014       2013
Agency RMBS                39.3  %    52.3  %
Non-Agency RMBS            29.8  %    36.5  %
GSE CRT                     5.6  %       -  %
CMBS                       31.7  %    19.9  %
Residential Loans           3.4  %     4.8  %
Commercial Loans            3.7  %     0.3  %
Unconsolidated Ventures     1.7  %     1.4  %

Exchangeable Senior Notes (15.2 )% (15.2 )% Total 100.0 % 100.0 %

We have continued to hold 30 year fixed-rate Agency RMBS securities that offer higher coupons and which we expect to prepay relatively slowly based on the collateral attributes. Our sales of 30 year fixed-rate Agency RMBS have been primarily in 3% and 3.5% coupons. Therefore the average coupon of our 30 year fixed-rate Agency RMBS continued to increase to 4.17% at June 30, 2014, compared to 4.12% at March 31, 2014 and 3.92% at June 30, 2013. In addition, we hold 15 year fixed-rate Agency RMBS securities, Agency Hybrid ARM RMBS and Agency ARM RMBS that we believe to have lower durations and better cash flow certainty relative to current 30 year fixed-rate Agency RMBS. Further, we own Agency collateralized mortgage obligations ("CMO"), some of which are interest-only securities.


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The table below shows the breakdown of our investment portfolio as of June 30, 2014 and 2013:

                                          As of June 30,
$ in thousands                          2014          2013
Agency RMBS:
30 year fixed-rate, at fair value     6,239,995    10,561,425
15 year fixed-rate, at fair value     1,495,999     1,956,448
Hybrid ARM, at fair value             2,613,337       440,170
ARM, at fair value                      561,284        68,769
Agency CMO, at fair value               510,435       511,476
Non-Agency RMBS, at fair value (1)    3,282,525     3,750,428
GSE CRT, at fair value                  506,635             -
CMBS, at fair value                   3,037,579     2,517,442
Residential loans, at amortized cost  2,310,686     1,553,006
Commercial loans, at amortized cost      95,585         8,954
Total MBS and Loans portfolio        20,654,060    21,368,118

(1) Included in non-Agency RMBS are securities of $26.0 million for a future securitization not yet settled. Our portfolio of investments that have credit exposure include non-Agency RMBS, GSE CRT, CMBS and residential and commercial real estate loans. We use our proprietary models to perform a detailed review of each investment which often includes loan level analysis of expected performance. We do not place any reliance on ratings by various agencies as we believe our models more accurately evaluate the performance based on our assumptions about market conditions and are updated more frequently than agency ratings. As shown in the table above, we have increased our exposure to credit assets as we believe the improving economy will provide better risk-adjusted returns for this asset class while having lower interest rate exposure. With respect to our non-Agency RMBS portfolio, we primarily invest in RMBS collateralized by prime and Alt-A loans. In addition, we have invested in re-securitization of real estate mortgage investment conduit ("Re-REMIC") RMBS that we believe provide attractive risk adjusted returns. We also invest in GSE CRT. Based on our view of the improving housing market and relative value opportunities, we added to our position of non-Agency RMBS and GSE CRT during 2014. Our CMBS portfolio generally consists of assets originated prior to 2007, assets originated after 2010 ("CMBS 2.0") and multi-family CMBS issued by Freddie Mac under their "K" program. Since June 30, 2013, we grew our CMBS portfolio $520.1 million based on our view of the improving risk and return offered by this asset class. The primary focus of our investments was in the CMBS 2.0, where we grew the percentage of CMBS in our MBS portfolio to approximately 16.6% as of June 30, 2014 from approximately 12.7% as of June 30, 2013. During 2013 and 2014, we expanded our portfolio of credit assets by adding subordinate securities backed by residential loans. The residential loans collateralizing these securities consist are prime jumbo mortgages that were generally originated in 2011 or later. We believe these loans have high credit quality based on their risk characteristics, including but not limited to high FICO scores, low historical delinquencies and low loan-to-value ratios based on current home values. For further details on the loan portfolio, refer to Note 5
- "Residential Loans Held-for-Investment." We also added commercial real estate loans during 2013 and 2014. Our commercial real estate loan portfolio includes mezzanine loans, first mortgage loans and preferred equity investments we purchased or originated. For further details on the loan portfolio, refer to Note 6 - "Commercial Loans Held-for-Investment."


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Portfolio Characteristics
The table below represents the vintage of our MBS credit assets as of June 30,
2014 as a percentage of the fair value:

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