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OAKS > SEC Filings for OAKS > Form 10-Q on 14-Aug-2014All Recent SEC Filings

Show all filings for FIVE OAKS INVESTMENT CORP.

Form 10-Q for FIVE OAKS INVESTMENT CORP.


14-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 Five Oaks Investment Corp. as "we," "us," or "our," unless we specifically state otherwise or the context indicates otherwise. We refer to our external manager, Oak Circle Capital Partners LLC, as our "Manager" or "Oak Circle".

The following discussion should be read in conjunction with our financial statements and the accompanying notes to our financial statements, which are included in Item 1 of this report, as well as the information contained in our Annual Report on Form 10-K for the year ended December 31, 2013,or our 2013 Annual Report, filed with the Securities and Exchange Commission, or SEC, on March 12, 2014..

Forward-Looking Statements

We make forward-looking statements in this report that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our business, financial condition, liquidity, results of operations, plans and objectives. You can identify forward-looking statements by use of words such as "believe," "expect," "anticipate," "estimate," "plan," "continue," "intend," "should," "may" or similar expressions or other comparable terms, or by discussions of strategy, plans or intentions. Statements regarding the following subjects, among others, may be forward-looking: the return on equity; the yield on investments; the ability to borrow to finance assets; and risks associated with investing in real estate assets, including changes in business conditions and the general economy. Forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us. Actual results may differ from expectations, estimates and projections and, consequently, you should not rely on these forward looking statements as predictions of future events. Forward-looking statements are subject to substantial risks and uncertainties, many of which are difficult to predict and are generally beyond our control. Additional information concerning these and other risk factors are contained in our Annual Report on Form 10-K filed with the SEC, on March 12, 2014, which is available on the Securities and Exchange Commission's website at www.sec.gov.

All subsequent written and oral forward-looking statements that we make, or that are attributable to us, are expressly qualified in their entirety by this cautionary notice. Any forward-looking statement speaks only as of the date on which it is made. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Overview

We are a Maryland corporation focused on investing in, financing and managing a leveraged portfolio of mortgage-backed securities, or MBS, including non-Agency and Agency residential mortgage-backed securities, or RMBS, Multi-Family MBS, residential mortgage loans and other mortgage-related investments, which we collectively refer to as our target assets.

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 currently, or expect to, invest in the following assets:

Non-Agency RMBS, which are RMBS that are not issued or guaranteed by a U.S. Government-sponsored entity;

Residential mortgage loans and other mortgage-related investments, including securitizations backed by multi-family mortgage loans, or Multi-Family MBS, and mortgage servicing rights, or MSRs; and

Agency RMBS, which are residential mortgage-backed securities, for which a U.S. Government agency such as Ginnie Mae or a federally chartered corporation such as Fannie Mae or Freddie Mac, guarantees payments of principal and interest on the securities;

We finance our current investments in Non-Agency RMBS (including Non-Agency RMBS underlying Linked Transactions),Multi-Family MBS and Agency RMBS primarily through short-term borrowings structured as repurchase agreements. We finance our investments in residential mortgage loans primarily through short-term borrowings structured as either repurchase agreements or secured loan facilities.

We are externally managed and advised by Oak Circle pursuant to a management agreement between us and Oak Circle. Oak Circle, which was formed for the purpose of becoming our Manager, manages us exclusively and, unless and until Oak Circle agrees to manage any additional investment vehicle, it will not have to allocate investment opportunities in our target assets with any other REIT, investment pool or other entity. As our Manager, Oak Circle implements our business strategy, performs investment advisory services and activities with respect to our assets and is responsible for performing all of our day-to-day operations. Oak Circle is an investment adviser registered with the SEC.

We elected to be taxed as a REIT commencing with our short taxable year ended December 31, 2012, and comply with the provisions of the Internal Revenue Code with respect thereto. Accordingly, we are generally not subject to federal income tax on our REIT taxable income that we currently distribute to our stockholders so long as we maintain our qualification as a REIT. Our continued qualification as a REIT depends on our ability to meet, on a continuing basis, various complex requirements under the Internal Revenue Code relating to, among other things, the source of our gross income, the composition and values of our assets, our distribution levels and the concentration of ownership of our capital stock. Even if we maintain our qualification as a REIT, we may be subject to some federal, state and local taxes on our income.

Second Quarter 2014 Highlights

On May 27, 2014, we completed an underwritten public offering of an additional 690,000 shares, including 90,000 shares upon the exercise in full of the underwriters' overallotment option, of our 8.75% Series A cumulative redeemable preferred stock (liquidation value $25 per share), or our Series A Preferred Stock, resulting in net proceeds to us of $16.3 million; our Series A Preferred Stock was originally issued in December 2013.

On June 19, 2014, we completed an underwritten public offering of 3,500,000 shares of common stock, for estimated net proceeds of $38.3 million. In connection with the offering, we granted the underwriters a 30-day option to purchase up to an additional 15%, or 525,000 shares of common stock. The underwriters exercised this option after quarter end, on July 14, 2014.

We delivered a positive economic return on common equity of 2.3% for the quarter, or 9.2% annualized, comprised of $0.38 dividend per common share more than offsetting a modest $0.08 decrease in net book value per share, in the context of a quarter where we continued to increase our capital base.

During the quarter, we continued signing up mortgage lending correspondent relationships, and made our first investments in prime jumbo mortgage loans. As we continue to build out our whole loan infrastructure, and based on additional loan purchase commitments made, we anticipate a significant increase in loan activity in the third quarter.

Factors Impacting Our Operating Results

The results of our operations will 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, our target assets in the marketplace. Our net interest income, which reflects the amortization of purchase premiums and accretion of purchase discounts, will vary primarily as a result of changes in market interest rates and prepayment speeds, as measured by the constant prepayment rate, or CPR, on our MBS and mortgage loans. Interest rates 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. Our operating results may also be impacted by unanticipated credit events experienced by borrowers whose mortgage loans are included in our MBS, or whose loans we own directly. Our operating results will also be affected by general U.S. residential real estate fundamentals and the overall U.S. economic environment. In particular, our strategy is influenced by the specific characteristics of the residential real estate markets, including prepayment rates, credit and interest rate levels.

Market conditions. Due to the significant repricing of real estate assets after the 2007-2008 financial crisis, and the continuing uncertainty in the direction of the real estate markets, we believe a shortage of debt and equity capital available for investing in real estate has been created as many financial institutions, insurance companies, finance companies and fund managers have determined to reduce or discontinue investment in debt or equity related to real estate. Although housing prices in many markets have since recovered, there remain opportunities for us to capitalize on market dislocations and the increasing need for private capital in the U.S. mortgage market.

During the second quarter of 2014, financial markets remained sanguine about the Federal Reserve's policy of tapering, and reflected renewed concerns about the resiliency of economic growth. On April 30, 2014, the Federal Reserve announced that it would further reduce its monthly purchases of Agency RMBS and Treasury securities to $20 billion and $25 billion, respectively, and on June 18, 2014, an additional reduction of monthly purchases was announced to $15 billion and $20 billion for Agency RMBS and Treasury securities, respectively. Starting the quarter at 2.75%, the 10-year Treasury yield traded in a 2.44%-2.80% range, before ending the quarter at 2.53%. While this would suggest that markets are increasingly sanguine about continued tapering, and while we continue to believe that mortgage-related assets offer attractive investment opportunities for us, the potential for renewed fixed income and mortgage market volatility remains. We expect that market conditions will continue to impact our operating results and will cause us to continue adjusting our investment and financing strategies over time as new opportunities emerge and risk profiles of our business change.

Changes in market interest rates. With respect to our business operations, increases in interest rates, in general, may over time cause: (1) the value of our MBS and loan portfolio to decline; (2) coupons on our adjustable-rate and hybrid RMBS to reset, although on a delayed basis, to higher interest rates;
(3) prepayments on our MBS and loan portfolio to slow, thereby slowing the amortization of our purchase premiums and the accretion of our purchase discounts; (4) the interest expense associated with our borrowings to increase; and (5) to the extent we enter into interest rate swap agreements as part of our hedging strategy, the value of these agreements to increase. Conversely, decreases in interest rates, in general, may over time cause: (1) prepayments on our MBS and loan portfolio to increase, thereby accelerating the amortization of our purchase premiums and the accretion of our purchase discounts; (2) the value of our MBS and loan portfolio to increase; (3) coupons on our adjustable-rate and hybrid RMBS to reset, although on a delayed basis, to lower interest rates;
(4) the interest expense associated with our borrowings to decrease; and (5) to the extent we enter into interest rate swap agreements as part of our hedging strategy, the value of these agreements to decrease.

Prepayment speeds. Prepayment speeds, as reflected by the CPR, vary according to interest rates, the type of residential mortgage loan, conditions in financial markets and housing markets, availability of residential mortgages, borrowers' credit profiles, competition and other factors, none of which can be predicted with any certainty. CPR, expressed as a percentage over a pool of residential mortgages, is the rate at which principal is expected to prepay in the given year (usually the next one). For example, if a certain residential mortgage loan pool has a CPR of 9%, then 9% of the existing pool principal outstanding is expected to prepay over the next year. In general, when interest rates rise, it is relatively less attractive for borrowers to refinance their residential mortgage loans, and as a result, prepayment speeds tend to decrease. When interest rates fall, however, prepayment speeds tend to increase. When house price appreciation is positive, prepayment rates may increase, and when house prices depreciate in value, prepayment rates may decline. For RMBS and loans purchased at a premium, as prepayment speeds increase, the amount of income we will earn on these investments will be less than expected because the purchase premium we will pay for the bonds amortizes faster than expected. Conversely, decreases in prepayment speeds result in income greater than expected and can extend the period over which we amortize the purchase premium. For RMBS and loans purchased at a discount, as prepayment speeds increase, the amount of income we will earn will be greater than expected because of the acceleration of the accretion of the discount into interest income. Conversely, decreases in prepayment speeds result in income less than expected and can extend the period over which we accrete the purchase discount into interest income. Generally, our Multi-Family MBS investments are not subject to prepayment risk, because scheduled repayments on the underlying multi-family mortgage loans are allocated to the most senior security in each transaction, and unscheduled repayments are held in the trust until the maturity date of the MBS securities. As a result, our Multi-Family MBS investments are scheduled to be repaid in full on a bullet maturity date.

Changes in market value of our assets. Other than our residential mortgage loans, as discussed below, it is our business strategy to hold our target assets as long-term investments. As such, we expect that our securities will be carried at their fair value, as available-for-sale, or AFS, when applicable, in accordance with ASC 320-10 "Investments-Debt and Equity Securities," with changes in fair value recorded through accumulated other comprehensive income/(loss), a component of stockholders' equity, rather than through earnings. As a result, we do not expect that changes in the market value of the assets will normally impact our operating results. However, at least on a quarterly basis, we monitor our target assets for other-than-temporary impairment, which could result in our recognizing a charge through earnings. See "-Critical Accounting Policies" for further details. The primary exception to this accounting policy relates to residential mortgage loans, which we intend to sell, either into a securitization transaction, or into the secondary market. Accordingly, we have elected the fair value option for mortgage loan assets, and as such, changes in the market value of these assets will directly impact our earnings.

Credit risk. We expect to be subject to varying degrees of credit risk in connection with our Non-Agency RMBS, Multi-Family MBS investments and residential mortgage loans. Our Manager seeks to mitigate this credit risk by estimating expected losses on these assets and either (i) purchasing such assets at appropriate discounted prices, e.g. for Non-Agency RMBS; or (ii) reviewing credit risk on a loan-by-loan basis and rejecting individual loans when deemed appropriate. Nevertheless, unanticipated credit losses could occur, which could adversely impact our operating results.

Governmental actions. Since 2008, when both Fannie Mae and Freddie Mac were placed under the conservatorship of the U.S. government, there have been a number of proposals to reform the U.S. housing finance system in general, and Fannie Mae and Freddie Mac in particular. GSE reform efforts continued in the second quarter of 2014, when the Johnson-Crapo Bill was reported out of the Senate Banking Committee. Broadly modeled on earlier proposed legislation such as the Housing Finance Reform and Taxpayer Protection Act of 2013,also known as the Corker- Warner bill, it appears the Johnson-Crapo Bill is unlikely to reach the Senate floor in 2014. It remains unclear whether these or any other proposals will become law or, should such a proposal become law, if or how the enacted law will differ from the current draft of the bill. It is unclear how the proposals would impact housing finance, and what impact, if any, it will have on mortgage REITs.

For a discussion of additional risks relating to our business see "Risk Factors" in our 2013 Annual Report.

Investment Activities

As of June 30, 2014, on a GAAP basis we had increased our overall investments in MBS to $570.8 million, compared to $482.5 million as of March 31, 2014. Within this total, we had increased our Agency RMBS from $408.4 million to $501.0 million, decreased our Non-Agency RMBS from $64.5 million to $62.5 million, and decreased our Multi-Family MBS from $9.6 million to $7.2 million, from quarter-end to quarter-end. As of June 30, 2014, we owned $848.5 million of MBS on a non-GAAP basis (including Non-Agency RMBS and Multi-Family MBS underlying Linked Transactions), of which $501.0 million was in Agency RMBS, $208.1 million was in Non-Agency RMBS and $139.3 was in Multi-Family MBS. Of the $208.1 million, $145.6 million was in Non-Agency RMBS underlying Linked Transactions and of the $139.3 million; $132.1 million was in Multi-Family MBS underlying Linked Transactions. As of June 30, 2014, on a GAAP and non-GAAP basis we had $4.5 million in residential mortgage loans. These marked our first purchases of prime jumbo mortgage loans. As of June 30, 2014, for our available-for-sale securities we had entered into master repurchase agreements with 26 counterparties, and we had borrowed $508.3 million, on a GAAP basis, and $706.0 million, on a non-GAAP basis (including the repurchase agreement financing associated with the Non-Agency RMBS and Multi-Family MBS underlying Linked Transactions) under 17 of these agreements. This compares to $435.3 million, on a GAAP basis, and $582.8 million, on a non-GAAP basis, respectively, as of March 31, 2014. For our mortgage loans held-for-sale we had entered into 1 master repurchase agreement, and we had borrowed $4.0 million, on a GAAP and non-GAAP basis under this agreement, as of June 30, 2014. This marked our first financing of prime jumbo mortgage loans. The increase in borrowings between periods is a result of the increase in investment activity following our May 2014 Series A Preferred Stock offering and our June 2014 common stock offering. We have also entered into interest rate swap and swaption agreements designed to mitigate the effects of increases in interest rates under a portion of our repurchase agreements. During the second quarter we increased the notional amount of swap agreements to $378.0 million, compared to $358.0 million as of March 31, 2014. We maintained the notional amount of our swaption agreements at $25.0 million as of June 30, 2014, while increasing the range of other derivative instruments used during the quarter to help mitigate interest rate and other market risks, including Agency to be announced securities, or TBAs, and U.S. Treasury futures. We used futures during the period, and there were 1,470 futures contracts outstanding as of June 30, 2014, representing a notional amount of $147.0 million.

We use leverage to increase potential returns to our stockholders. To that end, subject to maintaining our qualification as a REIT and our exclusion from registration under the Investment Company Act, we use borrowings to fund the origination or acquisition of our target assets. We accomplish this by borrowing against existing assets through repurchase agreements. Neither our organizational documents nor our investment guidelines places any limit on the maximum amount of leverage that we may use, and we are not required to maintain any particular debt-to-equity leverage ratio. We may also change our financing strategy and leverage without the consent of our stockholders.

As of June 30, 2014, we borrowed 2.3 times our stockholders' equity (calculated in accordance with GAAP); 3.3 times after including repurchase agreements underlying Linked Transactions (calculated on a non-GAAP basis), representing a meaningful reduction from 2.8 times and 3.7 times, respectively, as of March 31, 2014. We expect our leverage (on both a GAAP and non-GAAP basis) will range between three and six times the amount of our stockholders' equity, depending upon the relative allocation to Agency RMBS, Non-Agency RMBS, Multi-Family MBS and residential mortgage loans. We expect to borrow between six and nine times the amount of our stockholders' equity in acquiring Agency RMBS and residential mortgage loans, between one and two times when acquiring Legacy Non-Agency RMBS, between one and three times when acquiring Multi-Family MBS, and between one and three times when acquiring New Issue Non-Agency RMBS. The leverage our Manager is comfortable applying to each asset class at any point in time is a function of the yield profile across housing environments and also a function of price or market values in environments of excessive volatility. The reduction in our leverage during the period was principally due to capital raises during the quarter and our continuing to transition our portfolio into lower levered Non-Agency RMBS and Multi-Family MBS. Depending on the different cost of borrowing funds at different maturities, we vary the maturities of our borrowed funds to attempt to produce lower borrowing costs and reduce interest rate risk. Generally, we enter into collateralized borrowings only with institutions that are rated investment grade by at least one nationally-recognized statistical rating organization. Going forward, as we seek to continue expanding the range of available financing sources, we may borrow from institutions that, although not rated investment grade by at least one nationally recognized statistical rating organization, in the assessment of our management team represent an acceptable counterparty credit risk in providing collateralized financing for our portfolio. Nonetheless, we expect that the preponderance of our sources of collateralized borrowings (83.0% as of June 30, 2014) will continue to either have an investment grade rating directly or be part of a group of companies which includes an institution that has such a rating.

The leverage that we employ is specific to each asset class in which we invest and will be determined based on several factors, including potential asset price volatility, margin requirements, the current cycle for interest rates, the shape of the yield curve, credit, security price, the outlook for interest rates and our ability to use and the effectiveness of interest rate hedges. We analyze both historical interest rate and credit volatility and market-driven implied volatility for each asset class in order to determine potential asset price volatility. Our leverage targets attempt to risk-adjust asset classes based on each asset class's potential price volatility. The goal of our leverage strategy is to ensure that, at all times, our investment portfolio's leverage ratio is appropriate for the level of risk inherent in the investment portfolio and that each asset class has individual leverage targets that are appropriate for its potential price volatility.

As of June 30, 2014, our Agency RMBS portfolio had a weighted average nominal coupon of 2.74% at a weighted average amortized cost of $101.4 per $100 of nominal, or face, value, or $501.0 million total cost. As of June 30, 2014, the weighted average market price of our Agency portfolio was $101.4 per $100 of nominal, or face, value, or $501.0 million in the aggregate. All of our Agency securities represent whole pool securities.

As of June 30, 2014, our Non-Agency RMBS portfolio, on a GAAP basis, had a weighted average nominal coupon of 0.38% at a weighted average amortized cost of $62.0 per $100 of nominal, or face, value, or $56.0 million total cost. As of June 30, 2014, the weighted average market price of our Non-Agency RMBS portfolio, on a GAAP basis, was $69.3 per $100 of nominal, or face, value, or $62.5 million in the aggregate.

As of June 30, 2014, our Multi-Family MBS portfolio, on a GAAP basis, had a weighted average nominal coupon of 4.09% at a weighted average amortized cost of $97.5 per $100 of nominal, or face, value, or $6.8 million total cost. As of June 30, 2014, the weighted average market price of our multi-family RMBS portfolio, on a GAAP basis, was $103.1 per $100 of nominal, or face, value, or $7.2 million in aggregate.

As of June 30, 2014, our Non-Agency RMBS portfolio on a non-GAAP basis (including Non-Agency RMBS underlying Linked Transactions) had a weighted average nominal coupon of 0.38% at a weighted average amortized cost of $64.4 per $100 of nominal, or face, value, or $190.9 million total cost. As of June 30, 2014, the weighted average market price of our Non-Agency RMBS portfolio on a non-GAAP basis (including Non-Agency RMBS underlying Linked Transactions) was $70.2 per $100 of nominal, or face, value, or $208.1 million in the aggregate.

As of June 30, 2014, our Multi-Family MBS portfolio on a non-GAAP basis (including Multi-Family MBS underlying Linked Transactions) had a weighted average nominal coupon of 2.11% at a weighted at a weighted average amortized cost of $84.3 per $100 of nominal, or face, value, or $133.9 million total cost. As of June 30, 2014, the weighted average market price of our Multi-Family MBS portfolio on a non-GAAP basis (including multi-family RMBS underlying Linked Transactions) was $87.7 per $100 of nominal, or face, value, or $139.3 million in aggregate.

As of June 30, 2014, our residential mortgage loan portfolio on a GAAP and non-GAAP basis, had a weighted average nominal coupon 4.18% at a weighted average amortized cost $100.5 per $100 of nominal, or face, value, or $4.4 million in the aggregate. As of June 30, 2014, the weighted average market price of our residential mortgage loan portfolio was $102.6 per $100 of nominal, or face, value, or $4.5 million in the aggregate. All of our residential mortgage loans are secured by first priority mortgages on the underlying properties.

Investment Portfolio

The following table summarizes certain characteristics of our investment portfolio as of June 30, 2014: (1) as reported in accordance with GAAP, which excludes the Non-Agency RMBS and Multi-Family MBS underlying our Linked Transactions, (2) to show separately the Non-Agency RMBS and Multi-Family MBS underlying our Linked Transactions; and (3) on a non-GAAP combined basis (which reflects the inclusion of the Non-Agency RMBS and Multi-Family MBS underlying our Linked Transactions combined with our GAAP-reported MBS):

GAAP Basis

                                                                                                                                     Net
                                            Unamortized        Designated                         Unrealized                       Weighted
                           Principal          Premium            Credit          Amortized           Gain/           Fair          Average         Average
$ in thousands              Balance          (Discount)          Reserve            Cost            (Loss)           Value         Coupon(1)       Yield(2)
Agency RMBS
15 year fixed-rate        $      2,660     $           66     $           -     $      2,726     $         (24 )   $    2,702            2.50 %          1.96 %
30 year fixed-rate             122,157              6,868                 -          129,025            (3,270 )      125,755            3.50 %          2.69 %
Hybrid ARMS                    369,257                 37                 -          369,294             3,266        372,560            2.49 %          2.69 %

Total Agency RMBS              494,074              6,971                 -          501,045               (28 )      501,017            2.74 %          2.68 %

Multi-Family MBS
Excluding Linked
Transactions                     7,000               (175 )               -            6,825               395          7,220            4.09 %          4.44 %
Non-Agency RMBS
. . .
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