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JMI > SEC Filings for JMI > Form 10-Q on 15-Nov-2012All Recent SEC Filings




Quarterly Report

Item 2. 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 our financial statements and related notes included elsewhere in this report.

References to "we," "us," "our," "JAVELIN" or the "Company" are to JAVELIN Mortgage Investment Corp. References to "Manager" or "ARRM" are to ARMOUR Residential Management LLC, a Delaware limited liability company and the external manager of JAVELIN.


We are a newly-organized Maryland corporation formed to invest in and manage a leveraged portfolio of residential mortgage-backed securities issued or guaranteed by a U.S. Government-sponsored entity ("GSE"), such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), or guaranteed by the Government National Mortgage Administration (Ginnie Mae), (collectively, "Agency Securities"), non-Agency Securities and other mortgage-related investments, which we refer to as our target assets. We will be externally managed by ARRM an investment advisor registered with the Securities and Exchange Commission ("SEC"). ARRM is also the external manager of ARMOUR Residential REIT, Inc. ("ARMOUR"), a publicly traded REIT, which invests in and manages a leveraged portfolio of hybrid adjustable rate, adjustable rate and fixed rate Agency Securities. Our executive officers also serve as the executive officers of ARMOUR.

As of September 30, 2012, we had not commenced operations. The discussion and analysis set forth below is as of September 30, 2012, unless indicated otherwise.

We seek attractive long-term investment returns by investing our equity capital and borrowed funds in our targeted asset class. We plan to earn returns on the spread between the yield on our assets and our costs, including the cost of the funds we borrow, after giving effect to our hedges. We plan to identify and acquire our target assets, finance our acquisitions with borrowings under a series of short-term repurchase agreements at the most competitive interest rates available to us and then cost-effectively mitigate our interest rate and other risks based on our entire portfolio of assets, liabilities and derivatives and our management's view of the market. Successful implementation of this approach requires us to address and effectively mitigate interest rate risk and maintain adequate liquidity. We believe that the residential mortgage market will undergo significant changes in the coming years as the role of GSEs, such as Fannie Mae and Freddie Mac, is diminished, which we expect will create attractive investment opportunities for us.

We intend to elect to qualify as a real estate investment trust ("REIT") for federal income tax purposes and will elect to be taxed as a REIT under the Code commencing with our taxable year ending December 31, 2012. We generally will not be subject to federal income taxes on our taxable income to the extent that we annually distribute all of our taxable income to stockholders and maintain our intended qualification as a REIT. We also intend to operate our business in a manner that will permit us to maintain an exclusion from registration under the Investment Company Act of 1940 ("1940 Act").

Recent Developments

The registration statement on Form S-11 (the "Registration Statement") for our initial public offering of common stock (the "IPO") was filed with, and declared effective by the SEC, on October 2, 2012, and we consummated the IPO and Private Placement on October 5, 2012. On October 3, 2012, our common stock commenced trading on the New York Stock Exchange under the symbol "JMI." We sold to the public 7,250,000 shares and sold to SBBC 250,000 shares of common stock for $20.00 per share. Net proceeds from the IPO and Private Placement totaled $150,000,000. On November 2, 2012, the underwriters in the IPO decided not to exercise their over-allotment option to purchase up to an additional 1,087,500 shares of common stock.

On October 5, 2012, we entered into a management agreement with ARRM that governs the relationship between us and our Manager, ARRM, and describes the services to be provided by the Manager and the compensation we pay our Manager for those services. Pursuant to the management agreement, ARRM is entitled to receive a monthly management fee equal to 1/12th of (a) 1.5% of Gross Equity Raised (as defined below) up to $1 billion and (b) 1.0% of Gross Equity Raised in excess of $1 billion. Pursuant to the management agreement, "Gross Equity Raised" is defined as an amount in dollars calculated as of the date of determination that is equal to (a) the initial equity capital of JAVELIN following the IPO and the Private Placement, plus (b) equity capital raised in public or private issuances of JAVELIN's equity securities (calculated before underwriting fees and distribution expenses, if any are payable by us), less (c) capital returned to the stockholders of JAVELIN, as adjusted to exclude (d) one-time charges pursuant to changes in GAAP and certain non-cash charges after discussion between the Manager and the board of directors (the "Board") and approved by a majority of the Board.

ARRM will be entitled to receive a monthly management fee regardless of the performance of our portfolio. Accordingly, the payment of the monthly management fee may not decline in the event of a decline in our earnings and may cause us to incur losses.

Under the terms of the Management Agreement, ARRM is responsible for the costs incident to the performance of its duties, such as compensation of its employees and various overhead expenses. We are responsible for any costs and expenses that ARRM incurs solely on our behalf other than the various expenses specified in the Management Agreement.

The Management Agreement has an initial term of five years. Following the initial term, the Management Agreement will automatically renew for successive one-year renewal terms unless terminated under certain circumstances. Either party must provide 180 days prior written notice of any such termination.

Additionally, on October 5, 2012, JAVELIN and ARRM entered into a sub-management agreement with SBBC (the "Sub-Management Agreement"). Pursuant to the Sub-Management Agreement, SBBC provides the following services to support ARRM's performance of services to us under the Management Agreement, in each case upon reasonable request by ARRM: (i) serving as a consultant to ARRM with respect to the periodic review of our investment guidelines; (ii) identifying for ARRM potential new lines of business and investment opportunities for us; (iii) identifying for and advising ARRM with respect to selection of independent contractors that provide investment banking, securities brokerage, mortgage brokerage and other financial services, due diligence services, underwriting review services, legal and accounting services, and all other services as may be required relating to our investments; (iv) advising ARRM with respect to our stockholder and public relations matters; (v) advising and assisting ARRM with respect to our capital structure and capital raising; and (vi) advising ARRM on negotiating agreements relating to programs established by the U.S. government. In exchange for such services, ARRM pays SBBC a monthly retainer of $115,000 and a sub-management fee of 25% of the net management fee earned by ARRM under the Management Agreement we entered into with ARRM. The Sub-Management Agreement continues in effect until it is terminated in accordance with its terms. SBBC is also the sub-manager of ARMOUR and provides ARRM the services described above in connection with ARRM's management of ARMOUR.

On October 9, 2012, we commenced its operations.

On November 7, 2012, we announced a monthly dividend rate of $0.23 per outstanding common share of stock payable November 29, 2012 to holders of record on November 19, 2012 and payable December 28, 2012 to holders of record on December 14, 2012.

As of November 13, 2012, we have invested approximately $1.1 billion and $0.1 billion in Agency Securities and non-Agency Securities, respectively and have incurred liabilities of approximately $1.1 billion under repurchase agreements.

As of November 13, 2012, we have interest rate swap contracts with an aggregate notional balance of $0.3 billion and have entered into interest rate swaptions with an aggregate notional balance of $0.1 billion.

Factors that Affect our Results of Operations and Financial Condition

Our results of operations and financial condition will be affected by various factors, many of which will be beyond our control, including, among other things, our net interest income, the market value of our target assets and the supply of and demand for such assets. We intend to invest in financial assets and markets and recent events, such as those discussed below, may affect our business in ways that are difficult to predict. Our net interest income will likely vary primarily as a result of changes in interest rates, borrowing costs and prepayment speeds, the behavior of which involves various risks and uncertainties. We intend to invest across the spectrum of mortgage investments, from Agency Securities, for which the principal and interest payments are guaranteed by a GSE, to non-Agency securities, non-prime mortgage loans and unrated equity tranches of collateralized mortgage-backed securities ("CMBS"). As such, we expect our investments will be subject to risks arising from delinquencies and foreclosures, thereby exposing our investment portfolio to potential losses. We will also be exposed to changing credit spreads which could result in declines in the fair value of our investments. We believe our Manager's in-depth investment expertise across multiple sectors of the mortgage market, prudent asset selection and our hedging strategy will enable us to minimize our credit losses, our market value losses and financing costs. Prepayment rates, as reflected by the rate of principal pay downs, and interest rates will likely vary according to the type of investment, conditions in financial markets, government actions, competition and other factors, none of which can be predicted with any certainty. In general, as prepayment rates on our target assets purchased at a premium increase, related purchase premium amortization will increase, thereby reducing the net yield on such assets. Because changes in interest rates may significantly affect our activities, our operating results will depend, in large part, upon our ability to manage interest rate risks and prepayment risks effectively while maintaining our status as a REIT.

We anticipate that for any period during which changes in the interest rates earned on our target assets do not coincide with interest rate changes on our borrowings, such assets will reprice more slowly than the corresponding liabilities. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net interest income. We anticipate that interest rate increases will tend to decrease our net interest income and the market value of our target assets and therefore, our book value. Such rate increases could possibly result in operating losses or adversely affect our ability to make distributions to our stockholders.

Prepayments on our target assets may be influenced by changes in market interest rates and a variety of economic and geographic policy decisions by regulators as well as other factors beyond our control. Consequently prepayment rates cannot be predicted with certainty. To the extent we can acquire our target assets at a premium or discount to par, or face value, changes in prepayment rates may impact our anticipated yield. In periods of declining interest rates prepayments on our target assets will likely increase. If we are unable to reinvest the proceeds of such prepayments at comparable yields, our net interest income may suffer. The recent climate of government intervention in the housing finance markets significantly increases the risk associated with prepayments.

While we intend to use strategies to mitigate some of our interest rate risk, we do not intend to mitigate all of our exposure to changes in interest rates, as there are practical limitations on our ability to insulate our portfolio from all potential negative consequences associated with changes in short-term interest rates in a manner that will allow us to seek attractive net spreads on our portfolio.

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

our degree of leverage;

our access to funding and borrowing capacity;

our hedging activities; and

the REIT requirements, the requirements to qualify for an exemption under the 1940 Act and other regulatory and accounting policies related to our business.

Our Manager will be entitled to receive a management fee that is based on our Gross Equity Raised, regardless of the performance of our portfolio. Accordingly, the payment of our management fee may not decline in the event of a decline in our profitability and may cause us to incur losses.

For a discussion of additional risks relating to our business, see "Risk Factors" beginning on page 15 of our the Registration Statement and the risk factors in Part II, Item 1A of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2012, filed with the SEC on November 15, 2012.

Market and Interest Rate Trends and the Effect on our Portfolio

Credit Market Disruption

During the past few years, the residential housing and mortgage markets in the U.S. have experienced a variety of difficulties and changed economic conditions, including loan defaults, credit losses and decreased liquidity. These conditions have resulted in volatility in the value of the mortgage-related investments that we intend to purchase and an increase in the average collateral requirements under our repurchase agreements we expect to obtain. While these markets have recovered significantly, further increased volatility and deterioration in the broader residential mortgage and residential mortgage-backed securities markets may adversely affect the performance and market value of our target assets.

The uncertainty in the U.S. interest rate markets in 2011 and 2012 has produced volatility and opportunities in the markets in which we intend to invest. Early in 2011, optimism about an economic acceleration caused many economists to increase their U.S. Gross Domestic Product forecast, with some predicting a U.S. Federal Reserve tightening of monetary policy in early 2012. However, the Federal Reserve's Federal Open Market Committee ("FOMC") noted in late January 2012 that despite some evidence of moderate expansion in the economy and improvement in overall labor conditions and an increase in household spending, the unemployment rate remained elevated, business fixed investment had slowed and the housing sector remained depressed. Because of low rates of resource utilization and a subdued outlook for inflation, the FOMC said in its January meeting that it anticipated current economic conditions were likely to warrant exceptionally low levels for the Federal Funds Rate at least through late 2014.
In June 2012, the FOMC updated its assessment by noting that the economy was expanding moderately in 2012 with business fixed investment continuing to advance and inflation in decline. However, the FOMC also cautioned that growth in employment had slowed in recent months, and the unemployment rate remained elevated. Additionally, the FOMC noted household spending appeared to be rising at a somewhat slower pace than earlier in the year and despite some signs of improvement, the housing sector remained depressed. As a result, the FOMC announced that it expected to maintain a highly accommodative stance for monetary policy and to continue to maintain exceptionally low levels for the Federal Funds Rate through 2014. This environment and outlook has created strong demand for Agency Securities and has also reduced the costs of our financing and hedging.

On August 5, 2011, Standard & Poor's Corporation downgraded the U.S. Government's credit rating from AAA to AA+ and on August 8, 2011, Fannie Mae and Freddie Mac's credit ratings were downgraded from AAA to AA+. Because Fannie Mae and Freddie Mac are in conservatorship of the U.S. Government, the U.S. Government's credit rating downgrade and Fannie Mae's and Freddie Mac's credit rating downgrades will impact the credit risk associated with Agency Securities and, therefore, may decrease the value of the Agency Securities in our portfolio.

Developments at Fannie Mae and Freddie Mac

Payments on the Agency Securities in which we intend to invest will be guaranteed by Fannie Mae and Freddie Mac. Because of the guarantee and the underwriting standards associated with mortgages underlying Agency Securities, Agency Securities historically have had high stability in value and been considered to present low credit risk. In 2008, Fannie Mae and Freddie Mac were placed under the conservatorship of the U.S. Government due to the significant weakness of their financial condition. It is unclear how and when Fannie Mae and Freddie Mac may be restructured by the U.S. Government and the impact that may have on our anticipated portfolio and continuing investment strategy.

In response to the credit market disruption and the deteriorating financial condition of Fannie Mae and Freddie Mac, Congress and the U.S. Treasury undertook a series of actions in 2008 aimed at stabilizing the financial markets in general and the mortgage market in particular. These actions include the large-scale buying of mortgage-backed securities, significant equity infusions into banks and aggressive monetary policy.

In addition, the U.S. Federal Reserve initiated a program in 2008 to purchase $200.0 billion in direct obligations of Fannie Mae, Freddie Mac and the Federal Home Loan Banks and $1.3 trillion in Agency Securities issued and guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. The U.S. Federal Reserve stated that its actions were intended to reduce the cost and increase the availability of credit for the purchase of houses, which in turn was expected to support housing markets and foster improved conditions in financial markets more generally. This purchase program was completed on March 31, 2010. In March 2011, the U.S. Treasury announced that it will begin the orderly wind down of its remaining Agency Securities with sales up to $10.0 billion per month, subject to market conditions. We are unable to predict the timing or manner in which the U.S. Treasury or the Federal Reserve will liquidate their holdings or make further interventions in the Agency Securities markets, or what impact, if any, such action could have on the Agency Securities market, the Agency Securities we intend to hold, our business, results of operations and financial condition.

In February 2010, Fannie Mae and Freddie Mac announced that they would execute wholesale repurchases of loans which they considered seriously delinquent from existing mortgage pools. This action temporarily decreased the value of these securities until complete details of the programs and the timing were announced. Freddie Mac implemented its purchase program in February 2010 with actual purchases beginning in March 2010. Fannie Mae began their process in March 2010 and announced it would implement the initial purchases over a period of three months, beginning in April 2010. Further, both agencies announced that on an ongoing basis they would purchase loans from the pools of mortgage loans underlying their mortgage pass-through certificates that became 120 days delinquent.

In February 2011, the U.S. Treasury along with the U.S. Department of Housing and Urban Development released a report entitled, "Reforming America's Housing Finance Market" to the U.S. Congress outlining recommendations for reforming the U.S. housing system, specifically Fannie Mae and Freddie Mac and transforming the U.S. Government's involvement in the housing market. It is unclear how future legislation may impact the housing finance market and the investing environment for Agency Securities as the method of reform is undecided and has not yet been defined by the regulators. Without U.S. Government support for residential mortgages, we may not be able to execute our current business model in an efficient manner.

We cannot predict whether or when new actions may occur, the timing and pace of current actions already implemented, or what impact if any, such actions, or future actions, could have on our business, results of operations and financial condition.

U.S. Government Mortgage-Related Securities Market Intervention

The U.S. Federal Reserve's program to purchase Agency Securities, which commenced in January 2009 and terminated on March 31, 2010, has had a significant impact on market prices for Agency Securities. In total, $1.3 trillion of Agency Securities were purchased. In addition, through the course of 2009, the U.S. Treasury purchased $250.0 billion of Agency Securities. An effect of these purchases has been an increase in the prices of Agency Securities. When these programs terminated, the market expectation was that it might cause a decrease in demand for these securities which would likely reduce their market price. However, this has not happened and we continue to see strong demand as these securities remain desirable assets in this rather volatile economic environment. It is difficult to quantify the impact, as there are many factors at work at the same time that affect the price of Agency Securities and, therefore, yield and book value. Due to the unpredictability in the markets for our target assets in particular and yield generating assets in general, there is no pattern that can be implied with any certainty. In March 2011, the U.S. Treasury announced that it would begin the orderly wind down of its remaining Agency Securities with sales up to $10.0 billion per month, subject to market conditions. It is unclear how these sales will affect market conditions and pricing. On September 21, 2011, the U.S. Federal Reserve announced that it would begin reinvesting principal payments from its holdings of GSE debt and Agency Securities into Agency Securities.

In September 2012, the FOMC announced an open-ended program to purchase an additional $40 billion of Agency Securities per month until the unemployment rate, among other economic indicators, show signs of improvement. This program, which is popularly referred to as "QE3," when combined with the Federal Reserve's existing programs to extend its holdings' average maturity, and reinvest principal payments from its holdings of unsecured notes and bonds issued by GSEs (collectively, "Agency Debt") and Agency Securities into Agency Securities, is expected to increase the Federal Reserve's holdings of long-term securities by approximately $85 billion per month through the end of 2012. The Federal Reserve also announced that it will keep the target range for the Federal Funds Rate between zero and 0.25% through at least mid-2015, which is six months longer than the Federal Reserve had previously announced.

The Federal Reserve expects these measures to put downward pressure on long-term interest rates. In the short term, these actions have driven Agency Securities prices to all-time highs, which have further compressed interest spreads, and removed the historical correlation between mortgage rates and U.S. Treasury or interest rate swaps. These factors have contributed to a challenging interest rate hedging environment.

Financial Regulatory Reform Bill and Other Government Activity

Certain programs initiated by the U.S. Government through the Federal Housing Administration and the Federal Deposit Insurance Corporation ("FDIC") to provide homeowners with assistance in avoiding residential mortgage loan foreclosures are currently in effect. The programs may involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans or the rate of interest payable on the loans, or to extend the payment terms of the loans. While the effect of these programs has not been as extensive as originally expected, the effect of such programs for holders of Agency Securities could be that such holders would experience changes in the anticipated yields of their Agency Securities due to (i) increased prepayment rates and (ii) lower interest and principal payments.

In March 2009, the Home Affordable Modification Program ("HAMP") was introduced to provide homeowners with assistance in avoiding residential mortgage loan foreclosures. HAMP is designed to help at risk homeowners, both those who are in default and those who are at imminent risk of default, by providing the borrower with affordable and sustainable monthly payments. In an effort to continue to provide meaningful solutions to the housing crisis, effective June 1, 2012, the Obama administration expanded the population of homeowners that may be eligible for HAMP.

On July 21, 2010, President Obama signed the Dodd-Frank Act into law. The Dodd-Frank Act is extensive, complicated and comprehensive legislation that impacts practically all aspects of banking, and a significant overhaul of many aspects of the regulation of the financial services industry. Although many provisions remain subject to further rulemaking, the Dodd-Frank Act implements numerous and far-reaching changes that affect financial companies, including our company, and other banks and institutions which are important to our business model. Certain notable rules are, among other things:

requiring regulation and oversight of large, systemically important financial institutions by establishing an interagency council on systemic risk and implementation of heightened prudential standards and regulation by the Board of Governors of the U.S. Federal Reserve for systemically important financial institutions (including nonbank financial companies), as well as the implementation of the FDIC resolution procedures for liquidation of large financial companies to avoid market disruption;

applying the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies, savings and loan holding companies and systemically important nonbank financial companies;

limiting the U.S. Federal Reserve's emergency authority to lend to nondepository institutions to facilities with broad-based eligibility, and authorizing the FDIC to establish an emergency financial stabilization fund for solvent depository institutions and their holding companies, subject to the approval of Congress, the Secretary of the U.S. Treasury and the U.S. Federal Reserve;

creating regimes for regulation of over-the-counter derivatives and non-admitted property and casualty insurers and reinsurers;

implementing regulation of hedge fund and private equity advisers by requiring such advisers to register with the SEC;

providing for the implementation of corporate governance provisions for all public companies concerning proxy access and executive compensation;

reforming regulation of credit rating agencies; and expanding the jurisdiction of the Commodity Futures Trading Commission to include most swaps.

Many of the provisions of the Dodd-Frank Act, including certain provisions described above are subject to further study, rulemaking, and the discretion of regulatory bodies. As the hundreds of regulations called for by the Dodd-Frank Act are promulgated, we will continue to evaluate the impact of any such regulations. It is unclear how this legislation may impact the borrowing . . .

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