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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 
_______________________________________________ 
FORM 10-Q 
_______________________________________________
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2016
OR 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                  to                 
Commission file number 001-34385
ivrsinglelogojpega17.jpg

(Exact Name of Registrant as Specified in Its Charter)
_______________________________________________
Maryland
 
26-2749336
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
 
 
1555 Peachtree Street, N.E., Suite 1800
Atlanta, Georgia
 
30309
(Address of Principal Executive Offices)
 
(Zip Code)
(404) 892-0896
(Registrant’s Telephone Number, Including Area Code) 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): 
Large Accelerated filer
 
ý
 
  
Accelerated filer
 
o
Non-Accelerated filer
 
o
(Do not check if a smaller reporting company)
  
Smaller reporting company
 
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o    No  ý
As of November 1, 2016, there were 111,588,883 outstanding shares of common stock of Invesco Mortgage Capital Inc.

Table of Contents


INVESCO MORTGAGE CAPITAL INC.
TABLE OF CONTENTS
 
 
 
Page
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
Item 5.
 
 
 
Item 6.

Table of Contents


PART I
ITEM 1.
FINANCIAL STATEMENTS
INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
  
As of
 $ in thousands except share amounts
September 30, 2016
 
December 31, 2015
ASSETS
 
Mortgage-backed and credit risk transfer securities, at fair value (including pledged securities of $15,493,599 and $15,553,934, respectively)
16,074,077

 
16,065,935

Commercial loans, held-for-investment
273,291

 
209,062

Cash and cash equivalents
47,282

 
53,199

Due from counterparties
241,161

 
110,009

Investment related receivable
44,944

 
154,594

Accrued interest receivable
49,390

 
50,779

Derivative assets, at fair value
505

 
8,659

Other assets
183,514

 
115,072

Total assets
16,914,164

 
16,767,309

LIABILITIES AND EQUITY
 
 
 
Liabilities:
 
 
 
Repurchase agreements
12,060,502

 
12,126,048

Secured loans
1,650,000

 
1,650,000

Exchangeable senior notes
396,420

 
394,573

Derivative liabilities, at fair value
382,321

 
238,148

Dividends and distributions payable
50,921

 
51,734

Investment related payable
17

 
167

Accrued interest payable
23,915

 
21,604

Collateral held payable
—

 
4,900

Accounts payable and accrued expenses
1,477

 
2,376

Due to affiliate
10,295

 
10,851

Total liabilities
14,575,868

 
14,500,401

Equity:
 
 
 
Preferred Stock, par value $0.01 per share; 50,000,000 shares authorized:
 
 
 
7.75% Series A Cumulative Redeemable Preferred Stock: 5,600,000 shares issued and outstanding ($140,000 aggregate liquidation preference)
135,356

 
135,356

7.75% Fixed-to-Floating Series B Cumulative Redeemable Preferred Stock: 6,200,000 shares issued and outstanding ($155,000 aggregate liquidation preference)
149,860

 
149,860

Common Stock, par value $0.01 per share; 450,000,000 shares authorized; 111,588,883 and 113,619,471 shares issued and outstanding, respectively
1,116

 
1,136

Additional paid in capital
2,382,847

 
2,407,372

Accumulated other comprehensive income
585,563

 
318,624

Retained earnings (distributions in excess of earnings)
(943,771
)
 
(771,313
)
Total stockholders’ equity
2,310,971

 
2,241,035

Non-controlling interest
27,325

 
25,873

Total equity
2,338,296

 
2,266,908

Total liabilities and equity
16,914,164

 
16,767,309

The accompanying notes are an integral part of these condensed consolidated financial statements.

 
1
 

Table of Contents


INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited) 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands, except share amounts
2016
 
2015
 
2016
 
2015
Interest Income

 

 

 

Mortgage-backed and credit risk transfer securities
112,467

 
128,305

 
347,573

 
395,844

Residential loans (1)
—

 
28,380

 
—

 
88,001

Commercial loans
5,680

 
3,743

 
16,520

 
11,349

Total interest income
118,147

 
160,428

 
364,093

 
495,194

Interest Expense

 

 

 

Repurchase agreements
24,892

 
41,303

 
97,952

 
125,544

Secured loans
2,746

 
1,622

 
8,149

 
4,639

Exchangeable senior notes
5,620

 
5,620

 
16,847

 
16,840

Asset-backed securities (1)
—

 
20,686

 
—

 
64,913

Total interest expense
33,258

 
69,231

 
122,948

 
211,936

Net interest income
84,889

 
91,197

 
241,145

 
283,258

Reduction in provision for loan losses
—

 
81

 
—

 
213

Net interest income after reduction in provision for loan losses
84,889

 
91,278

 
241,145

 
283,471

Other Income (loss)

 

 

 

Gain (loss) on investments, net
(7,155
)
 
(1,967
)
 
5,860

 
11,019

Equity in earnings of unconsolidated ventures
729

 
1,894

 
1,992

 
9,131

Gain (loss) on derivative instruments, net
35,378

 
(220,602
)
 
(293,528
)
 
(287,344
)
Realized and unrealized credit derivative income (loss), net
31,926

 
2,928

 
57,564

 
24,904

Other investment income (loss), net
(554
)
 
739

 
(3,617
)
 
1,518

Total other income (loss)
60,324

 
(217,008
)
 
(231,729
)
 
(240,772
)
Expenses
 
 
 
 
 
 
 
Management fee – related party
6,719

 
10,058

 
25,292

 
28,816

General and administrative
1,836

 
2,507

 
5,769

 
6,186

Consolidated securitization trusts (1)
—

 
2,132

 
—

 
6,544

Total expenses
8,555

 
14,697

 
31,061

 
41,546

Net income (loss)
136,658

 
(140,427
)
 
(21,645
)
 
1,153

Net income (loss) attributable to non-controlling interest
1,723

 
(1,628
)
 
(235
)
 
(10
)
Net income (loss) attributable to Invesco Mortgage Capital Inc.
134,935

 
(138,799
)
 
(21,410
)
 
1,163

Dividends to preferred stockholders
5,716

 
5,716

 
17,148

 
17,148

Net income (loss) attributable to common stockholders
129,219

 
(144,515
)
 
(38,558
)
 
(15,985
)
Earnings (loss) per share:
 
 


 


 


Net income (loss) attributable to common stockholders
 
 

 

 

Basic
1.16

 
(1.18
)
 
(0.34
)
 
(0.13
)
Diluted
1.05

 
(1.18
)
 
(0.34
)
 
(0.13
)
Dividends declared per common share
0.40

 
0.40

 
1.20

 
1.30

(1)
The condensed consolidated statements of operations for the three and nine months ended September 30, 2015 include income and expenses of consolidated variable interest entities ("VIEs"). The Company deconsolidated these VIEs in December 2015. Refer to Note 2 - “Summary of Significant Accounting Policies” for further discussion.
The accompanying notes are an integral part of these condensed consolidated financial statements.

 
2
 

Table of Contents


INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
Net income (loss)
136,658

 
(140,427
)
 
(21,645
)
 
1,153

Other comprehensive income (loss):
 
 
 
 
 
 
 
Unrealized gain (loss) on mortgage-backed and credit risk transfer securities, net
32,015

 
42,933

 
270,591

 
(30,611
)
Reclassification of unrealized (gain) loss on sale of mortgage-backed and credit risk transfer securities to gain (loss) on investments, net
—

 
389

 
(11,581
)
 
(4,152
)
Reclassification of amortization of net deferred (gain) loss on de-designated interest rate swaps to repurchase agreements interest expense
(4,831
)
 
15,724

 
11,331

 
51,182

Currency translation adjustments on investment in unconsolidated venture
(235
)
 
(33
)
 
(10
)
 
(33
)
Total other comprehensive income
26,949

 
59,013

 
270,331

 
16,386

Comprehensive income (loss)
163,607

 
(81,414
)
 
248,686

 
17,539

Less: Comprehensive income (loss) attributable to non-controlling interest
(2,063
)
 
942

 
(3,157
)
 
(191
)
Less: Dividends to preferred stockholders
(5,716
)
 
(5,716
)
 
(17,148
)
 
(17,148
)
Comprehensive income (loss) attributable to common stockholders
155,828

 
(86,188
)
 
228,381

 
200

The accompanying notes are an integral part of these condensed consolidated financial statements.


 
3
 

Table of Contents


INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF EQUITY
For the nine months ended September 30, 2016
(Unaudited)
 
 
 
 
 
 
 
Attributable to Common Stockholders
 
 
 
 
 
 
 
 
 
 
 
 
 
Additional
Paid in
Capital
 
Accumulated
Other
Comprehensive
Income
 
Retained
Earnings
(Distributions
in excess of
earnings)
 
Total
Stockholders’
Equity
 
Non-
Controlling
Interest
 
 
 
Series A
Preferred Stock
 
Series B
Preferred Stock
 
 
 
 
$ in thousands except
 share amounts
 
 
Common Stock
 
Total
Equity
Shares
 
Amount
 
Shares
 
Amount
 
Shares
 
Amount
 
 
 
 
 
 
Balance at December 31, 2015
5,600,000

 
135,356

 
6,200,000

 
149,860

 
113,619,471

 
1,136

 
2,407,372

 
318,624

 
(771,313
)
 
2,241,035

 
25,873

 
2,266,908

Net loss
—

 
—

 
—

 
—

 
—

 


 
—

 
—

 
(21,410
)
 
(21,410
)
 
(235
)
 
(21,645
)
Other comprehensive income
—

 
—

 
—

 
—

 
—

 
—

 
—

 
266,939

 
—

 
266,939

 
3,392

 
270,331

Proceeds from issuance of common stock, net of offering costs
—

 
—

 
—

 
—

 
3,201

 
—

 
35

 
—

 
—

 
35

 
—

 
35

Repurchase of shares of common stock
—

 
—

 
—

 
—

 
(2,063,451
)
 
(20
)
 
(24,980
)
 
—

 
—

 
(25,000
)
 
—

 
(25,000
)
Stock awards
—

 
—

 
—

 
—

 
29,662

 
—

 
—

 
—

 
—

 
—

 
—

 
—

Common stock dividends
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

 
(133,900
)
 
(133,900
)
 
—

 
(133,900
)
Common unit dividends
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

 
(1,710
)
 
(1,710
)
Preferred stock dividends
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

 
(17,148
)
 
(17,148
)
 
—

 
(17,148
)
Amortization of equity-based compensation
—

 
—

 
—

 
—

 
—

 
—

 
420

 
—

 


 
420

 
5

 
425

Balance at September 30, 2016
5,600,000

 
135,356

 
6,200,000

 
149,860

 
111,588,883

 
1,116

 
2,382,847

 
585,563

 
(943,771
)
 
2,310,971

 
27,325

 
2,338,296

The accompanying notes are an integral part of this condensed consolidated financial statement.


 
4
 

Table of Contents


INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
  
Nine Months Ended September 30,
$ in thousands
2016
 
2015
Cash Flows from Operating Activities
 
 
 
Net income (loss)
(21,645
)
 
1,153

Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
Amortization of mortgage-backed and credit risk transfer securities premiums and (discounts), net
85,522

 
90,900

Amortization of residential loans and asset-backed securities premiums (discount), net
—

 
(639
)
Amortization of commercial loan origination fees
(219
)
 
(51
)
Reduction in provision for loan losses
—

 
(213
)
Unrealized (gain) loss on derivative instruments, net
150,842

 
104,546

Unrealized (gain) loss on credit derivatives, net
(45,192
)
 
(7,923
)
(Gain) loss on investments, net
(5,860
)
 
(11,019
)
Realized (gain) loss on derivative instruments, net
62,222

 
44,394

Realized (gain) loss on credit derivatives, net
6,017

 
2,184

Equity in earnings of unconsolidated ventures
(1,992
)
 
(9,131
)
Amortization of equity-based compensation
425

 
422

Amortization of deferred securitization and financing costs
1,847

 
2,391

Amortization of net deferred losses on de-designated interest rate swaps
11,331

 
51,182

(Gain) loss on foreign currency transactions, net
6,080

 
619

Changes in operating assets and liabilities:
 
 
 
(Increase) decrease in operating assets
1,260

 
(3,289
)
Increase in operating liabilities
858

 
10,512

Net cash provided by operating activities
251,496

 
276,038

Cash Flows from Investing Activities
 
 
 
Purchase of mortgage-backed and credit risk transfer securities
(2,367,991
)
 
(1,821,811
)
Purchase of U.S. Treasury securities
(403,105
)
 
—

Proceeds from sale of U.S. Treasury securities
524,478

 
—

(Contributions) distributions (from) to investment in unconsolidated ventures, net
7,632

 
15,174

Change in other assets
(73,875
)
 
(12,875
)
Principal payments from mortgage-backed and credit risk transfer securities
1,920,352

 
1,910,904

Proceeds from sale of mortgage-backed and credit risk transfer securities
659,959

 
290,561

Payments on sale of credit derivatives
(6,017
)
 
(2,184
)
Payment of premiums for interest rate swaptions
—

 
(1,485
)
Payments for termination of futures, forwards, swaps and TBAs, net
(60,737
)
 
(34,066
)
Purchase of residential loans held-for-investment
—

 
(372,305
)
Principal payments from residential loans held-for-investment
—

 
424,644

Principal payments from commercial loans held-for-investment
15,000

 
63,132

Origination and advances of commercial loans, net of origination fees
(85,033
)
 
(104,965
)
Net cash provided by investing activities
130,663

 
354,724

Cash Flows from Financing Activities
 
 
 
Proceeds from issuance of common stock
35

 
158

Repurchase of common stock
(25,000
)
 
(49,999
)
Cost of issuance of preferred stock
—

 
(36
)
Due from counterparties
(138,959
)
 
(118,562
)
Change in collateral held payable
(4,900
)
 
(14,890
)
Proceeds from repurchase agreements
97,653,895

 
105,832,915

Principal repayments of repurchase agreements
(97,719,439
)
 
(106,543,411
)
Proceeds from asset-backed securities issued by securitization trusts
—

 
336,077

Principal repayments of asset-backed securities issued by securitization trusts
—

 
(400,207
)
Proceeds from secured loans
125,000

 
2,100,000

Principal repayments on secured loans
(125,000
)
 
(1,675,000
)
Payments of deferred costs
(136
)
 
—

Payments of dividends and distributions
(153,572
)
 
(185,293
)
Net cash used in financing activities
(388,076
)
 
(718,248
)
Net change in cash and cash equivalents
(5,917
)
 
(87,486
)
Cash and cash equivalents, beginning of period
53,199

 
164,144

Cash and cash equivalents, end of period
47,282

 
76,658

Supplement Disclosure of Cash Flow Information
 
 
 
Interest paid
116,401

 
162,906

Non-cash Investing and Financing Activities Information
 
 
 
Net change in unrealized gain on mortgage-backed and credit risk transfer securities
259,010

 
(34,763
)
Dividends and distributions declared not paid
50,921

 
54,067

Net change in investment related payable (receivable)
117,295

 
53,089

Change in due from counterparties
7,807

 
1,425

The accompanying notes are an integral part of these condensed consolidated financial statements.

 
5
 

Table of Contents


INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1 – Organization and Business Operations
Invesco Mortgage Capital Inc. (the “Company”) is a Maryland corporation primarily focused on investing in, financing and managing residential and commercial mortgage-backed securities and mortgage loans. The Company conducts its business through IAS Operating Partnership LP (the “Operating Partnership”), a variable interest entity ("VIE"), as its sole general partner. As of September 30, 2016, the Company owned 98.7% of the Operating Partnership, and a wholly-owned subsidiary of Invesco owned the remaining 1.3%. The Company has one operating segment.
The Company primarily invests in:
•
Residential mortgage-backed securities ("RMBS") that are guaranteed by a U.S. government agency such as the Government National Mortgage Association, or a federally chartered corporation such as the Federal National Mortgage Association ("Fannie Mae") or the Federal Home Loan Mortgage Corporation ("Freddie Mac") (collectively "Agency RMBS");
•
RMBS that are not guaranteed by a U.S. government agency (“non-Agency RMBS”);
•
Credit risk transfer securities that are unsecured obligations issued by government-sponsored enterprises ("GSE CRT");
•
Commercial mortgage-backed securities ("CMBS");
•
Residential and commercial mortgage loans; and
•
Other real estate-related financing agreements.
The Company is externally managed and advised by Invesco Advisers, Inc. (the "Manager"), a registered investment adviser and an indirect, wholly-owned subsidiary of Invesco Ltd. (“Invesco”), a leading independent global investment management firm. The Company 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, commencing with the Company's taxable year ended December 31, 2009. To maintain the Company’s REIT qualification, the Company is generally required to distribute at least 90% of its REIT taxable income to its stockholders annually. The Company operates its business in a manner that permits exclusion from the "Investment Company" definition under the Investment Company Act of 1940, as amended.
Note 2 – Summary of Significant Accounting Policies
Basis of Presentation and Consolidation
Certain disclosures included in the Company’s Annual Report on Form 10-K are not required to be included on an interim basis in the Company’s quarterly reports on Form 10-Q. The Company has condensed or omitted these disclosures. Therefore, this Form 10-Q should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.
In the opinion of management, the condensed consolidated financial statements reflect all adjustments, consisting of normal recurring accruals, which are necessary for a fair statement of the financial condition and results of operations for the periods presented. All significant intercompany transactions, balances, revenues and expenses are eliminated upon consolidation.
The condensed consolidated financial statements have been prepared in accordance with U.S. GAAP and consolidate the financial statements of the Company and its controlled subsidiaries. During the period from January 1, 2015 through December 9, 2015, the condensed consolidated financial statements also include the results of operations of certain residential loan securitization trusts (the "residential securitizations") that meet the definition of a VIE. On December 9, 2015, the Company completed the sale of certain beneficial interests in the residential securitizations and deconsolidated the residential securitizations.

 
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Table of Contents


Revision of Previously Issued Financial Statements
During the second quarter of 2016, the Company corrected errors in its accounting for premiums and discounts associated with non-Agency RMBS not of high credit quality. The Company concluded that the errors are immaterial to each of the annual and interim consolidated financial statements which were included in the Company's Annual Report on Form 10-K for the year ended December 31, 2015 and its interim report on Form 10-Q for the quarter ended March 31, 2016. The Company has corrected its financial statements for previous periods included in this filing on Form 10-Q and will correct its previously issued financial statements for these errors as the financial statements are presented in future periodic filings.
Refer to Note 16 - "Revision of Previously Issued Financial Statements" for additional details.
Use of Estimates
The preparation of condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Examples of estimates include, but are not limited to, estimates of the fair values of financial instruments, interest income on mortgage-backed and credit risk transfer securities, allowance for loan losses and other-than-temporary impairment charges. Actual results may differ from those estimates.
Significant Accounting Policies
There have been no changes to the Company's accounting policies included in Note 2 to the consolidated financial statements of the Company’s Annual Report on Form 10-K for the year ended December 31, 2015, other than the significant accounting policies disclosed below.
U.S. Treasury Securities
U.S. Treasury Securities are classified as trading securities and are recorded at fair value. The Company records its purchases of U.S. Treasury Securities on the trade date. Changes in fair value are recognized in gain (loss) on investments, net in the Company’s consolidated statements of operations. Interest income is accrued based on the outstanding principal balance of the securities and their contractual terms. Premiums are amortized into interest income over the contractual lives of the securities using a level yield method.
Fair Value Measurements
The Company reports its mortgage-backed and credit risk transfer securities and derivative assets and liabilities at fair value as determined by an independent pricing service. The Company generally obtains one price per instrument from its primary pricing service. If the primary pricing service cannot provide a price, the Company will seek a value from other pricing services.
The pricing service uses two types of valuation approaches to determine the valuation of the Company’s various mortgage-backed and credit risk transfer securities: a market approach, which uses observable prices and other relevant information that is generated by market transactions involving identical or comparable assets or liabilities; and an income approach, which uses valuation techniques to convert future amounts to a single, discounted present value amount. In instances where sufficient market activity may not exist, the pricing service may utilize proprietary valuation models that may consider market transactions in comparable securities and the various relationship between securities in determining fair value and/or market characteristics to estimate relevant cash flows, which are then discounted to calculate the fair values. Observable inputs may include a combination of benchmark yields, executed trades, broker/dealer quotes, issuer spreads, bids, offers and benchmark securities to determine prices. In addition, the valuation models utilized by pricing services may consider additional pool level information such as prepayment speeds, default frequencies and default severities, if applicable. Both the Company and the pricing service continuously monitor market indicators and economic events to determine if any may have an impact on the valuations.
The pricing service values interest rate swaps and interest rate swaptions under the income approach using valuation models. The significant inputs in these models are readily available in public markets or can be derived from observable market transactions for substantially the full terms of the contracts.
The pricing service values U.S. Treasury futures, currency forward contracts and to-be-announced securities (“TBAs”) under the market approach through the use of quoted market prices available in an active market.
Overrides of prices from pricing services are rare in the current market environment for the assets the Company holds. Examples of instances that would cause an override include if the Company recently traded the same security or there is an indication of market activity that would cause the pricing service price to no longer be indicative of fair value. In the rare instance where a price is adjusted, the Company has a control process to monitor the reason for such adjustment.

 
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To gain comfort that pricing service prices are representative of current market information, the Company compares the transaction prices of security purchases and sales to the valuation levels provided by the pricing services. Price differences exceeding pre-defined tolerance levels are identified and investigated and may be challenged. Trends are monitored over time and if there are indications that the valuations are not comparable to market activity, the pricing services are asked to provide detailed information regarding their methodology and inputs. Transparency tools are also available from the pricing services which help the Company understand data points and/or market inputs used for pricing securities.
The Company also reviews daily price movements for interest rate swaps, interest rate swaptions, U.S. Treasury futures, currency forward contracts and TBAs. Price movements exceeding pre-defined tolerance levels are investigated using an alternate price from another pricing service as well as available market information. Based on the Company’s findings, the primary pricing service may be challenged, or in rare cases, overridden with an alternate pricing source.
In addition, the Company performs due diligence procedures on all pricing services on at least an annual basis. A questionnaire is sent to pricing services which requests information such as changes in methodologies, business recovery preparedness, internal controls and confirmation that evaluations are generated based on market data. Physical visits are also made to each pricing service's office.
As described in Note 10 - "Fair Value of Financial Instruments," the Company evaluates the source used to fair value its assets and liabilities and makes a determination on its categorization within the fair value hierarchy. If the price of a security is obtained from quoted prices for identical instruments in active markets, the security is classified as a level 1 security. If the price of a security is obtained from quoted prices for similar instruments or model-derived valuations whose inputs are observable, the security is classified as a level 2 security. If the inputs appear to be unobservable, the security would be classified as a level 3 security. Transfers between levels, if any, are determined by the Company at the end of the reporting period.
Mortgage-Backed and Credit Risk Transfer Securities
All of the Company’s mortgage-backed securities ("MBS") and GSE CRTs are reported at fair value. Fair value is determined by obtaining valuations from an independent source. If the fair value of a security is not available from a third-party pricing service, or such data appears unreliable, the Company may estimate the fair value of the security using a variety of methods including other pricing services, discounted cash flow analysis, matrix pricing, option adjusted spread models and other fundamental analysis of observable market factors.
The Company records its purchases of MBS and GSE CRTs on the trade date. Although the Company generally intends to hold most of its MBS and GSE CRTs until maturity, the Company may sell any of its mortgage-backed and credit risk transfer securities as part of its overall management of its investment portfolio.
The Company has elected the fair value option for all of its MBS purchased on or after September 1, 2016. Prior to September 1, 2016, the Company had also elected the fair value option for its RMBS interest-only securities (“RMBS IOs”). RMBS IOs are hybrid financial instruments that contain embedded derivatives. Under the fair value option, changes in fair value are recognized in the Company’s consolidated statements of operations. In the Company's view, this election more appropriately reflects the results of the Company's operations because MBS fair value changes are accounted for in the same manner as fair value changes in economic hedging instruments.
Except for RMBS IOs, MBS purchased prior to September 1, 2016 are classified as available-for-sale securities. Unrealized gains or losses on available-for-sale securities are recorded in accumulated other comprehensive income, a separate component of stockholders' equity, until sale or disposition of the investment. Upon sale or disposition, the cumulative gain or loss previously reported in stockholders' equity is recognized in income. Realized gains and losses from sales of MBS are determined based upon the specific identification method.
The Company has elected the fair value option for GSE CRTs purchased on or after August 24, 2015. GSE CRTs are hybrid financial instruments that contain embedded derivatives. Coupon payments on the securities are based on LIBOR, and principal payments are based on prepayments, losses and defined credit events in a reference pool of mortgage loans that collateralize Agency RMBS. The Company elected the fair value option for these securities due to the complexities associated with bifurcation of GSE CRTs into the debt host contract and embedded derivative. Under the fair value option, changes in fair value for GSE CRTs are recognized in the Company's consolidated statements of operations.
GSE CRTs purchased prior to August 24, 2015 are also reported at fair value but are accounted for as hybrid financial instruments consisting of a debt host contract and an embedded derivative. Unrealized gains or losses arising from changes in fair value of the debt host contract, excluding other-than-temporary impairment, are recognized in accumulated other comprehensive income, a separate component of stockholders’ equity, until sale or disposition of the investment. Upon sale or disposition of the debt host contract, the cumulative gain or loss previously reported in stockholders’ equity is recognized in income. Realized gains and losses from sales of GSE CRTs are determined based upon the specific identification method.

 
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Realized and unrealized gains or losses arising from changes in fair value of the embedded derivative are recognized in realized and unrealized credit derivative income (loss), net in the Company’s consolidated statements of operations.
The Company’s interest income recognition policies for MBS and GSE CRTs is described below in the Interest Income Recognition section of this Note 2 to the Company’s consolidated financial statements.
The Company considers its portfolio of Agency RMBS to be of high credit quality under applicable accounting guidance. For non-Agency RMBS, GSE CRTs and CMBS, the Company does not rely on ratings from third party agencies to determine the credit quality of the investment. The Company uses internal models that analyze the loans underlying each security and evaluates factors including, but not limited to, delinquency status, loan-to-value ratios, borrower credit scores, occupancy status and geographic concentration to estimate the expected future cash flows. The Company places reliance on these internal models in determining credit quality.
While non-Agency RMBS, GSE CRTs and CMBS with expected future losses would generally be purchased at a discount to par, the potential for a significant adverse change in expected cash flows remains. The Company therefore evaluates each security for other-than-temporary impairment at least quarterly.
The determination of whether a security is other-than-temporarily impaired involves judgments and assumptions based on subjective and objective factors. Consideration is given to (i) the length of time and the extent to which the fair value has been less than amortized cost, (ii) the financial condition and near-term prospects of recovery in fair value of the security, and (iii) the Company’s intent to sell the security and whether it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis.
The Company recognizes in earnings and reflects as a reduction in the cost basis of the security the amount of any other-than-temporary impairment related to credit losses or impairments on securities that the Company intends to sell or for which it is more likely than not that the Company will need to sell before recoveries. The amount of the other-than-temporary impairment on debt securities related to other factors is recorded consistent with changes in the fair value of all other available-for-sale securities as a component of consolidated stockholders’ equity in other comprehensive income or loss with no change to the cost basis of the security.
Interest Income Recognition
Mortgage-Backed Securities
Interest income on MBS is accrued based on the outstanding principal balance of the securities and their contractual terms. Premiums or discounts are amortized or accreted into interest income over the life of the investment using the effective interest method.
Interest income on the Company's non-Agency MBS (and other prepayable mortgage-backed securities where the Company may not recover substantially all of its initial investment) is based on estimated future cash flows. Management estimates future expected cash flows at the time of purchase and determines the effective interest rate based on these estimated cash flows and the Company’s purchase price. Over the life of the investments, management updates these estimated future cash flows and computes a revised yield based on the current amortized cost of the investment. In estimating these future cash flows, there are a number of assumptions that are subject to uncertainties and contingencies, including the rate and timing of principal payments (prepayments, repurchases, defaults and liquidations), the pass through or coupon rate, and interest rate fluctuations. These uncertainties and contingencies are difficult to predict and are subject to future events that may impact management’s estimates and the Company's interest income. When actual cash flows vary from expected cash flows, the difference is recorded as an adjustment to the amortized cost of the security and the security's yield is revised prospectively. Changes in cash flows from the Company's original or most recent projection may result in a prospective change in interest income recognized on these securities, or the amortized cost of these securities.
For Agency RMBS that cannot be prepaid in such a way that the Company would not recover substantially all of its initial investment, interest income recognition is based on contractual cash flows. The Company does not estimate prepayments in applying the effective interest method.

 
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Reverse Repurchase Agreements
Reverse repurchase agreements are treated as collateralized financing transactions. Cash paid to the borrower is recorded as other assets on the Company's consolidated balance sheets. Interest receivable on reverse repurchase agreements is recorded as accrued interest receivable. The Company reflects all proceeds and repayments of reverse repurchase agreement on a net basis in the Company's consolidated statement of cash flows. The Company monitors the market value of the underlying collateral to ensure it remains sufficient to protect the Company in the event of default by the counterparty. If the Company were to sell the underlying collateral, the Company would recognize its obligation to return the underlying collateral as due to counterparties on the Company's consolidated balance sheets.
Reclassifications
Certain prior period reported amounts have been reclassified to be consistent with the current presentation. Such reclassifications had no impact on net income or equity attributable to common stockholders.
Accounting Pronouncements Recently Adopted and Pending Accounting Pronouncements
Effective January 1, 2016, the Company adopted the newly issued accounting guidance for presentation of debt issuance costs. Under the new standard, debt issuance costs are required to be presented in the consolidated balance sheets as a direct deduction from the carrying value of the associated debt liability. The Company adopted the accounting standard on a retrospective basis, which required the restatement of the Company's December 31, 2015 balance sheet. The adoption resulted in a $5.4 million reduction in exchangeable senior notes and a corresponding reduction in other assets.
Effective January 1, 2016, the Company adopted the newly issued accounting guidance for reporting entities that are required to determine whether they should consolidate certain legal entities. The Company adopted the accounting standard on a modified retrospective approach which did not require restatement of prior periods to conform to the post adoption presentation. The Company did not consolidate or deconsolidate any legal entities as a result of implementing the new guidance.
In January 2016, the FASB issued guidance to improve certain aspects of classification and measurement of financial instruments, including significant revisions in accounting related to the classification and measurement of investments in equity securities and presentation of certain fair value changes for financial liabilities when the fair value option is elected. The guidance also amends certain disclosure requirements associated with the fair value of financial instruments. The Company is required to adopt the new guidance in the first quarter of 2018. Early adoption is permitted. The Company is currently evaluating the potential impact of the new guidance on its consolidated financial statements, as well as available transition methods.
In June 2016, the FASB issued an amendment to the guidance on reporting credit losses for assets measured at amortized cost and available-for-sale securities. The Company is required to adopt the new guidance in the first quarter of 2020. Early adoption is permitted. The Company is currently evaluating the potential impacts of the new guidance on its consolidated financial statements, as well as available transition methods.
In August 2016, the FASB issued new guidance that is intended to reduce diversity in practice in how certain transactions are classified in the statement of cash flows. The Company is required to adopt the new guidance in the first quarter of 2018. Early adoption is permitted, provided that all of the amendments are adopted in the same period. The Company is currently evaluating the potential impacts of the new guidance on its consolidated financial statements.
Note 3 – Variable Interest Entities
The Company's maximum risk of loss in VIEs in which the Company is not the primary beneficiary at September 30, 2016 is presented in the table below.
$ in thousands
Carrying Amount
 
Company's Maximum Risk of Loss
CMBS
2,668,290

 
2,668,290

Non-Agency RMBS
2,109,115

 
2,109,115

Investments in unconsolidated ventures
32,763

 
32,763

Total
4,810,168

 
4,810,168

Refer to Note 4 - "Mortgage-Backed and Credit Risk Transfer Securities" and Note 6 - "Other Assets" for additional details regarding these investments.

 
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Note 4 – Mortgage-Backed and Credit Risk Transfer Securities
The following tables summarize the Company’s MBS and GSE CRT portfolio by asset type as of September 30, 2016 and December 31, 2015.
September 30, 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
$ in thousands
Principal/ Notional
Balance
 
Unamortized
Premium
(Discount)
 
Amortized
Cost
 
Unrealized
Gain/
(Loss), net
 
Fair
Value
 
Net
Weighted
Average
Coupon (1)
 
Period-
end
Weighted
Average
Yield (2)
 
Quarterly
Weighted
Average
Yield (3)
Agency RMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
15 year fixed-rate
3,453,364

 
153,698

 
3,607,062

 
30,890

 
3,637,952

 
3.13
%
 
2.21
%
 
1.86
%
30 year fixed-rate
3,331,034

 
215,594

 
3,546,628

 
88,937

 
3,635,565

 
4.21
%
 
2.72
%
 
2.55
%
ARM*
321,140

 
2,917

 
324,057

 
7,896

 
331,953

 
2.71
%
 
2.62
%
 
2.18
%
Hybrid ARM
2,593,484

 
46,411

 
2,639,895

 
44,213

 
2,684,108

 
2.71
%
 
2.55
%
 
2.06
%
Total Agency pass-through
9,699,022

 
418,620

 
10,117,642

 
171,936

 
10,289,578

 
3.38
%
 
2.49
%
 
2.17
%
Agency-CMO(4)
1,611,750

 
(1,257,836
)
 
353,914

 
10,122

 
364,036

 
2.22
%
 
3.25
%
 
2.42
%
Non-Agency RMBS(5)(6)(7)
4,078,976

 
(2,065,395
)
 
2,013,581

 
95,534

 
2,109,115

 
2.18
%
 
5.06
%
 
5.06
%
GSE CRT(8)(9)
591,460

 
20,580

 
612,040

 
31,018

 
643,058

 
1.53
%
 
0.83
%
 
0.98
%
CMBS(10)(11)
3,076,101

 
(559,789
)
 
2,516,312

 
151,978

 
2,668,290

 
3.89
%
 
4.33
%
 
4.28
%
Total
19,057,309

 
(3,443,820
)
 
15,613,489

 
460,588

 
16,074,077

 
3.05
%
 
3.07
%
 
2.84
%
* Adjustable-rate mortgage ("ARM")
 
(1)
Net weighted average coupon as of September 30, 2016 is presented net of servicing and other fees.
(2)
Period-end weighted average yield is based on amortized cost as of September 30, 2016 and incorporates future prepayment and loss assumptions.
(3)
Quarterly weighted average portfolio yield for the period was calculated by dividing interest income, including amortization of premiums and discounts, by the Company's average of the amortized cost of the investments. All yields are annualized.
(4)
Agency collateralized mortgage obligation ("Agency-CMO") includes interest-only securities ("Agency IO"), which represent 83.5% of principal/notional balance, 24.0% of amortized cost and 24.3% of fair value.
(5)
Non-Agency RMBS held by the Company is 46.8% fixed rate, 46.1% variable rate, and 7.1% floating rate based on fair value.
(6)
Of the total discount in non-Agency RMBS, $261.7 million is non-accretable based on the Company's estimated future cash flows of the securities.
(7)
Non-Agency RMBS includes interest-only securities which represent 44.0% of principal/notional balance, 1.5% of amortized cost and 1.4% of fair value.
(8)
The Company has elected the fair value option for GSE CRT purchased on or after August 24, 2015, which represent 3.5% of the balance based on fair value. As a result, GSE CRT accounted for under the fair value option are not bifurcated between the debt host contract and the embedded derivative.
(9)
GSE CRT weighted average coupon and weighted average yield excludes coupon interest associated with embedded derivatives not accounted for under the fair value option recorded as realized and unrealized credit derivative income (loss), net.
(10)
CMBS includes interest-only securities which represent 20.2% of principal/notional balance, 0.9% of amortized cost and 0.9% of fair value.
(11)
The Company has elected the fair value option for CMBS purchased on or after September 1, 2016 which represent 0.4% of principal/notional balance, 0.6% of amortized cost and 0.5% of fair value.


 
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December 31, 2015
 
 
 
 
 
 
 
 
 
 
 
 
 
 
$ in thousands
Principal/Notional
Balance
 
Unamortized
Premium
(Discount)
 
Amortized
Cost
 
Unrealized
Gain/
(Loss), net
 
Fair
Value
 
Net
Weighted
Average
Coupon (1)
 
Period-
end
Weighted
Average
Yield (2)
 
Quarterly
Weighted
Average
Yield (3)
Agency RMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
15 year fixed-rate
1,527,877

 
72,389

 
1,600,266

 
10,664

 
1,610,930

 
3.72
%
 
2.47
%
 
2.40
%
30 year fixed-rate
3,796,091

 
249,285

 
4,045,376

 
18,581

 
4,063,957

 
4.24
%
 
2.81
%
 
2.85
%
ARM
417,424

 
4,625

 
422,049

 
3,976

 
426,025

 
2.72
%
 
2.58
%
 
2.26
%
Hybrid ARM
3,240,967

 
63,324

 
3,304,291

 
5,234

 
3,309,525

 
2.73
%
 
2.56
%
 
2.22
%
Total Agency pass-through
8,982,359

 
389,623

 
9,371,982

 
38,455

 
9,410,437

 
3.54
%
 
2.65
%
 
2.53
%
Agency-CMO(4)
1,774,621

 
(1,386,284
)
 
388,337

 
482

 
388,819

 
2.23
%
 
4.29
%
 
3.42
%
Non-Agency RMBS(5)(6)(7)
4,965,978

 
(2,363,799
)
 
2,602,179

 
90,308

 
2,692,487

 
2.20
%
 
5.11
%
 
4.90
%
GSE CRT(8)(9)
657,500

 
22,593

 
680,093

 
(21,865
)
 
658,228

 
1.32
%
 
0.72
%
 
0.62
%
CMBS(10)
3,429,655

 
(558,749
)
 
2,870,906

 
45,058

 
2,915,964

 
3.95
%
 
4.30
%
 
4.35
%
Total
19,810,113

 
(3,896,616
)
 
15,913,497

 
152,438

 
16,065,935

 
3.08
%
 
3.31
%
 
3.16
%
 
(1)
Net weighted average coupon as of December 31, 2015 is presented net of servicing and other fees.
(2)
Period-end weighted average yield is based on amortized cost as of December 31, 2015 and incorporates future prepayment and loss assumptions.
(3)
Quarterly weighted average portfolio yield for the period was calculated by dividing interest income, including amortization of premiums and discounts, by the Company's average of the amortized cost of the investments. All yields are annualized.
(4)
Agency collateralized mortgage obligation ("Agency CMO") includes interest-only securities ("Agency IO"), which represent 84.4% of principal (notional) balance, 27.5% of amortized cost and 27.6% of fair value.
(5)
Non-Agency RMBS held by the Company is 48.4% variable rate, 45.2% fixed rate, and 6.4% floating rate based on fair value.
(6)
Of the total discount in non-Agency RMBS, $281.6 million is non-accretable based on the Company's estimated future cash flows of the securities.
(7)
Non-Agency RMBS includes interest-only securities, which represent 42.1% of principal/notional balance, 1.3% of amortized cost and1.3% of fair value.
(8)
The Company has elected the fair value option for GSE CRT purchased on or after August 24, 2015, which represent 1.9% of the balance based on fair value. As a result, GSE CRT accounted for under the fair value option are not bifurcated between the debt host contract and the embedded derivative.
(9)
GSE CRT weighted average coupon and weighted average yield excludes coupon interest associated with embedded derivatives not accounted for under the fair value option recorded as realized and unrealized credit derivative income (loss), net.
(10)
CMBS includes interest-only securities and commercial real estate mezzanine loan pass-through certificates, which represent 0.9% and 0.7% of the balance based on fair value, respectively.
The following table summarizes the Company's non-Agency RMBS portfolio by asset type based on fair value as of September 30, 2016 and December 31, 2015.
$ in thousands
September 30, 2016
 
% of Non-Agency
 
December 31, 2015
 
% of Non-Agency
Prime
938,893

 
44.5
%
 
1,081,428

 
40.2
%
Alt-A
465,127

 
22.1
%
 
544,306

 
20.2
%
Re-REMIC
406,703

 
19.3
%
 
663,853

 
24.7
%
Subprime/reperforming
298,392

 
14.1
%
 
402,900

 
14.9
%
Total Non-Agency
2,109,115

 
100.0
%
 
2,692,487

 
100.0
%

 
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The following table summarizes the credit enhancement provided to the Company's re-securitization of real estate mortgage investment conduit ("Re-REMIC") holdings as of September 30, 2016 and December 31, 2015.
  
Percentage of Re-REMIC Holdings at Fair Value
Re-REMIC Subordination(1)
September 30, 2016
 
December 31, 2015
0% - 10%
15.9
%
 
11.0
%
10% - 20%
7.3
%
 
5.6
%
20% - 30%
13.5
%
 
12.7
%
30% - 40%
16.1
%
 
20.8
%
40% - 50%
28.5
%
 
32.8
%
50% - 60%
16.1
%
 
13.3
%
60% - 70%
2.6
%
 
3.8
%
Total
100.0
%
 
100.0
%
 
(1)
Subordination refers to the credit enhancement provided to the Re-REMIC tranche held by the Company by any junior Re-REMIC tranche or tranches in a resecuritization. This figure reflects the percentage of the balance of the underlying securities represented by any junior tranche or tranches at the time of resecuritization. Generally, principal losses on the underlying securities in excess of the subordination amount would result in principal losses on the Re-REMIC tranche held by the Company. 32.6% of the Company's Re-REMIC holdings are not senior tranches.
The components of the carrying value of the Company’s MBS and GSE CRT portfolio at September 30, 2016 and December 31, 2015 are presented below. 
$ in thousands
September 30, 2016
 
December 31, 2015
Principal balance
19,057,309

 
19,810,113

Unamortized premium
512,631

 
495,539

Unamortized discount
(3,956,451
)
 
(4,392,155
)
Gross unrealized gains
485,503

 
303,890

Gross unrealized losses
(24,915
)
 
(151,452
)
Fair value
16,074,077

 
16,065,935

The following table summarizes the Company’s MBS and GSE CRT portfolio according to estimated weighted average life classifications as of September 30, 2016 and December 31, 2015. 
$ in thousands
September 30, 2016
 
December 31, 2015
Less than one year
238,817

 
427,678

Greater than one year and less than five years
10,957,834

 
6,237,547

Greater than or equal to five years
4,877,426

 
9,400,710

Total
16,074,077

 
16,065,935



 
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The following tables present the estimated fair value and gross unrealized losses of the Company's MBS and GSE CRTs by length of time that such securities have been in a continuous unrealized loss position at September 30, 2016 and December 31, 2015.
September 30, 2016
  
Less than 12 Months
 
12 Months or More
 
Total
$ in thousands
Fair
Value
 
Unrealized
Losses
 
Number
of
Securities
 
Fair
Value
 
Unrealized
Losses
 
Number
of
Securities
 
Fair
Value
 
Unrealized
Losses
 
Number
of
Securities
Agency RMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
15 year fixed-rate
785,124

 
(2,384
)
 
36

 
69,916

 
(680
)
 
14

 
855,040

 
(3,064
)
 
50

30 year fixed-rate
36,352

 
(27
)
 
5

 
891,280

 
(5,546
)
 
37

 
927,632

 
(5,573
)
 
42

ARM
—

 
—

 
—

 
1,360

 
(36
)
 
1

 
1,360

 
(36
)
 
1

Hybrid ARM
89,303

 
(217
)
 
7

 
254

 
(4
)
 
2

 
89,557

 
(221
)
 
9

Total Agency pass-through
910,779

 
(2,628
)
 
48

 
962,810

 
(6,266
)
 
54

 
1,873,589

 
(8,894
)
 
102

Agency-CMO (1)
24,918

 
(1,255
)
 
15

 
26,085

 
(759
)
 
4

 
51,003

 
(2,014
)
 
19

Non-Agency RMBS
582,750

 
(7,881
)
 
63

 
265,241

 
(3,824
)
 
27

 
847,991

 
(11,705
)
 
90

GSE CRT (2)
—

 
—

 
—

 
36,080

 
(947
)
 
3

 
36,080

 
(947
)
 
3

CMBS (3)
68,209

 
(318
)
 
10

 
61,382

 
(1,037
)
 
6

 
129,591

 
(1,355
)
 
16

Total
1,586,656

 
(12,082
)
 
136

 
1,351,598

 
(12,833
)
 
94

 
2,938,254

 
(24,915
)
 
230

(1)
Fair value includes unrealized losses on Agency IO of $1.7 million and unrealized losses on CMO of $346,000.
(2)
Fair value includes unrealized losses on both the debt host contract and the embedded derivative.
(3)
Amounts disclosed includes CMBS with a fair value of $10.7 million for which the fair value option has been elected. Such securities have unrealized losses of $36,000.
December 31, 2015
  
Less than 12 Months
 
12 Months or More
 
Total
$ in thousands
Fair
Value
 
Unrealized
Losses
 
Number
of
Securities
 
Fair
Value
 
Unrealized
Losses
 
Number
of
Securities
 
Fair
Value
 
Unrealized
Losses
 
Number
of
Securities
Agency RMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
15 year fixed-rate
600,480

 
(8,081
)
 
33

 
77,506

 
(1,482
)
 
6

 
677,986

 
(9,563
)
 
39

30 year fixed-rate
776,065

 
(14,827
)
 
32

 
1,120,391

 
(39,497
)
 
47

 
1,896,456

 
(54,324
)
 
79

ARM
200,863

 
(501
)
 
11

 
—

 
—

 
—

 
200,863

 
(501
)
 
11

Hybrid ARM
1,913,872

 
(17,082
)
 
111

 
—

 
—

 
—

 
1,913,872

 
(17,082
)
 
111

Total Agency pass-through
3,491,280

 
(40,491
)
 
187

 
1,197,897

 
(40,979
)
 
53

 
4,689,177

 
(81,470
)
 
240

Agency-CMO (1)
166,754

 
(3,296
)
 
14

 
9,118

 
(6,934
)
 
9

 
175,872

 
(10,230
)
 
23

Non-Agency RMBS
872,575

 
(7,286
)
 
66

 
316,010

 
(10,699
)
 
20

 
1,188,585

 
(17,985
)
 
86

GSE CRT (2)
340,116

 
(10,050
)
 
16

 
120,877

 
(13,605
)
 
7

 
460,993

 
(23,655
)
 
23

CMBS
1,224,985

 
(17,328
)
 
85

 
31,533

 
(784
)
 
2

 
1,256,518

 
(18,112
)
 
87

Total
6,095,710

 
(78,451
)
 
368

 
1,675,435

 
(73,001
)
 
91

 
7,771,145

 
(151,452
)
 
459

(1)
Fair value includes unrealized losses on Agency IO of $8.3 million and unrealized losses on CMO of $1.9 million.
(2)
Fair value includes unrealized losses on both the debt host contract and the embedded derivative. Amounts disclosed includes GSE CRT with a fair value of $12.4 million for which the fair value option has been elected. Such securities have unrealized losses of $56,000.
Gross unrealized losses on the Company’s Agency RMBS and CMO were $8.9 million and $346,000, respectively, at September 30, 2016. Due to the inherent credit quality of Agency RMBS and CMO, the Company determined that at September 30, 2016, any unrealized losses on its Agency RMBS and CMO portfolio are not other than temporary.

 
14
 

Table of Contents


Gross unrealized losses on the Company’s Agency IO, non-Agency RMBS, GSE CRT and CMBS were $15.7 million at September 30, 2016. The Company does not consider these unrealized losses to be credit related, but rather due to non-credit related factors such as interest rate spreads, prepayment speeds, and market fluctuations. These investment securities are included in the Company’s assessment for other-than-temporary impairment on a quarterly basis.
The Company assesses its investment securities for other-than-temporary impairment on a quarterly basis. When the fair value of an investment is less than its amortized cost at the balance sheet date of the reporting period for which impairment is assessed, the impairment is designated as either “temporary” or “other-than-temporary.” This analysis includes a determination of estimated future cash flows through an evaluation of the characteristics of the underlying loans and the structural features of the investment. Underlying loan characteristics reviewed include, but are not limited to, delinquency status, loan-to-value ratios, borrower credit scores, occupancy status and geographic concentration.
The Company recorded $1.2 million and $8.4 million in other-than-temporary impairments ("OTTI") on RMBS interest-only and non-Agency RMBS securities during the three and nine months ended September 30, 2016, respectively. As the Company had previously elected the fair value option for RMBS interest-only securities, the OTTI was recorded as a reclassification from an unrealized to a realized loss within gain (loss) on investments, net on the consolidated statement of operations. The Company did not record any OTTI for the three and nine months ended September 30, 2015. As of September 30, 2016, the Company did not intend to sell the securities and determined that it was not more likely than not that the Company will be required to sell the securities.
The following table presents the changes in OTTI included in earnings for the three and nine months ended September 30, 2016 and 2015.
$ in thousands
Three Months 
 ended 
 September 30, 2016
 
Three Months 
 ended 
 September 30, 2015
 
Nine Months ended 
 September 30, 2016
 
Nine Months ended 
 September 30, 2015
Cumulative credit loss at beginning of period
7,208

 
—

 
—

 
—

Additions:
—

 
—

 
—

 
—

Other-than-temporary impairments not previously recognized
1,038

 
—

 
8,364

 
—

Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments
118

 
—

 
—

 
—

Cumulative credit loss at end of period
8,364

 
—

 
8,364

 
—

The following table summarizes the changes in accumulated other comprehensive income (loss) related to the Company’s GSE CRT debt host contracts and available-for-sale MBS for the three and nine months ended September 30, 2016 and 2015.  The Company reclassifies unrealized gains and losses from other comprehensive income to gain (loss) on investments, net when it sells investments.
The table excludes MBS and GSE CRT that are accounted for under the fair value option.
$ in thousands
Three Months 
 ended 
 September 30, 2016
 
Three Months 
 ended 
 September 30, 2015
 
Nine Months ended 
 September 30, 2016
 
Nine Months ended 
 September 30, 2015
Accumulated other comprehensive income (loss) from MBS and GSE CRT securities:
 
 
 
 
 
 
 
Unrealized gain (loss) on MBS and GSE CRT at beginning of period
404,794

 
298,251

 
177,799

 
376,336

Unrealized gain (loss) on MBS and GSE CRT
32,015

 
42,933

 
270,591

 
(30,611
)
Reclassification of unrealized (gain) loss on sale of MBS and GSE CRT to gain (loss) on investments, net
—

 
389

 
(11,581
)
 
(4,152
)
Balance at the end of period
436,809

 
341,573

 
436,809

 
341,573



 
15
 

Table of Contents


The following table summarizes the components of the Company's total gain (loss) on investments, net for the three and nine months ended September 30, 2016 and 2015.
$ in thousands
Three Months 
 ended 
 September 30, 2016
 
Three Months 
 ended 
 September 30, 2015
 
Nine Months ended 
 September 30, 2016
 
Nine Months ended 
 September 30, 2015
Gross realized gain on sale of investments
144

 
991

 
14,196

 
5,498

Gross realized loss on sale of investments
(1,449
)
 
(1,404
)
 
(3,920
)
 
(1,370
)
Other-than-temporary impairment losses
(1,156
)
 
—

 
(8,364
)
 
—

Net unrealized gains and losses on MBS accounted for under the fair value option
(5,412
)
 
(1,554
)
 
2,530

 
6,891

Net unrealized gains and losses on GSE CRT accounted for under the fair value option
1,181

 
—

 
1,418

 
—

Net unrealized gains and losses on U.S. Treasury securities accounted for as trading securities
(463
)
 
—

 
—

 
—

Total gain (loss) on investments, net
(7,155
)
 
(1,967
)
 
5,860

 
11,019

The following table presents components of interest income recognized on the Company’s MBS and GSE CRT portfolio for the three and nine months ended September 30, 2016 and 2015. GSE CRT interest income excludes coupon interest associated with embedded derivatives not accounted for under the fair value option recorded as realized and unrealized credit derivative income (loss), net.
For the three months ended September 30, 2016
$ in thousands
Coupon
Interest
 
Net (Premium
Amortization)/Discount
Accretion
 
Interest
Income
Agency
88,615

 
(31,773
)
 
56,842

Non-Agency
22,775

 
3,509

 
26,284

GSE CRT
2,268

 
(765
)
 
1,503

CMBS
29,872

 
(2,788
)
 
27,084

Other
795

 
(41
)
 
754

Total
144,325

 
(31,858
)
 
112,467

For the three months ended September 30, 2015
$ in thousands
Coupon
Interest
 
Net (Premium
Amortization)/Discount
Accretion
 
Interest
Income
Agency
93,366

 
(32,153
)
 
61,213

Non-Agency
26,761

 
4,452

 
31,213

GSE CRT
1,663

 
(782
)
 
881

CMBS
38,350

 
(3,342
)
 
35,008

Other
(10
)
 
—

 
(10
)
Total
160,130

 
(31,825
)
 
128,305


 
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For the nine months ended September 30, 2016
$ in thousands
Coupon
Interest
 
Net (Premium
Amortization)/Discount
Accretion
 
Interest
Income
Agency
258,826

 
(84,235
)
 
174,591

Non-Agency
72,751

 
9,645

 
82,396

GSE CRT
6,601

 
(2,307
)
 
4,294

CMBS
93,612

 
(8,567
)
 
85,045

Other
1,305

 
(58
)
 
1,247

Total
433,095

 
(85,522
)
 
347,573

For the nine months ended September 30, 2015
$ in thousands
Coupon
Interest
 
Net (Premium
Amortization)/Discount
Accretion
 
Interest
Income
Agency
282,132

 
(93,840
)
 
188,292

Non-Agency
85,854

 
13,445

 
99,299

GSE CRT
4,849

 
(2,312
)
 
2,537

CMBS
113,862

 
(8,193
)
 
105,669

Other
47

 
—

 
47

Total
486,744

 
(90,900
)
 
395,844

Note 5 – Commercial Loans Held-for-Investment
The following table summarizes commercial loans held-for-investment as of September 30, 2016 and December 31, 2015 that were purchased or originated by the Company.
September 30, 2016
$ in thousands
Number of
loans
 
Principal
Balance
 
Unamortized (fees)/
costs, net
 
Carrying
value
 
Weighted Average Coupon
 
Weighted Average Years to Maturity (1)
Mezzanine loans
10

 
273,686

 
(395
)
 
273,291

 
8.07
%
 
1.86
Total
10

 
273,686

 
(395
)
 
273,291

 
8.07
%
 
1.86
December 31, 2015
$ in thousands
Number of
loans
 
Principal
Balance
 
Unamortized (fees)/
costs, net
 
Carrying
value
 
Weighted Average Coupon
 
Weighted Average Years to Maturity (1)
Mezzanine loans
6

 
210,769

 
(1,707
)
 
209,062

 
7.97
%
 
1.75
Total
6

 
210,769

 
(1,707
)
 
209,062

 
7.97
%
 
1.75
(1)
Weighted average years to maturity is based on the contractual maturity date. Certain loans may contain either an option to prepay or an option to extend beyond their contractual maturity dates as specified in the respective loan agreements.
These loans were not impaired, and no allowance for loan loss has been recorded as of September 30, 2016 and December 31, 2015.

 
17
 

Table of Contents


Note 6 – Other Assets
The following table summarizes the Company's other assets as of September 30, 2016 and December 31, 2015.
$ in thousands
September 30, 2016
 
December 31, 2015
Reverse repurchase agreement
75,000

 
—

FHLBI stock
74,250

 
75,375

Investments in unconsolidated ventures
32,763

 
38,413

Prepaid expenses
1,501

 
1,284

Total
183,514

 
115,072

The Company entered in a short-term reverse repurchase agreement in September 2016 with a fixed rate of 0.90% and received U.S. Treasury securities as collateral under the agreement. The reverse repurchase agreement is treated as a collateralized financing transaction and carried at its contractual amount, including accrued interest. The Company did not sell or repledge the collateral received.
IAS Services LLC, the Company's wholly-owned subsidiary, is required to purchase and hold FHLBI stock as a condition of membership in the Federal Home Loan Bank of Indianapolis ("FHLBI"). The stock is recorded at cost.
The Company has invested in unconsolidated ventures that are managed by an affiliate of the Company's Manager. The unconsolidated ventures invest in the Company's target assets. Refer to Note 15 - "Commitments and Contingencies" for additional details regarding the Company's commitments to these unconsolidated ventures.

 
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Table of Contents


Note 7 – Borrowings
The Company has financed the majority of its investment portfolio through repurchase agreements, secured loans and exchangeable senior notes. The following table summarizes certain characteristics of the Company’s borrowings at September 30, 2016 and December 31, 2015.
$ in thousands
September 30, 2016
 
 
 
 
Weighted
 
 
 
 
Weighted
 
Average
 
MBS and
 
 
Average
 
Remaining
 
GSE CRTs
Amount
 
Interest
 
Maturity
 
Pledged as
Outstanding
 
Rate
 
(days)
 
Collateral (1)
Repurchase Agreements:
 
 
 
 
 
 
 
Agency RMBS
9,002,003

 
0.70
%
 
15

 
9,495,729

Non-Agency RMBS
1,626,907

 
1.91
%
 
34

 
2,017,629

GSE CRT
434,128

 
2.11
%
 
26

 
588,017

CMBS
997,464

 
1.70
%
 
18

 
1,242,964

Total Repurchase Agreements
12,060,502

 
1.07
%
 
18

 
13,344,339

Secured Loans
1,650,000

 
0.63
%
 
2,774

 
1,979,412

Exchangeable Senior Notes (2)
400,000

 
5.00
%
 
531

 
—

Total Borrowings
14,110,502

 
1.07
%
 
355

 
15,323,751

$ in thousands
December 31, 2015
 
 
 
 
Weighted
 
 
 
 
Weighted
 
Average
 
MBS and
 
 
Average
 
Remaining
 
GSE CRTs
Amount
 
Interest
 
Maturity
 
Pledged as
Outstanding
 
Rate
 
(days)
 
Collateral(1)
Repurchase Agreements:
 
 
 
 
 
 
 
Agency RMBS
8,389,643

 
0.65
%
 
24

 
8,827,976

Non-Agency RMBS
2,077,240

 
1.68
%
 
32

 
2,563,877

GSE CRT
488,275

 
1.91
%
 
19

 
640,828

CMBS
1,170,890

 
1.49
%
 
23

 
1,427,607

Total Repurchase Agreements
12,126,048

 
0.96
%
 
25

 
13,460,288

Secured Loans
1,650,000

 
0.55
%
 
2,937

 
1,949,699

Exchangeable Senior Notes (2)
400,000

 
5.00
%
 
805

 
—

Total Borrowings
14,176,048

 
1.02
%
 
386

 
15,409,987

(1)
Amount pledged as collateral is measured at fair value as described in Note 2 - "Summary of Significant Accounting Policies." As of September 30, 2016, the Company also pledged Agency RMBS with a fair value of $169.8 million (December 31, 2015: $143.9 million) as collateral against its interest rate swaps. See Note 8 - "Derivative and Hedging Activities" for additional information.
(2)
The carrying value of exchangeable senior notes is $396.4 million and $394.6 million as of September 30, 2016 and December 31, 2015, respectively. The carrying value is net of debt issuance costs of $3.6 million and $5.4 million as of September 30, 2016 and December 31, 2015, respectively.
The following table shows the aggregate amount of maturities of the Company's outstanding borrowings:
$ in thousands
As of September 30,
2017
12,060,502

2018
400,000

2019
—

2020
300,000

2021
100,000

Thereafter
1,250,000

Total
14,110,502


 
19
 

Table of Contents


The following tables summarize certain characteristics of the Company’s repurchase agreements and secured loans at September 30, 2016 and December 31, 2015.
September 30, 2016
 
 
 
 
 
$ in thousands
Amount Outstanding
 
Percent of Total Amount Outstanding
 
MBS and GSE CRTs Collateral Pledged (1)
Repurchase Agreement Counterparties:
 
 
 
 
 
HSBC Securities (USA) Inc
1,525,553

 
11.1
%
 
1,585,305

ING Financial Market LLC
1,282,856

 
9.4
%
 
1,357,344

Royal Bank of Canada
1,141,588

 
8.3
%
 
1,346,702

South Street Securities LLC
808,445

 
5.9
%
 
846,859

Mitsubishi UFJ Securities (USA), Inc.
751,338

 
5.5
%
 
791,305

Industrial and Commercial Bank of China Financial Services LLC
687,602

 
5.0
%
 
723,710

Pierpont Securities LLC
677,562

 
4.9
%
 
710,636

JP Morgan Securities Inc.
506,780

 
3.7
%
 
587,973

Scotia Capital
504,986

 
3.7
%
 
524,343

Goldman, Sachs & Co.
503,471

 
3.7
%
 
642,598

KGS-Alpha Capital Markets, L.P.
477,243

 
3.5
%
 
503,042

Citigroup Global Markets Inc.
443,440

 
3.2
%
 
556,574

E D & F Man Capital Markets Inc
405,297

 
3.0
%
 
427,750

BNP Paribas Securities Corp.
389,923

 
2.8
%
 
429,201

Guggenheim Liquidity Services, LLC
374,773

 
2.7
%
 
394,749

Wells Fargo Securities, LLC
366,147

 
2.7
%
 
437,727

Societe Generale
332,727

 
2.4
%
 
436,285

Natixis, New York Branch
276,918

 
2.0
%
 
299,093

All other counterparties (2)
603,853

 
4.5
%
 
743,143

Total Repurchase Agreement Counterparties
12,060,502

 
88.0
%
 
13,344,339

Secured Loans Counterparty:
 
 
 
 
 
FHLBI
1,650,000

 
12.0
%
 
1,979,412

Total
13,710,502

 
100.0
%
 
15,323,751

(1)
Amount pledged as collateral is measured at fair value as described in Note 2 - "Summary of Significant Accounting Policies."
(2)
Represents amounts outstanding with seven counterparties.


 
20
 

Table of Contents


December 31, 2015
 
 
 
 
 
$ in thousands
Amount Outstanding
 
Percent of Total Amount Outstanding
 
MBS and GSE CRTs Collateral Pledged (1)
Repurchase Agreement Counterparties:
 
 
 
 
 
HSBC Securities (USA) Inc
1,566,747

 
11.4
%
 
1,611,020

Royal Bank of Canada
1,148,480

 
8.3
%
 
1,383,839

ING Financial Market LLC
1,050,548

 
7.6
%
 
1,112,102

South Street Securities LLC
799,783

 
5.8
%
 
838,600

Pierpont Securities LLC
786,623

 
5.7
%
 
814,804

Industrial and Commercial Bank of China Financial Services LLC
695,933

 
5.1
%
 
730,941

Mitsubishi UFJ Securities (USA), Inc.
627,383

 
4.6
%
 
657,201

JP Morgan Securities Inc.
622,665

 
4.5
%
 
728,502

Citigroup Global Markets Inc.
585,632

 
4.3
%
 
725,882

Scotia Capital
576,137

 
4.2
%
 
598,343

BNP Paribas Securities Corp.
474,053

 
3.4
%
 
530,584

Wells Fargo Securities, LLC
463,673

 
3.4
%
 
551,667

Goldman, Sachs & Co.
428,799

 
3.1
%
 
552,549

KGS-Alpha Capital Markets, L.P.
380,286

 
2.8
%
 
400,758

Banc of America Securities LLC
380,520

 
2.8
%
 
442,801

Morgan Stanley & Co. Incorporated
273,124

 
2.0
%
 
320,484

Guggenheim Liquidity Services, LLC
265,709

 
1.9
%
 
279,345

All other counterparties (2)
999,953

 
7.1
%
 
1,180,866

Total Repurchase Agreement Counterparties:
12,126,048

 
88.0
%
 
13,460,288

Secured Loans Counterparty:
 
 
 
 
 
FHLBI
1,650,000

 
12.0
%
 
1,949,699

Total
13,776,048

 
100.0
%
 
15,409,987


(1)
Amount pledged as collateral is measured at fair value as described in Note 2 - "Summary of Significant Accounting Policies."
(2)
Represents amounts outstanding with nine counterparties.
Repurchase Agreements
Repurchase agreements bear interest at a contractually agreed upon rate and have maturities ranging from one month to twelve months. Repurchase agreements are accounted for as secured borrowings since the Company maintains effective control of the financed assets. Collateral posted with the Company's repurchase agreement counterparties is segregated in the Company's books and records. The repurchase agreement counterparties have the right to resell and repledge the collateral posted but have the obligation to return the pledged collateral, or substantially the same collateral if agreed to by the Company, upon maturity of the repurchase agreement. Under the repurchase agreements, the respective lender retains the contractual right to mark the underlying collateral to fair value as determined by a pricing service agreed to by the Company and the respective lender. A reduction in the value of pledged assets would require the Company to provide additional collateral or fund margin calls. The Company intends to maintain a level of liquidity that will enable the Company to meet margin calls. In addition, the repurchase agreements are subject to certain financial covenants. The Company was in compliance with these covenants at September 30, 2016.
The Company's repurchase agreement collateral ratio (Company MBS and GSE CRTs Held as Collateral/Amount Outstanding) was 111% as of September 30, 2016 ( December 31, 2015: 111%).

The Company was not required to post cash collateral with its repurchase agreement counterparties at September 30, 2016 (December 31, 2015: posted $710,000). Cash margin posted by the Company is classified as due from counterparties.

 
21
 

Table of Contents


Secured Loans
The Company's wholly-owned captive insurance subsidiary, IAS Services LLC is a member of the FHLBI. As a member of the FHLBI, IAS Services LLC may borrow funds from the FHLBI in the form of secured advances.
As of September 30, 2016, IAS Services LLC, had $1.65 billion in outstanding secured advances from the FHLBI. These secured advances have floating rates. Floating rates are based on the three-month FHLB swap rate plus a spread. For the nine months ended September 30, 2016, IAS Services LLC had weighted average borrowings of $1.65 billion with a weighted average borrowing rate of 0.66% and a weighted average maturity of 7.60 years.
The Federal Housing Finance Agency’s ("FHFA") final rule governing Federal Home Loan Bank membership (the “FHFA Rule”) was effective on February 19, 2016. The FHFA Rule, among other provisions, excludes captive insurance companies from membership eligibility. The FHFA Rule permits existing captive insurance companies, such as IAS Services LLC, to remain members for a period of five years following the effective date of the FHFA Rule. New advances or renewals that mature beyond the five year period are prohibited. As permitted by the FHFA Rule, the FHLBI has indicated it will honor the contractual maturity dates of existing advances to IAS Services LLC that were made prior to the effective date of the final FHFA Rule and extend beyond the five year period. The Company does not expect there to be any impact to its existing FHLBI borrowings under the FHFA rule. The ability to borrow from the FHLBI is subject to the Company's continued creditworthiness, pledging of sufficient eligible collateral to secure advances, and compliance with certain agreements with FHLBI and FHFA rules. Collateral posted with the FHLBI is held in trust for the benefit of the FHLBI and is not commingled with the Company’s other assets. The FHLBI does not have the right to resell or repledge collateral posted unless an event of default occurs. The FHLBI retains the right to mark the underlying collateral for FHLBI advances to fair value as determined by the FHLBI in its sole discretion. A reduction in the value of pledged assets would require IAS Services LLC to provide additional collateral.
As of September 30, 2016, the FHLBI advances were collateralized by CMBS and Agency RMBS with a fair value of $1.4 billion and $554.1 million, respectively as determined by an independent third party pricing service as described in Note 2 - “Summary of Significant Accounting Policies - Fair Value” of the Company’s financial statements.
As discussed in Note 6 - "Other Assets," IAS Services LLC is required to purchase and hold a certain amount of FHLBI stock, which is based, in part, upon the outstanding principal balance of secured advances from the FHLBI.
Note 8 – Derivatives and Hedging Activities
The following table presents information with respect to the Company's derivative instruments:
$ in thousands
Notional Amount as
of January 1, 2016
 
Additions
 
Settlement,
Termination,
Expiration
or Exercise
 
Notional Amount as
of September 30, 2016
Interest Rate Swaps
11,450,000

 
—

 
(4,950,000
)
 
6,500,000

Interest Rate Swaptions
300,000

 
—

 
(300,000
)
 
—

Currency Forward Contracts
76,324

 
231,205

 
(240,256
)
 
67,273

Credit Derivatives
645,000

 
—

 
(74,110
)
 
570,890

Total
12,471,324

 
231,205

 
(5,564,366
)
 
7,138,163

Interest Rate Swaps
The Company's repurchase agreements are usually settled on a short-term basis ranging from one to twelve months. At each settlement date, the Company typically refinances each repurchase agreement at the market interest rate at that time. In addition, the Company's secured loans have floating interest rates. As such, the Company is exposed to changing interest rates. The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposures to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.
Effective December 31, 2013, the Company voluntarily discontinued cash flow hedge accounting for its interest rate swaps to gain greater flexibility in managing interest rate exposures. Amounts recorded in AOCI prior to the Company discontinuing cash flow hedge accounting for its interest rate swaps are reclassified to interest expense on repurchase agreements on the condensed consolidated statements of operations as interest is accrued and paid on the related repurchase agreements over the remaining life of the interest rate swap agreements. The Company reclassified $4.8 million as a decrease (September 30, 2015: $15.7 million as an increase) and $11.3 million (September 30, 2015: $51.2 million) as an increase to interest expense for the three and nine months ended September 30, 2016, respectively. During the next 12 months, the Company estimates that $25.3

 
22
 

Table of Contents


million will be reclassified as a decrease to interest expense, repurchase agreements. As of September 30, 2016, $159.5 million (December 31, 2015: $148.3 million) of unrealized gain/(loss) on discontinued cash flow hedges, net is still included in accumulated other comprehensive income.
As of September 30, 2016, the Company had the following interest rate swaps outstanding:
$ in thousands
Counterparty
Notional
 
Maturity Date
 
Fixed Interest Rate
in Contract
ING Capital Markets LLC
350,000

 
2/24/2018
 
0.95
%
UBS AG
500,000

 
5/24/2018
 
1.10
%
ING Capital Markets LLC
400,000

 
6/5/2018
 
0.87
%
CME Central Clearing
300,000

 
2/5/2021
 
2.50
%
CME Central Clearing
300,000

 
2/5/2021
 
2.69
%
Wells Fargo Bank, N.A.
200,000

 
3/15/2021
 
3.14
%
CME Central Clearing
500,000

 
5/24/2021
 
2.25
%
Citibank, N.A.
200,000

 
5/25/2021
 
2.83
%
CME Central Clearing
500,000

 
6/24/2021
 
2.44
%
HSBC Bank USA, National Association
550,000

 
2/24/2022
 
2.45
%
CME Central Clearing
1,000,000

 
6/9/2022
 
2.21
%
The Royal Bank of Scotland Plc
500,000

 
8/15/2023
 
1.98
%
CME Central Clearing
600,000

 
8/24/2023
 
2.88
%
HSBC Bank USA, National Association
500,000

 
12/15/2023
 
2.20
%
CME Central Clearing
100,000

 
4/2/2025
 
2.04
%
Total
6,500,000

 
 
 
2.14
%
At September 30, 2016, the Company’s counterparties held $241.2 million in cash margin deposits and approximately $169.8 million in Agency RMBS as collateral against its interest rate swaps. Cash margin posted by the Company is classified as due from counterparties, and cash margin posted by counterparties that are restricted in use, if any, is classified as restricted cash. As of September 30, 2016 and December 31, 2015, the Company did not have any restricted cash. The Agency RMBS collateral posted by the Company is included in total mortgage-backed and credit risk transfer securities on the Company’s condensed consolidated balance sheets. Cash collateral that is not restricted for use by the Company is included in cash and cash equivalents and the liability to return the collateral is included in collateral held payable on the condensed consolidated balance sheets. Non-cash collateral posted by counterparties to the Company would be recognized if any counterparty defaults or if the Company sold the pledged collateral. As of September 30, 2016 and December 31, 2015, the Company did not recognize any non-cash collateral held as collateral.

 
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Interest Rate Swaptions
The Company has purchased interest rate swaptions to help mitigate the potential impact of increases or decreases in interest rates on the performance of a portion of the Company’s investment portfolio (referred to as “convexity risk”). The interest rate swaptions provide the Company the option to enter into interest rate swap agreements for a predetermined notional amount, stated term and pay and receive interest rates in the future. The premium paid for interest rate swaptions is reported as a derivative asset in the Company’s condensed consolidated balance sheets. The premium is valued at an amount equal to the fair value of the swaption that would have the effect of closing the position adjusted for nonperformance risk, if any. The difference between the premium and the fair value of the swaption is reported in gain (loss) on derivative instruments, net in the Company’s condensed consolidated statements of operations. If an interest rate swaption expires unexercised, the loss on the interest rate swaption would be equal to the premium paid. If the Company sells or exercises an interest rate swaption, the realized gain or loss on the interest rate swaption would be equal to the difference between the cash or the fair value of the underlying interest rate swap received and the premium paid. As of September 30, 2016, the Company has no outstanding interest rate swaptions.
TBAs, Futures and Currency Forward Contracts
The Company purchases or sells certain TBAs and U.S. Treasury futures contracts to help mitigate the potential impact of changes in interest rates on the performance of the Company's portfolio. Realized and unrealized gains and losses associated with the purchase or sales of the TBAs and U.S. Treasury futures contracts are recognized in gain (loss) on derivative instruments, net in the Company's condensed consolidated statements of operations. As of September 30, 2016, the Company has no outstanding TBAs and futures contracts.
The Company uses currency forward contracts to help mitigate the potential impact of changes in foreign currency exchange rates on the Company's investments denominated in foreign currencies. Realized and unrealized gains and losses associated with the purchases or sales of currency forward contracts are recognized in gain (loss) on derivative instruments, net in the Company's condensed consolidated statements of operations.
Credit Derivatives
The Company's GSE CRTs purchased prior to August 24, 2015 are accounted for as hybrid financial instruments consisting of a debt host contract and an embedded credit derivative. Embedded derivatives associated with GSE CRTs are recorded within mortgage-backed and credit risk transfer securities, at fair value, on the consolidated balance sheets. At September 30, 2016 and December 31, 2015, terms of the GSE CRT embedded derivatives are:
$ in thousand
September 30, 2016
 
December 31, 2015
Fair value amount
19,470

 
(25,722
)
Notional amount
570,890

 
645,000

Maximum potential amount of future undiscounted payments
570,890

 
645,000

Tabular Disclosure of the Effect of Derivative Instruments on the Balance Sheet
The table below presents the fair value of the Company’s derivative financial instruments, as well as their classification on the condensed consolidated balance sheets as of September 30, 2016 and December 31, 2015.
$ in thousands
Derivative Assets
 
Derivative Liabilities
 
 
As of September 30, 2016
 
As of December 31, 2015
 
 
 
As of September 30, 2016
 
As of December 31, 2015
Balance
Sheet
 
Fair Value
 
Fair Value
 
Balance
Sheet
 
Fair Value
 
Fair Value
Interest Rate Swap Asset
 
—

 
6,795

 
Interest Rate Swap Liability
 
382,237

 
238,045

Currency Forward Contracts
 
505

 
1,864

 
Currency Forward Contracts
 
84

 
103



 
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Tabular Disclosure of the Effect of Derivative Instruments on the Income Statement
The tables below present the effect of the Company’s derivative financial instruments on the condensed consolidated statements of operations for the three and nine months ended September 30, 2016 and 2015.
$ in thousands
 
 
 
 
Derivative
not designated as
hedging instrument
 
Location of unrealized gain (loss)
recognized in income
on derivative
 
Three months ended September 30, 2016
 
Three months ended 
 September 30, 2015
CDS Contract
 
Realized and unrealized credit derivative income (loss), net
 
—

 
(96
)
GSE CRT Embedded Derivatives
 
Realized and unrealized credit derivative income (loss), net
 
25,963

 
(3,848
)
Total
 
 
 
25,963

 
(3,944
)
$ in thousands
 
 
 
 
Derivative
not designated as
hedging instrument
 
Location of unrealized gain (loss)
recognized in income
on derivative
 
Nine months ended September 30, 2016
 
Nine months ended September 30, 2015
CDS Contract
 
Realized and unrealized credit derivative income (loss), net
 
—

 
648

GSE CRT Embedded Derivatives
 
Realized and unrealized credit derivative income (loss), net
 
39,175

 
7,275

Total
 
 
 
39,175

 
7,923

The following table summarizes the effect of interest rate swaps, swaption contracts, TBAs, futures contracts and currency forward contracts reported in gain (loss) on derivative instruments, net on the condensed consolidated statements of operations for the three and nine months ended September 30, 2016 and 2015:
$ in thousands
 
Three months ended September 30, 2016
Derivative
not designated as
hedging instrument
 
Realized gain (loss) on derivative instruments, net
 
 Contractual net interest expense
 
Unrealized gain (loss), net
 
Gain (loss) on derivative instruments, net
Interest Rate Swaps
 
(5,090
)
 
(26,388
)
 
65,396

 
33,918

Currency Forward Contracts
 
6,437

 
—

 
(4,977
)
 
1,460

Total
 
1,347

 
(26,388
)
 
60,419

 
35,378


$ in thousands
 
Nine months ended September 30, 2016
Derivative
not designated as
hedging instrument
 
Realized gain (loss) on derivative instruments, net
 
 Contractual net interest expense
 
Unrealized gain (loss), net
 
Gain (loss) on derivative instruments, net
Interest Rate Swaps
 
(69,090
)
 
(80,464
)
 
(150,986
)
 
(300,540
)
Interest Rate Swaptions
 
(1,485
)
 
—

 
1,485

 
—

Currency Forward Contracts
 
8,353

 
—

 
(1,341
)
 
7,012

Total
 
(62,222
)
 
(80,464
)
 
(150,842
)
 
(293,528
)

 
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Table of Contents


$ in thousands
 
Three months ended September 30, 2015
Derivative
not designated as
hedging instrument
 
Realized gain (loss) on derivative instruments, net
 
 Contractual net interest expense
 
Unrealized gain (loss), net
 
Gain (loss) on derivative instruments, net
Interest Rate Swaps
 
—

 
(46,785
)
 
(173,817
)
 
(220,602
)
Interest Rate Swaptions
 
(2,590
)
 
—

 
2,590

 
—

Currency Forward Contracts
 
(489
)
 
—

 
489

 
—

Total
 
(3,079
)
 
(46,785
)
 
(170,738
)
 
(220,602
)

$ in thousands
 
Nine months ended September 30, 2015
Derivative
not designated as
hedging instrument
 
Realized gain (loss) on derivative instruments, net
 
 Contractual net interest expense
 
Unrealized gain (loss), net
 
Gain (loss) on derivative instruments, net
Interest Rate Swaps
 
(31,881
)
 
(138,404
)
 
(113,151
)
 
(283,436
)
Interest Rate Swaptions
 
(10,328
)
 
—

 
8,594

 
(1,734
)
TBAs
 
(2,292
)
 
—

 
558

 
(1,734
)
Futures Contracts
 
(943
)
 
—

 
(90
)
 
(1,033
)
Currency Forward Contracts
 
1,050

 
—

 
(457
)
 
593

Total
 
(44,394
)
 
(138,404
)
 
(104,546
)
 
(287,344
)
Credit-risk-related Contingent Features
The Company has agreements with each of its bilateral derivative counterparties. Some of those agreements contain a provision whereby if the Company defaults on any of its indebtedness, including default whereby repayment of the indebtedness has not been accelerated by the lender, the Company could be declared in default on its derivative obligations.
At September 30, 2016, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for non-performance risk related to these agreements, was $153.0 million. The Company has minimum collateral posting thresholds with certain of its derivative counterparties and has posted collateral of $169.8 million of Agency RMBS and $241.2 million of cash as of September 30, 2016. If the Company had breached any of these provisions at September 30, 2016, it could have been required to settle its obligations under the agreements at their termination value.
In addition, as of September 30, 2016, the Company has an agreement with a central clearing counterparty. The fair value of such derivatives in a net liability position, which includes accrued interest but excludes any adjustment for non-performance risk related to this agreement, was $245.5 million.
The Company was in compliance with all of the financial provisions of these counterparty agreements as of September 30, 2016.
Note 9 – Offsetting Assets and Liabilities
Certain of the Company's repurchase agreements and derivative transactions are governed by underlying agreements that generally provide for a right of setoff under master netting arrangements (or similar agreements) in the event of default or in the event of bankruptcy of either party to the transactions. Assets and liabilities subject to such arrangements are presented on a gross basis in the condensed consolidated balance sheets.
The following tables present information about the assets and liabilities that are subject to master netting agreements (or similar agreements) and can potentially be offset on the Company’s condensed consolidated balance sheets at September 30, 2016 and December 31, 2015.

 
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Offsetting of Derivative Assets
As of September 30, 2016
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Condensed Consolidated Balance Sheets
 
 
$ in thousands
Description
Gross
Amounts of
Recognized
Assets
 
Gross
Amounts
Offset in the Condensed Consolidated
Balance
Sheets
 
Net Amounts
of Assets
presented in
the Condensed
Consolidated
Balance Sheets
 
Financial
Instruments
 
Cash Collateral
Received
 
Net Amount
Derivatives (1) (5)
505

 
—

 
505

 
(84
)
 
—

 
421

Reverse Repurchase Agreement (2)
75,000

 
—

 
75,000

 
(74,791
)
 
—

 
209

Total
75,505

 
—

 
75,505

 
(74,875
)
 
—

 
630

Offsetting of Derivative Liabilities, Repurchase Agreements and Secured Loans
As of September 30, 2016
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Condensed Consolidated Balance Sheets
 
 
$ in thousands
Description
Gross
Amounts of
Recognized
Liabilities
 
Gross
Amounts
Offset in the Condensed Consolidated
Balance
Sheets
 
Net Amounts
of Liabilities
presented in
the Condensed
Consolidated
Balance Sheets
 
Financial
Instruments (3)
 

Cash Collateral
Posted
 
Net Amount
Derivatives (5)
382,321

 
—

 
382,321

 
(151,820
)
 
(230,501
)
 
—

Repurchase Agreements (4)
12,060,502

 
—

 
12,060,502

 
(12,060,502
)
 
—

 
—

Secured Loans (6)
1,650,000

 
—

 
1,650,000

 
(1,650,000
)
 
—

 
—

Total
14,092,823

 
—

 
14,092,823

 
(13,862,322
)
 
(230,501
)
 
—

Offsetting of Derivative Assets
As of December 31, 2015
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Condensed Consolidated Balance Sheets
 
 
$ in thousands
Description
Gross
Amounts of
Recognized
Assets
 
Gross
Amounts
Offset in the Condensed Consolidated
Balance
Sheets
 
Net Amounts
of Assets
presented in
the Condensed
Consolidated
Balance Sheets
 
Financial
Instruments
 
Cash Collateral
Received
 
Net Amount
Derivatives (1) (5)
8,659

 
—

 
8,659

 
(4,142
)
 
(4,517
)
 
—

Total
8,659

 
—

 
8,659

 
(4,142
)
 
(4,517
)
 
—


 
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Offsetting of Derivative Liabilities and Repurchase Agreements
As of December 31, 2015
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Condensed Consolidated Balance Sheets
 
 
$ in thousands
Description
Gross
Amounts of
Recognized
Liabilities
 
Gross
Amounts
Offset in the Condensed Consolidated
Balance
Sheets
 
Net Amounts
of Liabilities
presented in
the Condensed
Consolidated
Balance Sheets
 
Financial
Instruments (3)
 

Cash Collateral
Posted
 
Net Amount
Derivatives (5)
238,148

 
—

 
238,148

 
(117,240
)
 
(109,299
)
 
11,609

Repurchase Agreements (4)
12,126,048

 
—

 
12,126,048

 
(12,126,048
)
 
—

 
—

Secured Loans (6)
1,650,000

 
—

 
1,650,000

 
(1,650,000
)
 
—

 
—

Total
14,014,196

 
—

 
14,014,196

 
(13,893,288
)
 
(109,299
)
 
11,609


(1)
Amounts represent derivatives in an asset position which could potentially be offset against derivatives in a liability position at September 30, 2016 and December 31, 2015, subject to a netting arrangement.
(2)
The Company received U.S. Treasury securities with a fair value of $74.8 million as collateral under a reverse repurchase agreement as of September 30, 2016.
(3)
Amounts represent collateral pledged that is available to be offset against liability balances associated with repurchase agreements, secured loans and derivatives.
(4)
The fair value of securities pledged against the Company's borrowing under repurchase agreements was $13.3 billion and $13.5 billion at September 30, 2016 and December 31, 2015, respectively.
(5)
No cash collateral was posted by the Company's derivative counterparties at September 30, 2016 (December 31, 2015: $4.9 million). Cash collateral posted by the Company on its derivatives was $241.2 million and $109.3 million at September 30, 2016 and December 31, 2015, respectively.
(6)
The fair value of securities pledged against IAS Services LLC's borrowing under secured loans was $2.0 billion and $1.9 billion at September 30, 2016 and December 31, 2015, respectively.
Note 10 – Fair Value of Financial Instruments
A three-level valuation hierarchy exists for disclosure of fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels are defined as follows:
•
Level 1 Inputs – Quoted prices for identical instruments in active markets.
•
Level 2 Inputs – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
•
Level 3 Inputs – Instruments with primarily unobservable value drivers.

 
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The following tables present the Company's assets and liabilities measured at fair value on a recurring basis.
 
September 30, 2016
 
 
 
Fair Value Measurements Using:
 
 
 
 
 
 
 
 
 
Total at
$ in thousands
Level 1
 
Level 2
 
Level 3
 
Fair Value
Assets:
 
 
 
 
 
 
 
Mortgage-backed and credit risk transfer securities(1) (2)
—

 
16,054,607

 
19,470

 
16,074,077

Derivative assets
—

 
505

 
—

 
505

Total assets
—

 
16,055,112

 
19,470

 
16,074,582

Liabilities:
 
 
 
 
 
 
 
Derivative liabilities
—

 
382,321

 
—

 
382,321

Total liabilities
—

 
382,321

 
—

 
382,321

 
December 31, 2015
 
 
 
Fair Value Measurements Using:
 
 
 
 
 
 
 
 
 
Total at
$ in thousands
Level 1
 
Level 2
 
Level 3
 
Fair Value
Assets:
 
 
 
 
 
 
 
Mortgage-backed and credit risk transfer securities(1) (2)
—

 
16,091,657

 
(25,722
)
 
16,065,935

Derivative assets
—

 
8,659

 
—

 
8,659

Total assets
—

 
16,100,316

 
(25,722
)
 
16,074,594

Liabilities:
 
 
 
 
 
 
 
Derivative liabilities
—

 
238,148

 
—

 
238,148

Total liabilities
—

 
238,148

 
—

 
238,148

(1)
For more detail about the fair value of the Company's MBS and GSE CRTs, refer to Note 4 - "Mortgage-Backed and Credit Risk Transfer Securities."
(2)
The Company's GSE CRTs purchased prior to August 24, 2015 are accounted for as hybrid financial instruments with an embedded derivative. The hybrid instruments consist of debt host contracts classified as Level 2 and embedded derivatives classified as Level 3. As of September 30, 2016, the net embedded derivative asset position of $19.5 million includes $22.7 million of embedded derivatives in an asset position and $3.3 million of embedded derivatives in a liability position. As of December 31, 2015, the net embedded derivative liability position of $25.7 million includes $1.0 million of embedded derivatives in an asset position and $26.7 million of embedded derivatives in a liability position.
The following table shows a reconciliation of the beginning and ending fair value measurements of the Company's GSE CRT embedded derivatives, which the Company has valued utilizing Level 3 inputs:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
Beginning balance
(6,493
)
 
(10,372
)
 
(25,722
)
 
(21,495
)
Sales and settlements
—

 
(284
)
 
6,017

 
2,184

Total net gains / (losses) included in net income:
—

 
—

 
—

 
—

Realized gains/(losses), net
—

 
284

 
(6,017
)
 
(2,184
)
Unrealized gains/(losses), net
25,963

 
(3,848
)
 
45,192

 
7,275

Ending balance
19,470

 
(14,220
)
 
19,470

 
(14,220
)


 
29
 

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The following table summarizes significant unobservable inputs used in the fair value measurement of the Company's GSE CRT embedded derivatives:
 
Fair Value at
 
Valuation
 
Unobservable
 
 
 
Weighted
$ in thousands
September 30, 2016
 
Technique
 
Input
 
Range
 
Average
GSE CRT Embedded Derivatives
19,470

 
Market Comparables, Vendor Pricing
 
Weighted average life
 
2.7 - 8.1
 
5.9
 
Fair Value at
 
Valuation
 
Unobservable
 
 
 
Weighted
$ in thousands
December 31, 2015
 
Technique
 
Input
 
Range
 
Average
GSE CRT Embedded Derivatives
(25,722
)
 
Market Comparables
 
Prepayment Rate
 
5.72% - 14.37%
 
7.83
%
 
 
 
Vendor Pricing
 
Default Rate
 
0.10% - 0.35%
 
0.16
%
These significant unobservable inputs change according to market conditions and security performance. The Company estimates the weighted average life of GSE CRTs in order to identify GSE corporate debt with a similar maturity. Prior to the third quarter of 2016, the Company used prepayment and default rates to estimate the weighted average life. During the third quarter of 2016, the Company utilized weighted average life estimates obtained from a third party provider. Although weighted average life is a significant input, changes in weighted average life may not have an explicit directional impact on the fair value measurement.
The following table presents the carrying value and estimated fair value of the Company's financial instruments that are not carried at fair value on the condensed consolidated balance sheets at September 30, 2016 and December 31, 2015:
 
September 30, 2016
 
December 31, 2015
$ in thousands
Carrying
Value
 
Estimated
Fair Value
 
Carrying
Value
 
Estimated
Fair Value
Financial Assets
 
 
 
 
 
 
 
Commercial loans, held-for-investment
273,291

 
273,920

 
209,062

 
209,790

Other assets
183,514

 
183,514

 
115,072

 
115,072

Total
456,805

 
457,434

 
324,134

 
324,862

Financial Liabilities
 
 
 
 
 
 
 
Repurchase agreements
12,060,502

 
12,060,505

 
12,126,048

 
12,133,252

Secured loans
1,650,000

 
1,650,000

 
1,650,000

 
1,650,000

Exchangeable senior notes
396,420

 
400,000

 
394,573

 
376,500

Total
14,106,922

 
14,110,505

 
14,170,621

 
14,159,752

The following describes the Company’s methods for estimating the fair value for financial instruments.
•
The estimated fair value of commercial loans held-for-investment is a Level 3 fair value measurement. New commercial loans are carried at their unpaid principal balance until the end of the calendar year in which they were originated or purchased unless market factors indicate cost may not be a reliable indicator of fair value. Subsequent to the year of origination or purchase, commercial loan investments are valued on at least an annual basis by an independent third party valuation agent using a discounted cash flow technique.
•
The estimated fair value of FHLBI stock, included in "Other assets," is a Level 3 fair value measurement. FHLBI stock may only be sold back to the FHLBI at its discretion at cost. As a result, the cost of the FHLBI stock approximates its fair value. At September 30, 2016 and December 31, 2015, the fair value of FHLBI stock is $74.3 million and $75.4 million, respectively.
•
The estimated fair value of investments in unconsolidated ventures, included in "Other assets," is a Level 3 fair value measurement. The fair value measurement is based on the net asset value per share of the Company's investments. At September 30, 2016 and December 31, 2015, the fair value of investments in unconsolidated ventures is $32.8 million and $38.4 million, respectively.
•
The estimated fair value of the Company's reverse repurchase agreement, included in "Other assets," is a Level 2 fair value measurement. The reverse repurchase agreement has a fixed rate for a short term. Accordingly, the interest rate

 
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on the repurchase agreement is at market, and thus the carrying amount of $75.0 million at September 30, 2016 approximates fair value. The Company did not hold any reverse repurchase agreements as of December 31, 2015.
•
The estimated fair value of repurchase agreements is a Level 3 fair value measurement based on an expected present value technique. This method discounts future estimated cash flows using rates the Company determined best reflect current market interest rates that would be offered for repurchase agreements with similar characteristics and credit quality.
•
The estimated fair value of secured loans is a Level 3 fair value measurement. The secured loans have floating rates based on an index plus a spread and the spread is typically consistent with those demanded in the market. Accordingly, the interest rates on these secured loans are at market, and thus the carrying amount approximates fair value.
•
The estimated fair value of the exchangeable senior notes issued is a Level 2 fair value measurement based on valuation obtained from a third-party pricing service.
Note 11 – Related Party Transactions
The Company has invested $46.9 million and $47.4 million as of September 30, 2016 and December 31, 2015, respectively, in money market or mutual funds managed by affiliates of the Company’s Manager. The investments are reported as cash and cash equivalents on the Company’s condensed consolidated balance sheets.
Management Fee
The Company pays its Manager a management fee equal to 1.50% of the Company’s stockholders’ equity per annum. The fee is calculated and payable quarterly in arrears. For purposes of calculating the management fee, stockholders’ equity is equal to the sum of the net proceeds from all issuances of equity securities since inception (allocated on a pro rata daily basis for such issuances during the fiscal quarter of any such issuance), plus retained earnings at the end of the most recently completed calendar quarter (without taking into account any non-cash equity compensation expense incurred in current or prior periods), less any amount paid to repurchase common stock since inception. Stockholder's equity shall exclude (i) any unrealized gains, losses or other items that do not affect realized net income (regardless of whether such items are included in other comprehensive income or loss, or in net income); (ii) cumulative net realized losses that are not attributable to permanently impaired investments and that relate to the investments for which market movement is accounted for in other comprehensive income; provided, however, that such adjustment shall not exceed cumulative unrealized net gains in other comprehensive income; (iii) one-time events pursuant to changes in U.S. GAAP; and (iv) certain non-cash items after discussions between the Manager and the Company’s independent directors and approval by a majority of the Company’s independent directors.
The Company does not pay any management fees on its investments in unconsolidated ventures that are managed by an affiliate of the Manager.
For the three months ended September 30, 2016, the Company incurred management fees of $6.7 million (September 30, 2015: $10.1 million). For the nine months ended September 30, 2016, the Company incurred management fees of $25.3 million (September 30, 2015: $28.8 million). The Company recorded a cumulative one-time adjustment of $2.3 million during the three months ended September 30, 2016 related to a prior adjustment for the accounting for premiums and discounts associated with non-Agency RMBS not of high credit quality. Refer to Note 16 – “Revision of Previously Issued Financial Statements” for further information. As of September 30, 2016, the Company owes the Manager $9.0 million for management fees.

 
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Expense Reimbursement
The Company is required to reimburse its Manager for Company operating expenses incurred on its behalf by the Manager, including directors and officers insurance, accounting services, auditing and tax services, filing fees, and miscellaneous general and administrative costs. The Company’s reimbursement obligation is not subject to any dollar limitation.
The following table summarizes the costs originally paid by the Manager, incurred on behalf of the Company for the three and nine months ended September 30, 2016 and 2015.
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
Incurred costs, prepaid or expensed
2,652

 
2,690

 
5,827

 
5,039

Incurred costs, capitalized to other assets
—

 
—

 
50

 
—

Total incurred costs, originally paid by the Manager
2,652

 
2,690

 
5,877

 
5,039

The Company also pays the Manager a portion of the origination and commitment fees received from borrowers in connection with purchasing and originating commercial real estate loans. For the three months ended September 30, 2016, the Company did not incur any costs related to such transactions. For the nine months ended September 30, 2016, the Company incurred $692,000 (September 30, 2015: $0) of costs related to such transactions. As of September 30, 2016, the Company owed the Manager $2,000 for such costs.
Termination Fee
A termination fee is due to the Manager upon termination of the management agreement by the Company. The termination fee is equal to three times the sum of the average annual management fee earned by the Manager during the 24-month period before termination, calculated as of the end of the most recently completed fiscal quarter.
Note 12 – Stockholders’ Equity
Preferred Stock
Holders of the Company’s Series A Preferred Stock are entitled to receive dividends at an annual rate of 7.75% of the liquidation preference of $25.00 per share or $1.9375 per share per annum. The dividends are cumulative and payable quarterly in arrears.
Holders of the Company’s Series B Preferred Stock are entitled to receive dividends at an annual rate of 7.75% of the liquidation preference of $25.00 per share or $1.9375 per share per annum until December 27, 2024. After December 27, 2024, holders are entitled to receive dividends at a floating rate equal to three-month LIBOR plus a spread of 5.18% of the $25.00 liquidation preference per annum. Dividends are cumulative and payable quarterly in arrears.
The Company may elect to redeem shares of preferred stock at its option after July 26, 2017 (with respect to the Series A Preferred Stock) and after December 27, 2024 (with respect to the Series B Preferred Stock) for $25.00 per share, plus any accumulated and unpaid dividends through the date of the redemption. These shares are not redeemable, convertible into or exchangeable for any other property or any other securities of the Company prior to those times, except under circumstances intended to preserve the Company's qualification as a REIT or upon the occurrence of a change in control.
Common Stock
During the nine months ended September 30, 2016, the Company issued 3,201 shares of common stock at an average price of $11.08 under its dividend reinvestment and stock purchase plan (the "DRSPP"). The Company received total proceeds of approximately $35,000. Effective April 1, 2016, the Company terminated its DRSPP and replaced the DRSPP program with a direct stock purchase plan and dividend reinvestment program administered by an affiliate of its transfer agent.

 
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Accumulated Other Comprehensive Income
The following table presents the components of accumulated other comprehensive income at September 30, 2016 and December 31, 2015, respectively. The table excludes MBS and GSE CRTs that are accounted for under the fair value option.
$ in thousands
September 30, 2016
 
December 31, 2015
Unrealized gain/(loss) on mortgage-backed and credit risk transfer securities, net
426,142

 
170,383

Unrealized gain/(loss) on discontinued cash flow hedges, net
159,463

 
148,273

Currency translation adjustments on investment in unconsolidated venture
(42
)
 
(32
)
Accumulated other comprehensive income
585,563

 
318,624

Effective December 31, 2013, the Company voluntarily discontinued cash flow hedge accounting for its interest rate swaps to gain greater flexibility in managing interest rate exposures. Amounts recorded in AOCI prior to the Company discontinuing cash flow hedge accounting for its interest rate swaps are reclassified to interest expense on repurchase agreements on the condensed consolidated statements of operations as interest is accrued and paid on the related repurchase agreements over the remaining original life of the interest rate swap agreements.
Securities Convertible into Shares of Common Stock
The non-controlling interest holder of the Operating Partnership units, a wholly-owned Invesco subsidiary, has the right to cause the Operating Partnership to redeem their operating partnership ("OP Units") for cash equal to the market value of an equivalent number of shares of common stock, or at the Company’s option, the Company may purchase their OP Units by issuing one share of common stock for each OP Unit redeemed. The Company has also adopted an equity incentive plan which allows the Company to grant securities convertible into the Company’s common stock to its non-executive directors and employees of the Company's Manager and its affiliates.
Share Repurchase Program
In February 2016, the Company's board of directors authorized an additional share repurchase of up to 15,000,000 of its common shares with no expiration date. During the nine months ended September 30, 2016, the Company repurchased and concurrently retired 2,063,451 shares of its common stock at a weighted average repurchase price of $12.12 per share for a net cost of $25.0 million, including acquisition expenses. As of September 30, 2016, the Company had authority to purchase 18,239,082 additional shares of its common stock under its share repurchase program. The share repurchase program has no stated expiration date.
Share-Based Compensation
The Company has currently reserved 1,000,000 shares of common stock for issuance to its non-executive directors and officers and employees of the Manger and its affiliates under the terms of its 2009 Equity Incentive Plan (the "Incentive Plan"). Unless terminated earlier, the Incentive Plan will terminate in 2019, but will continue to govern the unexpired awards.
The Company recognized compensation expense of approximately $85,000 (September 30, 2015: $85,000) and approximately $255,000 (September 30, 2015: $255,000) related to the Company's non-executive directors for the three and nine months ended September 30, 2016 and 2015, respectively. During the three months ended September 30, 2016 and 2015, the Company issued 5,448 shares and 6,152 shares of stock, respectively, pursuant to the Incentive Plan to the Company’s non-executive directors. During the nine months ended September 30, 2016 and 2015, the Company issued 19,356 shares and 16,896 shares of stock, respectively, pursuant to the Incentive Plan to the Company’s non-executive directors. The fair market value of the shares granted was determined by the closing stock market price on the date of the grant. The grants vested immediately.
The Company recognized compensation expense of approximately $75,000 (September 30, 2015: $31,000) and $170,000 (September 30, 2015: $168,000) for the three and nine months ended September 30, 2016 and 2015, respectively, related to awards to employees of the Manager and its affiliates which is reimbursed by the Manager under the management agreement. At September 30, 2016 there was approximately $542,000 of total unrecognized compensation cost related to certain share-based compensation awards that is expected to be recognized over a period of up to 42 months, with a weighted-average remaining vesting period of 17.52 months.

 
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The following table summarizes the activity related to restricted stock units to employees of the Manager and its affiliates for the three and nine months ended September 30, 2016.
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
 
2016
 
Restricted Stock Units
 
Weighted Average Grant Date Fair Value (1)
 
Restricted Stock Units
 
Weighted Average Grant Date Fair Value (1)
Unvested at the beginning of the period
46,000

 
$
14.40

 
40,814

 
17.29

Shares granted during the period
—

 
—

 
21,099

 
11.28

Shares forfeited during the period
—

 
—

 
—

 
—

Shares vested during the period
—

 
—

 
(15,913
)
 
(17.66
)
Unvested at the end of the period
46,000

 
$
14.40

 
46,000

 
14.40

(1)
The grant date fair value of restricted stock awards is based on the closing market price of the Company’s common stock at the grant date.
Dividends
On September 14, 2016, the Company declared the following dividends:
•
a dividend of $0.40 per share of common stock to be paid on October 26, 2016 to stockholders of record as of the close of business on September 27, 2016;
•
a dividend of $0.4844 per share of Series A Preferred Stock to be paid on October 25, 2016 to stockholders of record as of the close of business on October 1, 2016; and
•
a dividend of $0.4844 per share of Series B Preferred Stock to be paid on December 27, 2016 to stockholders of record as of the close of business on December 5, 2016.
Note 13 – Earnings per Common Share
Earnings per share for the three and nine months ended September 30, 2016 and 2015 is computed as follows: 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ and share amounts in thousands
2016
 
2015
 
2016
 
2015
Numerator (Income)
 
 
 
 
 
 
 
Basic Earnings:
 
 
 
 
 
 
 
Net income (loss) available to common stockholders
129,219

 
(144,515
)
 
(38,558
)
 
(15,985
)
Effect of dilutive securities:
 
 
 
 
 
 
 
Income allocated to exchangeable senior notes
5,620

 
—

 
—

 
—

Income (loss) allocated to non-controlling interest
1,723

 
(1,628
)
 
(235
)
 
(10
)
Dilutive net income (loss) available to stockholders
136,562

 
(146,143
)
 
(38,793
)
 
(15,995
)
Denominator (Weighted Average Shares)
 
 
 
 
 
 
 
Basic Earnings:
 
 
 
 
 
 
 
Shares available to common stockholders
111,587

 
122,047

 
112,101

 
122,763

Effect of dilutive securities:
 
 

 
 
 
 
Restricted stock awards
46

 
—

 
—

 
—

OP units
1,425

 
1,425

 
1,425

 
1,425

Exchangeable senior notes
16,835

 
—

 
—

 
—

Dilutive Shares
129,893

 
123,472

 
113,526

 
124,188

The following potential common shares were excluded from diluted earnings per common share for the nine months ended September 30, 2016 as the effect would be anti-dilutive: 16,835,720 for the exchangeable senior notes and 44,785 for restricted stock awards, respectively. The following potential common shares were excluded from diluted earnings per share

 
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for the three and nine months ended September 30, 2015 as the effective would be anti-dilutive: 16,835,720 for the exchangeable senior notes, respectively, and 40,810 and 41,404 for restricted stock awards, respectively.
Note 14 – Non-controlling Interest - Operating Partnership
Non-controlling interest represents the aggregate Operating Partnership Units in the Company's Operating Partnership held by a wholly-owned Invesco subsidiary. Income allocated to the non-controlling interest is based on the Unit Holders’ ownership percentage of the Operating Partnership. The ownership percentage is determined by dividing the number of OP Units held by the Unit Holders by the total number of dilutive shares of common stock. The issuance of common stock (“Share” or “Shares”) or OP Units changes the percentage ownership of both the Unit Holders and the holders of common stock. Since an OP unit is generally redeemable for cash or Shares at the option of the Company, it is deemed to be a Share equivalent. Therefore, such transactions are treated as capital transactions and result in an allocation between stockholders’ equity and non-controlling interest in the accompanying condensed consolidated balance sheets. As of September 30, 2016 and December 31, 2015, non-controlling interest related to the outstanding 1,425,000 OP Units represented a 1.3% interest and 1.2% interest in the Operating Partnership, respectively.
The following table presents the net income (loss) allocated and distributions paid to the Operating Partnership non-controlling interest for the three and nine months ended September 30, 2016 and 2015.
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
Net income (loss) allocated
1,723

 
(1,628
)
 
(235
)
 
(10
)
Distributions paid
570

 
570

 
1,710

 
1,853

As of September 30, 2016 and December 31, 2015, distributions payable to the non-controlling interest were approximately $570,000 and $570,000, respectively.
Note 15 – Commitments and Contingencies
Commitments and Contingencies
Commitments and contingencies may arise in the ordinary course of business. The Company's material off balance sheet commitments as of September 30, 2016 are discussed below.
As discussed in Note 6 - "Other Assets", the Company has invested in unconsolidated ventures that are sponsored by an affiliate of the Company’s Manager. The unconsolidated ventures are structured as partnerships, and the Company invests in the partnerships as a limited partner. The entities are structured such that capital commitments are to be drawn down over the life of the partnership as investment opportunities are identified. As of September 30, 2016 and December 31, 2015, the Company’s undrawn capital and purchase commitments were $16.3 million and $21.1 million, respectively.
As discussed in Note 5 - “Commercial Loans Held-for-Investment”, the Company purchases and originates commercial loans. As of September 30, 2016 and December 31, 2015, the Company has unfunded commitments on commercial loans held-for-investment of $11.8 million and $2.1 million, respectively.
The Company has entered into agreements with financial institutions to guarantee certain obligations of its subsidiaries.  The Company would be required to perform under these guarantees in the event of certain defaults. The Company has not had prior claims or losses pursuant to these contracts and expects the risk of loss to be remote.

 
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Note 16 – Revision of Previously Issued Financial Statements
During the second quarter of 2016, the Company corrected errors in its accounting for premiums and discounts associated with non-Agency RMBS not of high credit quality. Premiums and discounts are amortized and recorded as interest income in the Company's financial statements based on estimated future cash flows. The Company determined that the future cash flow assumptions used to develop its estimated premium amortization and discount accretion did not support its reported interest income. The Company revised its future cash flow estimates and also corrected its financial statements to account for the difference between actual and expected future cash flows as an adjustment to the amortized cost of the security and a prospective adjustment to the security's yield. The Company concluded that the errors are immaterial to each of the annual and interim consolidated financial statements which were included in the Company's Annual Report on Form 10-K for the year ended December 31, 2015 and its interim report on Form 10-Q for the quarter ended March 31, 2016.  The Company has revised its consolidated financial statements as of December 31, 2015 and for the three and nine months ended September 30, 2015 presented in this Report on Form 10-Q and will revise its previously issued financial statements to correct these errors when the financial statements are presented in future periodic filings.
The following changes have been made to the Company's Consolidated Balance Sheet as of December 31, 2015:
$ in thousands
December 31, 2015
 
As Reported
 
Adjustment
 
As Revised
Accumulated other comprehensive income
303,110

 
15,514

 
318,624

Retained earnings (distributions in excess of earnings)
(755,799
)
 
(15,514
)
 
(771,313
)
The following changes have been made to the Company's Unaudited Consolidated Statements of Operations for the three and nine months ended September 30, 2015:
$ in thousands
Three Months Ended September 30, 2015
 
As Reported
 
Adjustment
 
As Revised
Interest Income
 
 
 
 
 
Mortgage-backed and credit risk transfer securities
129,260

 
(955
)
 
128,305

Other Income
 
 
 
 
 
Gain (loss) on investments, net
(2,958
)
 
991

 
(1,967
)
Net income
(140,463
)
 
36

 
(140,427
)
Net income attributable to non-controlling interest
(1,629
)
 
1

 
(1,628
)
Net income attributable to Invesco Mortgage Capital Inc.
(138,834
)
 
35

 
(138,799
)
Net income attributable to common stockholders
(144,550
)
 
35

 
(144,515
)
Earnings per share:
 
 
 
 
 
Net income attributable to common stockholders
 
 
 
 
 
   Basic
(1.18
)
 
—

 
(1.18
)
   Diluted
(1.18
)
 
—

 
(1.18
)
$ in thousands
Nine Months Ended September 30, 2015
 
As Reported
 
Adjustment
 
As Revised
Interest Income
 
 
 
 
 
Mortgage-backed and credit risk transfer securities
390,623

 
5,221

 
395,844

Other Income (loss)
 
 
 
 
 
Gain (loss) on investments, net
10,090

 
929

 
11,019

Net income
(4,997
)
 
6,150

 
1,153

Net income attributable to non-controlling interest
(80
)
 
70

 
(10
)
Net income attributable to Invesco Mortgage Capital Inc.
(4,917
)
 
6,080

 
1,163

Net income attributable to common stockholders
(22,065
)
 
6,080

 
(15,985
)
Earnings per share:
 
 
 
 
 
Net income attributable to common stockholders
 
 
 
 
 
   Basic
(0.18
)
 
0.05

 
(0.13
)
   Diluted
(0.18
)
 
0.05

 
(0.13
)

 
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The following changes have been made to the Company's Unaudited Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2015:
$ in thousands
Three Months Ended September 30, 2015
 
As Reported
 
Adjustment
 
As Revised
Net income (loss)
(140,463
)
 
36

 
(140,427
)
Unrealized gain (loss) on mortgage-backed and credit risk transfer securities, net
41,978

 
955

 
42,933

Reclassification of unrealized (gain) loss on sale of mortgage-backed and credit risk transfer securities to gain (loss) on investments, net
1,380

 
(991
)
 
389

Total other comprehensive income (loss)
59,049

 
(36
)
 
59,013

$ in thousands
Nine Months Ended September 30, 2015
 
As Reported
 
Adjustment
 
As Revised
Net income (loss)
(4,997
)
 
6,150

 
1,153

Unrealized gain (loss) on mortgage-backed and credit risk transfer securities, net
(25,390
)
 
(5,221
)
 
(30,611
)
Reclassification of unrealized (gain) loss on sale of mortgage-backed and credit risk transfer securities to gain (loss) on investments, net
(3,223
)
 
(929
)
 
(4,152
)
Total other comprehensive income (loss)
22,536

 
(6,150
)
 
16,386

The following changes have been made to the Company's Unaudited Consolidated Statement of Cash Flows for the nine months ended September 30, 2015:
$ in thousands
Nine Months Ended September 30, 2015
 
As Reported
 
Adjustment
 
As Revised
Cash Flows from Operating Activities
 
 
 
 
 
Net income
(4,997
)
 
6,150

 
1,153

Amortization of mortgage-backed and credit risk transfer securities premiums and (discounts), net
96,121

 
(5,221
)
 
90,900

(Gain) loss on investments, net
(10,090
)
 
(929
)
 
(11,019
)
Non-cash Investing and Financing Activities Information
 
 
 
 
 
Net change in unrealized gain on mortgage-backed and credit risk transfer securities
(28,613
)
 
(6,150
)
 
(34,763
)
Note 17 – Subsequent Events
The Company has reviewed subsequent events occurring through the date that these condensed consolidated financial statements were issued, and determined that no subsequent events occurred that would require accrual or additional disclosure.

 
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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. together with its consolidated subsidiaries (which does not include us), as “Invesco.”
The following discussion should be read in conjunction with our condensed consolidated financial statements and the accompanying notes to our condensed 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;
•
general volatility of financial markets and effects of governmental responses, including 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, actions and initiatives of foreign governmental agencies and central banks, monetary policy actions of the Federal Reserve, including actions relating to its agency mortgage-backed securities portfolio and the continuation of re-investment of principal payments, 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;
•
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;
•
effects of hedging instruments on our target assets;

 
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•
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;
•
compliance with financial covenants in our financing arrangements;
•
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 of our Manager;
•
the relationship with our Manager;
•
estimates relating to taxable income and our ability to continue to make distributions to our stockholders 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”);
•
the adequacy of our disclosure controls and procedures and internal controls over financial reporting; and
•
market trends in our industry, interest rates, real estate values, the debt securities markets or the general economy.
The forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us. You should not place undue reliance on these forward-looking statements. These beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to us. Some of these factors are described under the headings “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.” If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. Any forward-looking statement speaks only as of the date on which it is made. New risks and uncertainties arise over time, and it is not possible for us to predict those events or how they may affect us. 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.
The following discussion should be read in conjunction with our condensed consolidated financial statements and the accompanying notes to our condensed 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. 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:
•
Residential mortgage-backed securities (“RMBS”) that are guaranteed by 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”) (collectively "Agency RMBS");
•
RMBS that are not guaranteed by a U.S. government agency ("non-Agency RMBS");
•
Credit risk transfer securities that are unsecured obligations issued by government-sponsored enterprises ("GSE CRT");

 
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•
Commercial mortgage-backed securities (“CMBS”); 
•
Residential and commercial mortgage loans; and
•
Other real estate-related financing arrangements.
We are externally managed and advised by Invesco Advisers, Inc., our Manager, a registered investment adviser and an indirect, wholly-owned subsidiary of Invesco Ltd., a leading independent global investment management firm. 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 REIT taxable income to our stockholders annually. We operate our business in a manner that permits our exclusion from the definition of “Investment Company” under the 1940 Act.
Capital Activities
On September 14, 2016, we declared the following dividends:
•
a dividend of $0.40 per share of common stock to be paid on October 26, 2016 to stockholders of record as of the close of business on September 27, 2016;
•
a dividend of $0.4844 per share of Series A Preferred Stock to be paid on October 25, 2016 to stockholders of record as of the close of business on October 1, 2016; and
•
a dividend of $0.4844 per share of Series B Preferred Stock to be paid on December 27, 2016 to stockholders of record as of the close of business on December 5, 2016.
During the nine months ended September 30, 2016, we repurchased 2,063,451 shares of our common stock at a weighted average repurchase price of $12.12 per share for a net cost of $25.0 million, including acquisition expenses.
Factors Impacting Our Operating Results
Our operating results can be affected by a number of factors and primarily depend on the level of our net interest income and the market value of our assets. 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. The market value of our assets can be impacted by credit spread premiums (yield advantage over U.S. Treasury notes) and the supply of, and demand for, target assets in which we invest.
Market Conditions
Macroeconomic factors that affect our business include credit spread premiums, market interest rates, governmental policy initiatives, residential and commercial real estate prices, credit availability, personal income, corporate earnings, employment conditions, financial conditions and inflation. Global financial markets witnessed relatively low volatility in the third quarter of 2016 following the tumult caused by the U.K. referendum on European Union membership ("Brexit") near the end of the second quarter. U.S. equity markets ended higher as the quarterly return on the S&P 500 index was 3.85% and most global markets finished positive as well. Stock market volatility declined as evidenced by the CBOE SPX Volatility Index ("VIX") dropping approximately 2 points to 13.3. Financial conditions were relatively steady for most of the quarter though energy prices declined materially during the month of July before recovering to end nearly unchanged. Low equity price and interest rate volatility served as a support for credit spreads, which generally improved during the quarter. The Federal Reserve made it clear to markets as the quarter progressed that an increase in the Federal Funds Target Rate was possible at the September Federal Open Market Committee meetings, but subsequently kept rates unchanged while indicating the case for a rate increase has strengthened. U.S. Treasury bond yields ended the quarter higher as markets perceived the Federal Reserve is moving ever closer to the first rate increase in 2016. As we enter the fourth quarter, investor concerns include: central bank actions and their impact on the economy, the U.S. elections, regulations related to risk retention and higher global capital requirements for financial institutions, the sustainability of China's economic growth, and the potential impact of the Brexit process and resulting stress in the European banking system.
The consensus of economists’ forecast for U.S. domestic economic activity stands at 1.5% for 2016. At the beginning of the year, economists expected real GDP growth of 2.5% for 2016. The consensus for the 2016 core personal consumption expenditures deflator of 1.7% has not changed since the end of the second quarter, while the expectation for 2017 stands at 1.8%, still shy of the 2% target communicated by the U.S. Federal Reserve. Economists have over-estimated core inflation in each of the past three years. Monthly increases in payroll employment rose to 192,000 jobs per month for the third quarter of

 
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2016, slightly below the average of 204,000 over the last twelve months. The consensus of economists expects monthly payrolls to increase by 180,000 jobs per month in 2016. Looking forward, the improving labor market coupled with low interest rates and energy prices should be supportive of U.S. consumer spending. Countering that positive influence on the economy are weak capital investment and sluggish wage and consumer debt growth relative to previous economic expansions. The index of U.S. dollar exchange rates relative to a basket of major world currencies weakened slightly in the third quarter and remains lower year to date. In summary, it appears likely that the U.S. will continue to experience modest economic growth, accompanied by core inflation that is below the Federal Reserve’s policy objective of 2%.
Longer term U.S. interest rates are near the low end of the past three years' range, while shorter term rates are near the high end. During the third quarter the ten year Treasury note yield rose 12 basis points and the two year note yield rose 18 basis points. Three month LIBOR rates rose by 20 basis points in the quarter as impending money market reform drove down demand for prime money funds. We expect U.S interest rates will remain relatively low, as the Federal Reserve stays cautious, and quantitative easing by the European Central Bank and Bank of Japan continues. Broadly, this remains a welcome environment for MBS investors. Further, continued tight residential mortgage loan underwriting standards restrict the ability of many homeowners to refinance, which reduces prepayment risk and is beneficial for MBS investors. We believe global uncertainty and low or even negative interest rates abroad will support demand for Agency RMBS due to the relatively attractive yield and the implicit U.S. government guarantee. Further, the Federal Reserve is likely to continue re-investing prepayments on their MBS portfolio for another year, as they have signaled the intent to continue until well into the rate normalization process.
Fixed rate MBS broadly outperformed equal duration U.S. Treasury notes and interest rate swaps in the quarter. Five year and two year interest rate swaps widened relative to Treasuries whereas ten year swap spreads tightened. Prepayment rates have increased but remain relatively benign despite the large drop in interest rates that occurred in the first half of the year. Non-agency CMBS, RMBS, and GSE CRT securities outperformed Treasuries in the third quarter as narrowing of credit spreads boosted returns. Repurchase agreement financing rates on Agency MBS and borrowing rates from the FHLB were relatively steady in the third quarter despite higher LIBOR rates, but repurchase agreement rates on non-agency collateral rose with LIBOR.
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 affect our cost of doing business, may limit our investment opportunities and may affect the competitive balance within our industry and the markets in which we invest. For example, the Ability-to-Repay (“ATR”) rule requires lenders to make a reasonable, good-faith determination that residential borrowers have a reasonable ability to repay a mortgage loan. In addition to the ATR rule, the Consumer Financial Protection Bureau adopted a Qualified Mortgage (“QM”) framework that provides certain legal protections to residential mortgage loan lenders, which includes restrictions on loan features, points and fees 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 impact of these regulations and others could affect our ability to securitize or invest in newly originated loans in the future.
In addition, the regulatory landscape for our repurchase agreement counterparties continues to evolve following the adoption of new capital rules that generally affect the manner in which banks lend. Regulators are also focused on liquidity requirements which will likely impact 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 the terms on which we finance our assets in the future.
Investment Activities
In the third quarter of 2016, our investment portfolio remained positioned to take advantage of opportunities in both mortgage-backed and credit risk transfer securities and newly originated loans against a backdrop of broadly improving real estate markets.

 
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The table below shows the allocation of our equity as of September 30, 2016, December 31, 2015 and September 30, 2015:
 
As of
$ in thousands
September 30, 2016
 
December 31, 2015
 
September 30, 2015
Agency RMBS
44
%
 
37
%
 
35
%
Commercial Credit (1)
31
%
 
33
%
 
34
%
Residential Credit (2)
25
%
 
30
%
 
31
%
Total
100
%
 
100
%
 
100
%
(1)
CMBS, Commercial Loans and $32.8 million of Investments in unconsolidated ventures (which are included in Other Assets), are considered commercial credit.
(2)
Non-Agency RMBS, GSE CRT and Residential Loans are considered residential credit.
Over the past year our allocation of equity to Agency RMBS has increased to 44% and our allocation to residential and commercial credit has decreased to 56%. The shift reflects our strategy of decreasing risk in front of the upcoming elections, Federal Reserve meetings and Brexit negotiations, and creates capacity to invest in potential risk retention opportunities in the commercial real estate debt market.
The table below shows the breakdown of our investment portfolio as of September 30, 2016, December 31, 2015 and September 30, 2015:
 
As of
$ in thousands
September 30, 2016
 
December 31, 2015
 
September 30, 2015
Agency RMBS:
 
 
 
 
 
30 year fixed-rate, at fair value
3,635,565

 
4,063,957

 
4,214,946

15 year fixed-rate, at fair value
3,637,952

 
1,610,930

 
1,702,382

Hybrid ARM, at fair value
2,684,108

 
3,309,525

 
3,447,613

ARM, at fair value
331,953

 
426,025

 
452,831

Agency CMO, at fair value
364,036

 
388,819

 
416,662

Non-Agency RMBS, at fair value
2,109,115

 
2,692,487

 
2,624,608

GSE CRT, at fair value
643,058

 
658,228

 
651,705

CMBS, at fair value
2,668,290

 
2,915,964

 
3,304,214

Residential loans, at amortized cost
—

 
—

 
3,307,249

Commercial loans, at amortized cost
273,291

 
209,062

 
187,038

Investments in unconsolidated ventures
32,763

 
38,413

 
37,922

Total Investment portfolio
16,380,131

 
16,313,410

 
20,347,170

During the first nine months of 2016, we primarily reinvested cash flows from sales and principal repayments into 15 year fixed-rate Agency RMBS. In the third quarter of 2016, we purchased $1.2 billion of 15 year fixed-rate Agency RMBS. We have been increasing our holdings of 15 year fixed-rate Agency RMBS instead of 30 year fixed-rate agency RMBS to decrease our interest rate risk and further reduce book value volatility. As of September 30, 2016 our holdings of 15 year fixed-rate Agency RMBS represent 22% of our total investment portfolio versus 10% of our total investment portfolio as of December 31, 2015. We have continued to hold certain 30 year fixed-rate Agency RMBS that have relatively lower interest rate risk because they are collateralized by mortgages with higher coupons.  We expect these securities to prepay more favorably than their applicable cohorts based on their seasoning and collateral attributes. Additionally, we hold Hybrid ARM Agency RMBS and ARM Agency RMBS that we believe have lower durations and better cash flow certainty relative to current coupon 30 year fixed-rate Agency RMBS. Further, we own Agency collateralized mortgage obligations ("CMOs"), some of which are interest-only securities.
Our portfolio of investments that have credit exposure include non-Agency RMBS, GSE CRTs, CMBS and commercial real estate loans. Rather than relying on the rating agencies, we utilize proprietary models as well as third party applications to quantify and monitor the credit risk associated with our portfolio holdings. Our analysis generally begins at the underlying asset level, where we gather detailed information on loan, borrower, and property characteristics that inform our expectations for future performance. In addition to base case cash flow projections, we perform a range of scenario stresses to gauge the

 
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sensitivity of returns to potential deviations in underlying asset behavior. We perform this detailed credit analysis at the time of initial purchase and regularly throughout the holding period of each investment.
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-securitizations of real estate mortgage investment conduit ("Re-REMIC") RMBS and securitizations of reperforming mortgage loans that we believe provide attractive risk adjusted returns. We also invest in GSE CRTs, which have the added benefit of paying a floating rate coupon, reducing our need to hedge interest rate risk. Our GSE CRT holdings decreased modestly over the past nine months as we tactically sold certain positions with lower expected returns and allocated capital to more favorable opportunities.  We continue to view GSE CRT as an attractive asset class based on the strength of the U.S. housing market and potentially compelling relative value.
Our CMBS portfolio generally consists of assets originated before 2007 and assets originated after 2010 (“CMBS 2.0”). CMBS represent approximately 16% of our total investment portfolio as of September 30, 2016.
During the third quarter of 2016, we funded $2.0 million of commercial loan commitments. As of September 30, 2016, our commercial real estate loan portfolio includes ten mezzanine loans that we purchased or originated. For further details on our commercial loan portfolio, see Note 5 - "Commercial Loans Held-for-Investment" of our condensed consolidated financial statements. In addition, during the third quarter of 2016, we invested $3.9 million in our unconsolidated ventures. For further details on our investments in unconsolidated ventures, see Note 6 - "Other Assets" of our condensed consolidated financial statements.
Portfolio Characteristics
The table below represents the vintage of our MBS and GSE CRT credit assets as of September 30, 2016 as a percentage of the fair value: 
 
2003
 
2004
 
2005
 
2006
 
2007
 
2008
 
2009
 
2010
 
2011
 
2012
 
2013
 
2014
 
2015
 
2016
 
Total
Prime
0.5
%
 
1.6
%
 
4.3
%
 
3.7
%
 
8.0
%
 
2.2
%
 
—
%
 
—
%
 
—
%
 
—
%
 
12.5
%
 
10.2
%
 
1.3
%
 
0.2
%
 
44.5
%
Alt-A
—
%
 
0.6
%
 
7.5
%
 
6.3
%
 
7.7
%
 
—
%
 
—
%
 
—
%
 
—
%
 
—
%
 
—
%
 
—
%
 
—
%
 
—
%
 
22.1
%
Re-REMIC (1)
—
%
 
—
%
 
—
%
 
—
%
 
0.4
%
 
—
%
 
0.6
%
 
4.5
%
 
9.5
%
 
3.6
%
 
0.7
%
 
—
%
 
—
%
 
—
%
 
19.3
%
Subprime/reperforming
—
%
 
—
%
 
—
%
 
—
%
 
0.3
%
 
—
%
 
—
%
 
—
%
 
—
%
 
—
%
 
2.4
%
 
9.6
%
 
1.8
%
 
—
%
 
14.1
%
Total Non-Agency
0.5
%
 
2.2
%
 
11.8
%
 
10.0
%
 
16.4
%
 
2.2
%
 
0.6
%
 
4.5
%
 
9.5
%
 
3.6
%
 
15.6
%
 
19.8
%
 
3.1
%
 
0.2
%
 
100.0
%
GSE CRT
—
%
 
—
%
 
—
%
 
—
%
 
—
%
 
—
%
 
—
%
 
—
%
 
—
%
 
—
%
 
40.3
%
 
46.6
%
 
11.7
%
 
1.4
%
 
100.0
%
CMBS
—
%
 
—
%
 
0.2
%
 
0.6
%
 
—
%
 
—
%
 
—
%
 
6.2
%
 
23.8
%
 
14.8
%
 
15.3
%
 
33.6
%
 
5.5
%
 
—
%
 
100.0
%
(1)
For Re-REMICs, the table reflects the year in which the resecuritizations were issued. The vintage distribution of the securities that collateralize the Company’s Re-REMIC investments is 8.0% for 2005, 25.8% for 2006, and 66.2% for 2007.


 
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The tables below represent the geographic concentration of the underlying collateral for our MBS and GSE CRT credit assets as of September 30, 2016: 
Non-Agency RMBS
State
 
Percentage
 
GSE CRT
State
 
Percentage
 
CMBS
State
 
Percentage
California
 
41.8
%
 
California
 
20.5
%
 
California
 
14.8
%
New York
 
7.6
%
 
Texas
 
5.7
%
 
New York
 
13.9
%
Florida
 
6.2
%
 
Virginia
 
4.5
%
 
Texas
 
10.2
%
Virginia
 
3.6
%
 
New York
 
4.4
%
 
Florida
 
6.0
%
Maryland
 
3.5
%
 
Illinois
 
4.0
%
 
Pennsylvania
 
4.6
%
New Jersey
 
3.4
%
 
Florida
 
3.8
%
 
Illinois
 
4.3
%
Massachusetts
 
2.9
%
 
Massachusetts
 
3.6
%
 
New Jersey
 
3.7
%
Illinois
 
2.9
%
 
New Jersey
 
3.3
%
 
Ohio
 
3.0
%
Washington
 
2.6
%
 
Washington
 
3.2
%
 
Michigan
 
2.9
%
Texas
 
2.1
%
 
Colorado
 
3.1
%
 
Virginia
 
2.7
%
Other
 
23.4
%
 
Other
 
43.9
%
 
Other
 
33.9
%
Total
 
100.0
%
 
Total
 
100.0
%
 
Total
 
100.0
%
Financing and Other Liabilities
We enter into repurchase agreements to finance the majority of our target assets. These agreements are secured by our Agency RMBS, non-Agency RMBS, GSE CRTs and CMBS. In addition, these agreements are generally settled on a short-term basis, usually from one to twelve months, and bear interest at rates that have historically moved in close relationship to LIBOR. At each settlement date, we typically refinance each repurchase agreement at the market interest rate at that time. As of September 30, 2016, we had entered into repurchase agreements totaling $12.1 billion (December 31, 2015: $12.1 billion).
Our wholly-owned subsidiary, IAS Services, is a member of the FHLBI. As a member of the FHLBI, IAS Services has borrowed funds from the FHLBI in the form of secured advances. As of September 30, 2016, IAS Services had $1.65 billion in outstanding secured advances. For the nine months ended September 30, 2016, IAS Services had weighted average borrowings of $1.65 billion with a weighted average borrowing rate of 0.66% and a weighted average maturity of 7.60 years.
We have also committed to invest up to $122.4 million in unconsolidated ventures that are sponsored by an affiliate of our Manager. As of September 30, 2016, $106.1 million of our commitment to these unconsolidated ventures has been called. We are committed to fund $16.3 million in additional capital to fund future investments and cover future expenses should they occur.
We record a liability for mortgage-backed and credit risk transfer securities purchased, for which settlement has not taken place, as an investment related payable. As of September 30, 2016 and December 31, 2015, we had investment related payables of $17,000, and $167,000, respectively. Our liability balance fluctuates based on our volume of unsettled trades. None of these investment related payables were outstanding more than thirty days.
We record a receivable for mortgage-backed and credit risk transfer securities sold for which settlement has not taken place as an investment related receivable. As of September 30, 2016 and December 31, 2015, the Company had investment related receivables of $44.9 million and $154.6 million, respectively. Our receivable balance fluctuates based on our volume of unsettled trades. None of these investment related receivables were outstanding more than thirty days.

 
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The following table presents the amount of collateralized borrowings outstanding as of the end of each quarter, the average amount outstanding during the quarter and the maximum amount outstanding during the quarter:
$ in thousands
Collateralized borrowings under repurchase agreements and secured loans
Quarter Ended
Quarter-end balance
 
Average quarterly balance
 
Maximum balance of any quarter-end
September 30, 2015
14,587,131

 
14,765,282

 
14,879,873

December 31, 2015
13,776,048

 
14,286,242

 
14,730,071

March 31, 2016
12,837,159

 
13,137,569

 
13,501,433

June 30, 2016
13,418,647

 
13,075,770

 
13,418,647

September 30, 2016
13,710,502

 
13,826,469

 
13,984,960

As of September 30, 2016, we have entered into interest rate swap agreements designed to mitigate the effects of increases in interest rates under a portion of our borrowings. These swap agreements provide for fixed interest rates indexed off of one-month or three-month LIBOR and effectively fix the floating interest rates on $6.5 billion (September 30, 2015: $11.5 billion) of borrowings. During the nine months ended September 30, 2016, we terminated swaps with a notional amount of $5.0 billion and realized losses of $69.1 million. The terminated swaps were predominantly maturing in 2016 and offered little protection from rising rates. Additionally, our investment and repurchase agreement balances decreased due to asset sales to facilitate stock repurchases, further reducing our need for hedging. Our overall interest rate risk did not change materially as a result of the swap terminations.
As of September 30, 2016, we have no outstanding interest rate swaptions. As of September 30, 2015, we held $300.0 million in notional amount of fixed receive interest rate swaptions as an asset with a fair value of $73,000. During the nine months ended September 30, 2016 interest rate swaptions expired unexercised with a notional amount of approximately $300.0 million (September 30, 2015: $750.0 million), and the Company realized a loss of $1.5 million (September 30, 2015: $10.3 million) on these contracts. We purchase interest rate swaptions to reduce the impact that interest rate volatility has on our portfolio. The change in the notional amount of swaptions held was due to our views on the potential for change in volatility.
As of September 30, 2016 and September 30, 2015, we have no outstanding futures contracts. During the nine months ended September 30, 2015, we sold U.S. Treasury futures contracts of $248.3 million in notional amount and realized a net loss of $943,000. We periodically invest in U.S. Treasury futures contracts to help mitigate the potential impact of changes in interest rates on the performance of our portfolio.
As of September 30, 2016 and September 30, 2015, we have no outstanding to-be-announced securities ("TBAs"). During the nine months ended September 30, 2015, we settled TBAs of $446.0 million in notional amount and realized a net loss of $2.3 million. When we enter into TBAs, we agree to purchase or deliver in the future Agency RMBS with certain principal and interest terms. We periodically purchase or sell certain TBAs to help mitigate the potential impact of changes in interest rates on the performance of our portfolio.
As of September 30, 2016, we held $67.3 million (September 30, 2015: $6.9 million) in notional amount of currency forward contracts as an asset with a fair value of $505,000 (September 30, 2015: $191,000) and a liability with a fair value of $84,000 (September 30, 2015: $50,000). During the nine months ended September 30, 2016, we settled currency forward contracts of $240.3 million (September 30, 2015: $127.6 million) in notional amount and realized a net gain of $8.4 million (September 30, 2015: $1.1 million). We use currency forward contracts to help mitigate the potential impact of changes in foreign currency exchange rates on our investments denominated in foreign currencies.
Book Value per Share
Our book value per diluted common share was $18.08 and $17.14 as of September 30, 2016 and December 31, 2015, respectively. Book value per diluted common share is calculated as total equity less the liquidation preference of our Series A Preferred Stock ($140.0 million) and Series B Preferred Stock ($155.0 million); divided by total common shares outstanding plus Operating Partnership Units convertible into shares of common stock (1,425,000 shares). Our book value per diluted common share rose 5.5% as of September 30, 2016 compared to December 31, 2015 primarily due to higher valuations of our mortgage-backed and credit risk transfer securities portfolio resulting from broad credit spread tightening.

 
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Critical Accounting Policies
Our condensed consolidated financial statements are prepared in accordance with U.S. GAAP, which requires the use of estimates and assumptions that involve the exercise of judgment and use of assumptions as to future uncertainties. Accounting estimates and assumptions discussed in this section are those that we consider to be the most critical to an understanding of our financial statements because they involve significant judgments and uncertainties. All of these estimates reflect our best judgment about current, and for some estimates, future economic and market conditions and their effects based on information available as of the date of these financial statements. If conditions change from those expected, it is possible that the judgments and estimates described below could change, which may result in a change in valuation of our investment portfolio, future impairments of our MBS and GSE CRTs, change in our interest income recognition, allowance for loan losses, and a change in our tax liability among other effects.
There have been no significant changes to our critical accounting policies that are disclosed in our most recent Form 10-K for the year ended December 31, 2015, other than as disclosed below.
We have elected the fair value option for all of our MBS purchased on or after September 1, 2016. Prior to September 1, 2016, we have also elected the fair value option for our RMBS interest-only securities. We have also previously elected the fair value option for GSE CRTs purchased on or after August 24, 2015. Under the fair value option, changes in fair value are recognized in the consolidated statement of operations. In our view, the fair value option election more appropriately reflects the results of our operations because MBS and GSE CRT fair value changes are accounted for in the same manner as fair value changes in economic hedging instruments. As of September 30, 2016, $151.2 million or 0.9% of our MBS and GSE CRT are accounted for under the fair value option. Further information is provided in Note 2 - “Summary of Significant Accounting Policies” and Note 4 - “Mortgage-Backed and Credit Risk Transfer Securities”.
Expected Impact of New Authoritative Guidance on Future Financial Information
In January 2016, the FASB issued guidance to improve certain aspects of classification and measurement of financial instruments, including significant revisions in accounting related to the classification and measurement of investments in equity securities and presentation of certain fair value changes for financial liabilities when the fair value option is elected. The guidance also amends certain disclosure requirements associated with the fair value of financial instruments. We are required to adopt the new guidance in the first quarter of 2018. Early adoption is permitted. We are currently evaluating the potential impact of the new guidance on our consolidated financial statements, as well as available transition methods.
In June 2016, the FASB issued an amendment to the guidance on reporting credit losses for assets measured at amortized cost and available-for-sale securities. We are required to adopt the new guidance in the first quarter of 2020. Early adoption is permitted. We are currently evaluating the potential impacts of the new guidance on its consolidated financial statements, as well as available transition methods.
In August 2016, the FASB issued new guidance that is intended to reduce diversity in practice in how certain transactions are classified in the statement of cash flows. The Company is required to adopt the new guidance in the first quarter of 2018. Early adoption is permitted, provided that all of the amendments are adopted at the same period. The Company is currently evaluating the potential impacts of the new guidance on its consolidated financial statements.


 
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Results of Operations
The table below presents certain information from our condensed consolidated statements of operations for the three and nine months ended September 30, 2016 and 2015. 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands, except share data
2016
 
2015
 
2016
 
2015
Interest Income
 
 
 
 
 
 
 
Mortgage-backed and credit risk transfer securities
112,467

 
128,305

 
347,573

 
395,844

Residential loans (1)
—

 
28,380

 
—

 
88,001

Commercial loans
5,680

 
3,743

 
16,520

 
11,349

Total interest income
118,147

 
160,428

 
364,093

 
495,194

Interest Expense
 
 
 
 
 
 
 
Repurchase agreements
24,892

 
41,303

 
97,952

 
125,544

Secured loans
2,746

 
1,622

 
8,149

 
4,639

Exchangeable senior notes
5,620

 
5,620

 
16,847

 
16,840

Asset-backed securities (1)
—

 
20,686

 
—

 
64,913

Total interest expense
33,258

 
69,231

 
122,948

 
211,936

Net interest income
84,889

 
91,197

 
241,145

 
283,258

Reduction in provision for loan losses
—

 
81

 
—

 
213

Net interest income after reduction in provision for loan losses
84,889

 
91,278

 
241,145

 
283,471

Other Income (loss)
 
 
 
 
 
 
 
Gain (loss) on investments, net
(7,155
)
 
(1,967
)
 
5,860

 
11,019

Equity in earnings of unconsolidated ventures
729

 
1,894

 
1,992

 
9,131

Gain (loss) on derivative instruments, net
35,378

 
(220,602
)
 
(293,528
)
 
(287,344
)
Realized and unrealized credit derivative income (loss), net
31,926

 
2,928

 
57,564

 
24,904

Other investment income (loss), net
(554
)
 
739

 
(3,617
)
 
1,518

Total other income (loss)
60,324

 
(217,008
)
 
(231,729
)
 
(240,772
)
Expenses
 
 
 
 
 
 
 
Management fee – related party
6,719

 
10,058

 
25,292

 
28,816

General and administrative
1,836

 
2,507

 
5,769

 
6,186

Consolidated securitization trusts (1)
—

 
2,132

 
—

 
6,544

Total expenses
8,555

 
14,697

 
31,061

 
41,546

Net income (loss)
136,658

 
(140,427
)
 
(21,645
)
 
1,153

Net income (loss) attributable to non-controlling interest
1,723

 
(1,628
)
 
(235
)
 
(10
)
Net income (loss) attributable to Invesco Mortgage Capital Inc.
134,935

 
(138,799
)
 
(21,410
)
 
1,163

Dividends to preferred stockholders
5,716

 
5,716

 
17,148

 
17,148

Net income (loss) attributable to common stockholders
129,219

 
(144,515
)
 
(38,558
)
 
(15,985
)
Earnings (loss) per share:
 
 
 
 
 
 
 
Net income (loss) attributable to common stockholders
 
 
 
 
 
 
 
Basic
1.16

 
(1.18
)
 
(0.34
)
 
(0.13
)
Diluted
1.05

 
(1.18
)
 
(0.34
)
 
(0.13
)
Dividends declared per common share
0.40

 
0.40

 
1.20

 
1.30

Weighted average number of shares of common stock:
 
 
 
 
 
 
 
Basic
111,586,633

 
122,046,614

 
112,101,369

 
122,763,243

Diluted
129,893,354

 
123,471,614

 
113,526,369

 
124,188,243

(1)
The condensed consolidated statements of operations for the three and nine months ended September 30, 2015 include income and expenses of consolidated variable interest entities. The Company deconsolidated these VIEs in December 2015. Refer to Note 2 - “Summary of Significant Accounting Policies” of our condensed consolidated financial statements for further discussion.

 
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Net Income (Loss) Summary
For the three months ended September 30, 2016, our net income attributable to common stockholders was $129.2 million (September 30, 2015: $144.5 million net loss) or $1.16 basic and $1.05 diluted net income per average share available to common stockholders (September 30, 2015: $1.18 basic and diluted net loss per average share available to common stockholders). The change in net income (loss) attributable to common stockholders for the three months ended September 30, 2016 is primarily attributable to realized and unrealized gains on derivative instruments of $35.4 million in the 2016 period versus a $220.6 million loss in the 2015 period. As a result of discontinuing hedge accounting, beginning January 1, 2014, changes in the fair value of our interest rate swap agreements are recorded as gain (loss) on derivative instruments, net in our condensed consolidated statements of operations, rather than in accumulated other comprehensive income ("AOCI"). For the three months ended September 30, 2016, we recognized an unrealized gain for the change in fair value of our interest rates swaps of $65.4 million (September 30, 2015: $173.8 million unrealized loss). During the three months ended September 30, 2016, the realized and unrealized gain on derivatives were driven by a rise in the market interest rates associated with our interest rate swap hedges.
For the nine months ended September 30, 2016 our net loss attributable to common stockholders was $38.6 million (September 30, 2015: $16.0 million) or $0.34 basic and diluted net loss per average share available to common stockholders (September 30, 2015: $0.13). The change in net loss attributable to common stockholders for the nine months ended September 30, 2016 versus 2015 is primarily attributable to lower net interest income of $241.1 million in the 2016 period versus $283.3 million in the 2015 period that is partially offset by a $10.5 million reduction in total expenses. Net interest income and total expenses in the 2016 period were lower than in the 2015 period primarily due to the impact of the deconsolidation of our residential securitizations in December 2015 as discussed below. Net interest income for the nine months ended September 30, 2016 was also impacted by a decrease in our average earning assets due to share repurchases over the past twelve months. Since September 30, 2015, the Company has repurchased 7.9 million shares of common stock at a weighted average price of $12.72 per share for a net cost of $100.6 million including acquisition expenses.
Our net income (loss) attributable to common shareholders for the three and nine months ended September 30, 2015 includes interest income, interest expense and securitization trust expenses of our residential securitizations. On December 9, 2015, we completed the sale of certain beneficial interests in our residential securitizations for $69.0 million (the "Transaction"). The securities sold included the most subordinated classes of asset-backed securities issued by the residential securitizations. As a result of the Transaction, we no longer have the power to direct the activities of the residential securitizations through default oversight rights and are therefore no longer the primary beneficiary of the residential securitizations. We deconsolidated the assets and liabilities of the residential securitizations as of the date of the Transaction. Our consolidated statements of operations for the three and nine months ended September 30, 2015 include the following interest income, interest expense and expenses of the residential securitizations:
$ in thousands, except share data
Three Months 
 ended 
 September 30, 2015
 
Nine Months ended 
 September 30, 2015
Interest Income
 
 
 
Residential loans
28,380

 
88,001

Interest Expense
 
 
 
Asset-backed securities
20,686

 
64,913

Net interest income
7,694

 
23,088

Expenses
 
 
 
Consolidated securitization trusts
2,132

 
6,544

Total net income from residential securitizations
5,562

 
16,544


 
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Interest Income and Average Earning Asset Yield
The table below presents information related to our average earning assets and earning asset yields for the three and nine months ended September 30, 2016 and 2015. 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
Average Balances*:
 
 
 
 
 
 
 
Agency RMBS:
 
 
 
 
 
 
 
15 year fixed-rate, at amortized cost
3,409,739

 
1,673,615

 
2,409,219

 
1,723,135

30 year fixed-rate, at amortized cost
3,613,116

 
4,228,400

 
3,784,762

 
4,402,012

ARM, at amortized cost
332,801

 
450,691

 
368,409

 
452,654

Hybrid ARM, at amortized cost
2,703,529

 
3,403,052

 
2,893,860

 
3,182,022

Agency - CMO, at amortized cost
362,825

 
414,310

 
383,995

 
432,916

Non-Agency RMBS, at amortized cost
2,079,681

 
2,585,513

 
2,243,941

 
2,735,641

GSE CRT, at amortized cost
612,531

 
668,639

 
641,445

 
660,457

CMBS, at amortized cost
2,532,667

 
3,200,091

 
2,610,204

 
3,222,013

U.S. Treasury securities, at amortized cost
169,041

 
—

 
60,610

 
—

Residential loans, at amortized cost
—

 
3,355,373

 
—

 
3,399,570

Commercial loans, at amortized cost
272,614

 
176,857

 
263,532

 
168,390

Average earning assets
16,088,544

 
20,156,541

 
15,659,977

 
20,378,810

Average Earning Asset Yields (1):
 
 
 
 
 
 
 
Agency RMBS:
 
 
 
 
 
 
 
15 year fixed-rate
1.86
%
 
2.26
%
 
1.97
%
 
2.17
%
30 year fixed-rate
2.55
%
 
2.68
%
 
2.76
%
 
2.79
%
ARM
2.18
%
 
2.22
%
 
2.31
%
 
2.31
%
Hybrid ARM
2.06
%
 
2.18
%
 
2.15
%
 
2.10
%
Agency - CMO
2.42
%
 
2.31
%
 
2.60
%
 
3.08
%
Non-Agency RMBS
5.06
%
 
4.83
%
 
4.90
%
 
4.84
%
GSE CRT (2)
0.98
%
 
0.53
%
 
0.89
%
 
0.51
%
CMBS
4.28
%
 
4.38
%
 
4.34
%
 
4.37
%
U.S. Treasury securities
1.09
%
 
—
%
 
1.15
%
 
—
%
Residential loans
—
%
 
3.39
%
 
—
%
 
3.46
%
Commercial loans
8.27
%
 
8.39
%
 
8.35
%
 
8.16
%
Average earning asset yields
2.94
%
 
3.18
%
 
3.10
%
 
3.24
%
*
 Average amounts for each period are based on weighted month-end balances.
(1)
Average earning asset yield for the period was calculated by dividing interest income, including amortization of premiums and discounts, by our average of the amortized cost of the investments. All yields are annualized.
(2)
GSE CRT average earning asset yield excludes coupon interest associated with embedded derivatives on securities not accounted for under the fair value option that is recorded as realized and unrealized credit derivative income (loss), net under U.S. GAAP.
Our primary source of income is interest earned on our investment portfolio. We had average earning assets of approximately $16.1 billion (September 30, 2015: $20.2 billion) and earned interest income of $118.1 million (September 30, 2015: $160.4 million) for the three months ended September 30, 2016. The yield on our average earning assets was 2.94% for the three months ended September 30, 2016 (September 30, 2015: 3.18%).
We had average earning assets of approximately $15.7 billion (September 30, 2015: $20.4 billion) and earned interest income of $364.1 million (September 30, 2015: $495.2 million) for the nine months ended September 30, 2016. The yield on our average earning assets was 3.10% for the nine months ended September 30, 2016 (September 30, 2015: 3.24%).
Average earning assets and interest income declined during the three and nine months ended September 30, 2016 compared to 2015 primarily due to the deconsolidation of our residential loan securitizations in December 2015. We consolidated eleven residential loan securitizations as of September 30, 2015 with average assets of $3.4 billion that had an average earning asset yield of 3.39% and 3.46% for the three and nine months ended September 30, 2015, respectively. We

 
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recorded $28.4 million and $88.0 million of interest income on residential loans held by the consolidated securitizations in the three and nine months ended September 30, 2015, respectively.
The yield on our average Agency RMBS earning assets decreased for the three and nine months ended September 30, 2016 compared to 2015 primarily due to a change in portfolio composition and lower available reinvestment yields. Over the last twelve months, we reinvested cash flows from our Agency portfolio into 15 year fixed-rate Agency RMBS as we believe these securities have lower durations and better cash flow certainty relative to current coupon 30 year fixed-rate Agency RMBS. We continue to evaluate our investment portfolio and make adjustments based on our views of the market opportunities. As of September 30, 2016, approximately 44% of our equity is allocated to Agency RMBS; 31% is allocated to investments in commercial credit and 25% is allocated to residential credit.
The yield on our average non-Agency RMBS earning assets increased for the three and nine months ended September 30, 2016 primarily due to higher index interest rates in 2016 compared to the same periods in 2015.  As of September 30, 2016, approximately 53% of the Company’s non-Agency RMBS are variable or floating rate securities.
Prepayment Speeds
Our RMBS and GSE CRT portfolio is subject to inherent prepayment risk primarily driven by changes in interest rates, which impacts the amount of premium and discount on the purchase of these securities that is recognized into interest income. Expected future prepayment speeds on our RMBS and GSE CRT portfolio are estimated on a quarterly basis. Generally, in an environment of falling interest rates, prepayment speeds will increase as homeowners are more likely to prepay their existing mortgage and refinance into a lower borrowing rate. If the actual prepayment speed during the period is faster than estimated, the amortization on securities purchased at a premium to par value will be accelerated, resulting in lower interest income recognized. Conversely, for securities purchased at a discount to par value, interest income will be reduced in periods where prepayment speeds were slower than expected. The table below shows the three month constant prepayment rate for our RMBS and GSE CRT compared to bonds with similar characteristics (“Cohorts”):
 
Three Months Ended
 
September 30, 2016
 
September 30, 2015
 
Company
 
Cohorts
 
Company
 
Cohorts
15 year fixed-rate Agency RMBS
9.5

 
14.1

 
13.1

 
14.7

30 year fixed-rate Agency RMBS
16.2

 
19.3

 
14.8

 
16.7

Agency Hybrid ARM RMBS
21.7

 
 NA

 
15.2

 
NA

Non-Agency RMBS
16.5

 
 NA

 
15.3

 
NA

GSE CRT
17.9

 
 NA

 
12.6

 
NA

Weighted average CPR
16.1

 
 NA

 
14.7

 
NA

We recognized $31.9 million and $31.8 million of net premium amortization during the three months ended September 30, 2016 and 2015, respectively, on our RMBS and GSE CRT portfolio. Although prepayment speeds were higher in the three months ended September 30, 2016 than in the same periods in 2015, net premium amortization was relatively constant because of lower average earning assets following share repurchases.
Our interest income is subject to interest rate risk. Refer to Item 3. “Quantitative and Qualitative Disclosures about Market Risk” for more information relating to interest rate risk and its impact on our operating results.

 
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Interest Expense and the Cost of Funds
The table below presents the components of interest expense for the three and nine months ended September 30, 2016 and 2015:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
Interest Expense
 
 
 
 
 
 
 
Interest expense on repurchase agreements outstanding
29,723

 
25,579

 
86,621

 
74,362

Amortization of net deferred (gain) loss on de-designated interest rate swaps
(4,831
)
 
15,724

 
11,331

 
51,182

Repurchase agreements interest expense
24,892

 
41,303

 
97,952

 
125,544

Secured loans
2,746

 
1,622

 
8,149

 
4,639

Exchangeable senior notes
5,620

 
5,620

 
16,847

 
16,840

Asset-backed securities
—

 
20,686

 
—

 
64,913

Total interest expense
33,258

 
69,231

 
122,948

 
211,936

We enter into repurchase agreements to finance the majority of our target assets. These agreements are secured by our Agency RMBS, non-Agency RMBS, GSE CRTs and CMBS. In addition, these agreements are generally settled on a short-term basis, usually from one to twelve months, and bear interest at rates that have historically moved in close relationship to LIBOR. At each settlement date, we typically refinance each repurchase agreement at the market interest rate at that time. Our interest expense on repurchase agreements outstanding increased in the three months ended September 30, 2016 compared to the same period in 2015 primarily due to higher LIBOR rates.
Our repurchase agreement interest expense includes amortization of deferred gains and losses on de-designated interest rate swaps as summarized in the table above. Amortization of net deferred gains on de-designated interest rate swaps decreased our total interest expense by $4.8 million during the three months ended September 30, 2016 whereas amortization of net losses on de-designated interest rate swaps increased our total interest expense by $15.7 million during the three months ended September 30, 2015. In the nine months ended September 30, 2016, amortization of net deferred losses on interest rate swaps increased our total interest expense by $11.3 million compared to increasing total interest expense by $51.2 million in the nine months ended September 30, 2015. During the next twelve months, we estimate that $25.3 million of net deferred gains on de-designated interest rate swaps will be reclassified from other comprehensive income and recorded as a decrease to interest expense.
During the three and nine months ended September 30, 2016, interest expense for our secured loans increased compared to the same periods in 2015 primarily due to higher borrowing rates as a result of the December 2015 increase in the federal funds interest rate. For the nine months ended September 30, 2016, we had a weighted average borrowing rate of 0.66% as compared to 0.39% for the nine months ended September 30, 2015.
Our total interest expense during the three and nine months ended September 30, 2016 decreased from the same periods in 2015 primarily due to the deconsolidation of our residential securitizations in December 2015 as discussed below. Interest expense on asset-backed securities issued by securitization trusts totaled $20.7 million and $64.9 million in the three and nine months ended September 30, 2015, respectively.

 
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The table below presents information related to our borrowings and cost of funds for the three and nine months ended September 30, 2016 and 2015:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
Average Borrowings*:
 
 
 
 
 
 
 
Agency RMBS (1)
9,334,305

 
9,172,106

 
8,823,633

 
9,123,526

Non-Agency RMBS
1,681,136

 
2,405,227

 
1,812,516

 
2,524,969

GSE CRT
428,798

 
501,554

 
451,024

 
483,890

CMBS (1)
2,213,541

 
2,686,395

 
2,187,871

 
2,671,552

U.S. Treasury securities
168,689

 
—

 
73,310

 
—

Exchangeable senior notes
396,213

 
393,749

 
395,599

 
393,131

Asset-backed securities issued by securitization trusts
—

 
2,900,290

 
—

 
2,946,255

Total borrowed funds
14,222,682

 
18,059,321

 
13,743,953

 
18,143,323

Maximum borrowings during the period (2)
14,381,178

 
18,183,099

 
14,381,178

 
18,416,608

Average Cost of Funds (3):
 
 
 
 
 
 
 
Agency RMBS (1)
0.67
%
 
0.40
%
 
0.66
%
 
0.37
%
Non-Agency RMBS
1.94
%
 
1.60
%
 
1.86
%
 
1.56
%
GSE CRT
2.16
%
 
1.75
%
 
2.14
%
 
1.69
%
CMBS (1)
1.14
%
 
0.93
%
 
1.13
%
 
0.91
%
U.S. Treasury securities
0.26
%
 
—
%
 
0.25
%
 
—
%
Exchangeable senior notes
5.67
%
 
5.71
%
 
5.68
%
 
5.71
%
Asset-backed securities issued by securitization trusts
—
%
 
2.85
%
 
—
%
 
2.94
%
Cost of funds
0.94
%
 
1.53
%
 
1.19
%
 
1.56
%
Effective cost of funds (non-GAAP measure) (4)
1.82
%
 
2.22
%
 
1.86
%
 
2.20
%
*
 Average amounts for each period are based on weighted month-end balances.
(1)
Agency RMBS and CMBS average borrowings and average cost of funds include borrowings under repurchase agreements and secured loans.
(2)
Amount represents the maximum borrowings at month-end during each of the respective periods.
(3)
Average cost of funds is calculated by dividing annualized interest expense excluding amortization of net deferred gain (loss) on de-designated interest rate swaps by our average borrowings.
(4)
For a reconciliation of cost of funds to effective cost of funds, see "Non-GAAP Financial Measures"
We had average borrowed funds of $14.2 billion (September 30, 2015: $18.1 billion) and total interest expense of $33.3 million (September 30, 2015: $69.2 million) for the three months ended September 30, 2016. We had average borrowed funds of $13.7 billion (September 30, 2015: $18.1 billion) and total interest expense of $122.9 million (September 30, 2015: $211.9 million) for the nine months ended September 30, 2016. For the three months ended September 30, 2016, our cost of funds was 0.94% (September 30, 2015: 1.53%) and for the nine months ended September 30, 2016, our cost of funds was 1.19% (September 30, 2015: 1.56%). Average borrowed funds, interest expense and cost of funds for the three and nine months ended September 30, 2016 decreased compared to 2015 primarily due to the deconsolidation of our residential loan securitizations in December 2015. We consolidated eleven residential loan securitizations as of September 30, 2015 with average borrowings of $2.9 billion and an average cost of funds of 2.85% and 2.94% for the three and nine months ended September 30, 2015, respectively. We recorded $20.7 million and $64.9 million of interest expense on asset-backed securities issued by the consolidated securitizations in the three and nine months ended September 30, 2015, respectively.

 
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Net Interest Income
The table below presents the components of net interest income for the three and nine months ended September 30, 2016 and 2015:
$ in thousands
Three Months 
 ended 
 September 30, 2016
 
Three Months 
 ended 
 September 30, 2015
 
Nine Months ended 
 September 30, 2016
 
Nine Months ended 
 September 30, 2015
Interest Income
 
 
 
 
 
 
 
Mortgage-backed and credit risk transfer securities
112,467

 
128,305

 
347,573

 
395,844

Residential loans
—

 
28,380

 
—

 
88,001

Commercial loans
5,680

 
3,743

 
16,520

 
11,349

Total interest income
118,147

 
160,428

 
364,093

 
495,194

Interest Expense
 
 
 
 
 
 
 
Interest expense on repurchase agreements outstanding
29,723

 
25,579

 
86,621

 
74,362

Amortization of net deferred (gain) loss on de-designated interest rate swaps
(4,831
)
 
15,724

 
11,331

 
51,182

Repurchase agreements interest expense
24,892

 
41,303

 
97,952

 
125,544

Secured loans
2,746

 
1,622

 
8,149

 
4,639

Exchangeable senior notes
5,620

 
5,620

 
16,847

 
16,840

Asset-backed securities
—

 
20,686

 
—

 
64,913

Total interest expense
33,258

 
69,231

 
122,948

 
211,936

Net interest income
84,889

 
91,197

 
241,145

 
283,258

Our net interest income, which equals interest income less interest expense, totaled $84.9 million (September 30, 2015: $91.2 million) for the three months ended September 30, 2016 and $241.1 million (September 30, 2015: $283.3 million) for the nine months ended September 30, 2016. Our net interest rate margin, which equals the yield on our average assets for the period less the average cost of funds for the period, was 2.00% (September 30, 2015: 1.65%) for the three months ended September 30, 2016 and 1.91% (September 30, 2015: 1.68%) for the nine months ended September 30, 2016. The decrease in net interest income was primarily the result of the reduction in our investment portfolio for the three and nine months ended September 30, 2016 compared to 2015 and deconsolidation of our residential loan securitizations in December 2015. The increase in net interest rate margin for the three and nine months ended September 30, 2016 compared to 2015 was primarily due to a decrease in interest expense driven by a decline in amortization of net deferred losses on de-designated interest rate swaps. During the next 12 months, we estimate that $25.3 million of net deferred gains on de-designated interest rate swaps will be reclassified as a decrease to interest expense.
Refer to the table in the “Interest Income and Average Earning Asset Yield” section above for changes in average portfolio balance and yields.
Provision for Loan Losses
We evaluate the collectibility of our commercial loans held-for investment using the factors described in Note 2 - "Summary of Significant Accounting Policies" of our Annual Report on Form 10-K. We determined that no provision for loan losses for our commercial loans was required as of September 30, 2016.
Our provision for loan losses for the nine months ended September 30, 2015 was solely for residential loans held-for-investment by consolidated securitization trusts. We did not have a provision for residential loan losses as of September 30, 2016 because we deconsolidated our residential securitizations in December 2015.

 
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Gain (Loss) on Investments, net
The table below summarizes the components of gain (loss) on investments, net for the three and nine months ended September 30, 2016 and 2015:
$ in thousands
Three Months 
 ended 
 September 30, 2016
 
Three Months 
 ended 
 September 30, 2015
 
Nine Months ended 
 September 30, 2016
 
Nine Months ended 
 September 30, 2015
Realized gains and losses on sale of investments
(1,305
)
 
(413
)
 
10,276

 
4,128

Other-than-temporary impairment losses
(1,156
)
 
—

 
(8,364
)
 
—

Net unrealized gains and losses on MBS accounted for under the fair value option
(5,412
)
 
(1,554
)
 
2,530

 
6,891

Net unrealized gains and losses on GSE CRT accounted for under the fair value option
1,181

 
—

 
1,418

 
—

Net unrealized gains and losses on U.S. Treasury securities accounted for as trading securities
(463
)
 
—

 
—

 
—

Total gain (loss) on investments, net
(7,155
)
 
(1,967
)
 
5,860

 
11,019

As part of our investment process, our mortgage-backed and credit risk transfer securities are continuously reviewed to determine if they continue to meet our risk and return targets. This process involves looking at changing market assumptions and the impact those assumptions will have on the individual securities. Securities that do not meet our risk and return targets are sold.
We have elected the fair value option for all of our MBS purchased on or after September 1, 2016 and all of our GSE CRTs purchased on or after August 24, 2015. Prior to September 1, 2016, we had also elected the fair value option for our RMBS IOs. Under the fair value option, changes in fair value are recognized in income in the consolidated statements of operations.
For additional information regarding our assessment of other-than temporary impairment on our investment securities, refer to Note 4 – “Mortgage-Backed and Credit Risk Transfer Securities” of our condensed consolidated financial statements.
Equity in Earnings of Unconsolidated Ventures
For the three months ended September 30, 2016, we recorded equity in earnings of unconsolidated ventures of $729,000 (September 30, 2015: $1.9 million). For the nine months ended September 30, 2016, we recorded equity in earnings of unconsolidated ventures of $2.0 million (September 30, 2015: $9.1 million). Equity in earnings of unconsolidated ventures decreased for the three and nine months ended September 30, 2016 compared to 2015 primarily due to higher realized gains and unrealized appreciation of underlying portfolio investments in the 2015 period.
Gain (Loss) on Derivative Instruments, net
Our objectives in using interest rate derivatives are to add stability to interest expense and to manage our exposure to interest rate movements on our floating rate repurchase agreements and secured loans. To accomplish these objectives, we primarily use interest rate derivative instruments, including interest rate swaps, interest rate swaptions, U.S. Treasury futures contracts and TBAs as part of our interest rate risk management strategy. Interest rate swaps involve the receipt of variable-rate amounts from a counterparty in exchange for us making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. An interest rate swaption provides us the option to enter into an interest rate swap agreement for a predetermined notional amount, stated term and pay and receive interest rates in the future. The premium paid for interest rate swaptions is reported as an asset in our condensed consolidated balance sheets. The premium is valued at an amount equal to the fair value of the swaption that would have the effect of closing the position adjusted for nonperformance risk, if any. TBAs are reported on the balance sheet as an asset or liability at its fair value.
We also use currency forward contracts to help mitigate the potential impact of changes in foreign currency exchange rates on our investments denominated in foreign currencies.

 
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The tables below summarize our realized and unrealized gain (loss) on derivative instruments, net for the following periods:
$ in thousands
 
Three Months Ended September 30, 2016
Derivative
not designated as
hedging instrument
 
Realized gain (loss) on derivative instruments, net
 
 Contractual net interest expense
 
Unrealized gain (loss), net
 
Gain (loss) on derivative instruments, net
Interest Rate Swaps
 
(5,090
)
 
(26,388
)
 
65,396

 
33,918

Currency Forward Contracts
 
6,437

 
—

 
(4,977
)
 
1,460

Total
 
1,347

 
(26,388
)
 
60,419

 
35,378

$ in thousands
 
Nine Months Ended September 30, 2016
Derivative
not designated as
hedging instrument
 
Realized gain (loss) on derivative instruments, net
 
 Contractual net interest expense
 
Unrealized gain (loss), net
 
Gain (loss) on derivative instruments, net
Interest Rate Swaps
 
(69,090
)
 
(80,464
)
 
(150,986
)
 
(300,540
)
Interest Rate Swaptions
 
(1,485
)
 
—

 
1,485

 
—

Currency Forward Contracts
 
8,353

 
—

 
(1,341
)
 
7,012

Total
 
(62,222
)
 
(80,464
)
 
(150,842
)
 
(293,528
)
$ in thousands
 
Three Months Ended September 30, 2015
Derivative Instrument
 
Realized gain (loss) on derivative instruments, net
 
 Contractual net interest expense
 
Unrealized gain (loss), net
 
Gain (loss) on derivative instruments, net
Interest Rate Swaps
 
—

 
(46,785
)
 
(173,817
)
 
(220,602
)
Interest Rate Swaptions
 
(2,590
)
 
—

 
2,590

 
—

Currency Forward Contracts
 
(489
)
 
—

 
489

 
—

Total
 
(3,079
)
 
(46,785
)
 
(170,738
)
 
(220,602
)
$ in thousands
 
Nine Months Ended September 30, 2015
Derivative Instrument
 
Realized gain (loss) on derivative instruments, net
 
 Contractual net interest expense
 
Unrealized gain (loss), net
 
Gain (loss) on derivative instruments, net
Interest Rate Swaps
 
(31,881
)
 
(138,404
)
 
(113,151
)
 
(283,436
)
Interest Rate Swaptions
 
(10,328
)
 
—

 
8,594

 
(1,734
)
TBAs
 
(2,292
)
 
—

 
558

 
(1,734
)
Futures Contracts
 
(943
)
 
—

 
(90
)
 
(1,033
)
Currency Forward Contracts
 
1,050

 
—

 
(457
)
 
593

Total
 
(44,394
)
 
(138,404
)
 
(104,546
)
 
(287,344
)
As of September 30, 2016 and December 31, 2015, we held the following interest rate swaps whereby we receive interest at a one-month and three-month LIBOR rate:
$ in thousands
As of September 30, 2016
 
As of December 31, 2015
Derivative instrument
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
 
Notional Amounts (1)
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
Interest Rate Swaps
6,500,000

 
2.14
%
 
0.62
%
 
4.89
 
9,850,000

 
2.07
%
 
0.36
%
 
3.65
(1)
Excluding notional amounts for interest rate swaps with forward start date of February 2016, May 2016 and June 2016.

 
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During the nine months ended September 30, 2016, we terminated swaps with a notional amount of $5.0 billion and realized losses of $69.1 million. The terminated swaps were predominantly maturing in 2016 and offered little protection from rising rates. Additionally, our investment and repurchase agreement balances decreased due to asset sales to facilitate stock repurchases, further reducing our need for hedging. Our overall interest rate risk did not change materially as a result of the swap terminations. As a result of swap terminations, our contractual net interest expense for the three and nine months ended September 30, 2016, decreased to $26.4 million (three months ended September 30, 2015: $46.8 million) and $80.5 million (nine months ended September 30, 2015: $138.4 million), respectively.
Realized and Unrealized Credit Derivative Income (Loss), net
The table below summarizes the components of realized and unrealized credit derivative income (loss), net for the three and nine months ended September 30, 2016 and 2015.
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
GSE CRT embedded derivative coupon interest
5,963

 
6,373

 
18,389

 
18,443

Gain (loss) on settlement of GSE CRT embedded derivatives
—

 
284

 
(6,017
)
 
(2,184
)
Change in fair value of GSE CRT embedded derivatives
25,963

 
(3,848
)
 
45,192

 
7,275

Credit Default Swap ("CDS") premium income
—

 
215

 
—

 
722

Change in fair value of CDS
—

 
(96
)
 
—

 
648

Total
31,926

 
2,928

 
57,564

 
24,904

In the three months ended September 30, 2016, we recorded an unrealized gain on the change in the fair value of our GSE CRT embedded derivatives compared to an unrealized loss in the three months ended September 30, 2015. The unrealized gain was driven by a change in the fair value of our GSE CRTs accounted for as hybrid financial instruments with embedded derivatives. The increase in the value of our GSE CRT holdings during the third quarter of 2016 primarily resulted from broad credit spread tightening, increasing market demand for floating rate securities and positive rating actions by two nationally recognized statistical rating organizations.
Other Investment Income (Loss), net
Other investment income (loss), net primarily consists of quarterly dividends from FHLBI stock and foreign exchange rate gains and losses related to commercial loan investments denominated in a foreign currency. The table below summarizes the components of other investment income (loss), net for the three and nine months ended September 30, 2016 and 2015.
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
FHLBI dividend income
786

 
739

 
2,390

 
2,047

Gain (loss) on foreign currency transactions, net
(1,340
)
 
—

 
(6,007
)
 
(529
)
Total
(554
)
 
739

 
(3,617
)
 
1,518

We incurred foreign exchange losses on the translation of a commercial loan investment (notional amount of £34.5 million) for the three and nine months ended September 30, 2016 due to the significant decline in the Pound Sterling/ U.S. Dollar foreign exchange rate over the last nine months. Foreign exchange losses for the nine months ended September 30, 2015 relate to a foreign currency loan which prepaid in the second quarter 2015. We enter into currency forward contracts as an economic hedge against our foreign currency exposure.

 
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Expenses
For the three and nine months ended September 30, 2016, we incurred management fees of $6.7 million (September 30, 2015: $10.1 million) and $25.3 million (September 30, 2015: $28.8 million), respectively, which are payable to our Manager under our management agreement. Management fees decreased during the three and nine months ended September 30, 2016 compared to the three and nine months ended September 30, 2015 primarily due to a cumulative one-time adjustment of $2.3 million during the three months ended September 30, 2016 related to a prior adjustment for the accounting for premiums and discounts associated with non-Agency RMBS not of high credit quality. Refer to Note 16 – “Revision of Previously Issued Financial Statements” of our condensed consolidated financial statements for more detail. Management fees also decreased due to the impact of share repurchases over the past twelve months. Since September 30, 2015, we have repurchased 7.9 million shares of common stock for a net cost of $100.6 million including acquisition expenses. Refer to Note 11 – “Related Party Transactions” of our condensed consolidated financial statements for a discussion of our relationship with our Manager and description of how our fees are calculated.
For the three and nine months ended September 30, 2016, our general and administrative expenses not covered under our management agreement amounted to $1.8 million (September 30, 2015: $2.5 million) and $5.8 million (September 30, 2015: $6.2 million), respectively. General and administrative expenses not covered under our management agreement primarily consist of directors and officers insurance, legal costs, accounting, auditing and tax services, filing fees, organization expenses associated with our consolidated securitization trusts and miscellaneous general and administrative costs. General and administrative costs decreased for the three months ended September 30, 2016 compared to the three months ended September 30, 2015 primarily because the 2015 period included $750,000 of costs associated with the Company's 2015 restatement. General and administrative costs decreased for the nine months ended September 30, 2016 compared to the nine months ended September 30, 2015 also due to the impact of costs associated with the Company's 2015 restatement but were partially offset by costs associated with repositioning our hedging portfolio and purchasing new commercial loan investments in the first quarter of 2016.
For the three and nine months ended September 30, 2015, consolidated securitization trust expenses totaled $2.1 million and $6.5 million, respectively. Consolidated securitization trust expenses consisted of direct operating expenses incurred by consolidated residential loan securitizations. The Company deconsolidated its residential securitizations in December 2015.
Net Income (Loss) after Preferred Dividends and Return on Average Equity
For the three months ended September 30, 2016, our net income after preferred dividends was $130.9 million (September 30, 2015: $146.1 million net loss) and our annualized income on average equity was 24.60% (September 30, 2015: 25.50% annualized loss). The change in net income after preferred dividends and return on average equity was primarily attributable to realized and unrealized gains on derivative instruments of $35.4 million in the 2016 period versus realized and unrealized losses on derivative instruments of $220.6 million in the 2015 period. For the three months ended September 30, 2016, we recognized an unrealized gain for the change in fair value of our interest rates swaps of $65.4 million (September 30, 2015: $173.8 million unrealized loss). In addition, during the three months ended September 30, 2016, we recognized reclassification of amortization of net deferred gains on de-designated interest rate swaps to repurchase agreements interest expense previously recognized in other comprehensive income of $4.8 million (September 30, 2015: $15.7 million net deferred losses).
For the nine months ended September 30, 2016, our net loss after preferred dividends was $38.8 million (September 30, 2015: $16.0 million) and our annualized loss on average equity was 2.50% (September 30, 2015: 0.89%). The change in net income (loss) after preferred dividends and return on average equity was primarily attributable to realized and unrealized losses on derivatives instruments of $293.5 million in the 2016 period versus $287.3 million in the 2015 period. For the nine months ended September 30, 2016, we recognized an unrealized losses for the change in fair value of our interest rates swaps of $151.0 million (September 30, 2015: $113.2 million unrealized loss). In addition, during the nine months ended September 30, 2016, we recognized reclassification of amortization of net deferred losses on de-designated interest rate swaps to repurchase agreements interest expense previously recognized in other comprehensive losses of $11.3 million (September 30, 2015: $51.2 million).
Non-GAAP Financial Measures
We are presenting the following non-GAAP financial measures: core earnings (and by calculation, core earnings per common share), effective interest income (and by calculation, effective yield), effective interest expense (and by calculation, effective cost of funds), effective net interest income (and by calculation, effective interest rate margin), and repurchase agreement debt-to-equity ratio. Our management uses these non-GAAP financial measures in our internal analysis of results

 
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and believes these measures are useful to investors for the reasons explained below. The most directly comparable U.S. GAAP measures are net income attributable to common stockholders (and by calculation, basic earnings (loss) per common share), total interest income (and by calculation, earning asset yield), total interest expense (and by calculation, cost of funds), net interest income (and by calculation, net interest rate margin) and debt-to-equity ratio.  Certain prior period U.S. GAAP and non-GAAP financial measures have been revised to correct immaterial errors in accounting for premiums and discounts on non-Agency RMBS not of high credit quality. For further information, see Note 16 - "Revision of Previously Issued Financial Statements" of the Company's condensed consolidated financial statements filed in Item 1. of this Report.
These non-GAAP financial measures should not be considered as substitutes for any measures derived in accordance with U.S. GAAP and may not be comparable to other similarly titled measures of other companies. An analysis of any non-GAAP financial measure should be made in conjunction with results presented in accordance with U.S. GAAP. Additional reconciling items may be added in the future to these non-GAAP measures if deemed appropriate.
Core Earnings
We calculate core earnings as U.S. GAAP net income (loss) attributable to common stockholders adjusted for (gain) loss on investments, net; realized (gain) loss on derivative instruments, net; unrealized (gain) loss on derivative instruments, net; realized and unrealized (gain) loss on GSE CRT embedded derivatives, net; (gain) loss on foreign currency transactions, net; amortization of net deferred (gain) loss on de-designated interest rate swaps; and cumulative adjustments attributable to non-controlling interest. We record changes in the valuation of our mortgage-backed securities, excluding securities for which we elected the fair value option and the valuation assigned to the debt host contract associated with our GSE CRTs, in other comprehensive income on our consolidated balance sheets.
We believe the presentation of core earnings provides a consistent measure of operating performance by excluding the impact of gains and losses described above from operating results. We believe that providing transparency into core earnings enables our investors to consistently measure, evaluate and compare our operating performance to that of our peers over multiple reporting periods. However, we caution that core earnings should not be considered as an alternative to net income (determined in accordance with U.S. GAAP), or as an indication of our cash flow from operating activities (determined in accordance with U.S. GAAP), a measure of our liquidity, or as an indication of amounts available to fund our cash needs, including our ability to make cash distributions.
The table below provides a reconciliation of U.S. GAAP net income (loss) attributable to common stockholders to core earnings for the following periods:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands, except per share data
2016
 
2015
 
2016
 
2015
Net income (loss) attributable to common stockholders
129,219

 
(144,515
)
 
(38,558
)
 
(15,985
)
Adjustments:
 
 
 
 
 
 
 
(Gain) loss on investments, net
7,155

 
1,967

 
(5,860
)
 
(11,019
)
Realized (gain) loss on derivative instruments, net (1)
(1,347
)
 
3,079

 
62,222

 
44,394

Unrealized (gain) loss on derivative instruments, net (1)
(60,419
)
 
170,738

 
150,842

 
104,546

Realized and unrealized (gain) loss on GSE CRT embedded derivatives, net (2)
(25,963
)
 
3,564

 
(39,175
)
 
(5,091
)
(Gain) loss on foreign currency transactions, net (3)
1,340

 
—

 
6,007

 
529

Amortization of net deferred (gain) loss on de-designated interest rate swaps(4) 
(4,831
)
 
15,724

 
11,331

 
51,182

Subtotal
(84,065
)
 
195,072

 
185,367

 
184,541

Cumulative adjustments attributable to non-controlling interest
1,060

 
(2,260
)
 
(2,289
)
 
(2,141
)
Core earnings attributable to common stockholders
46,214

 
48,297

 
144,520

 
166,415

Basic income (loss) per common share
1.16

 
(1.18
)
 
(0.34
)
 
(0.13
)
Core earnings per share attributable to common stockholders(5)
0.41

 
0.40

 
1.29

 
1.36


 
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(1)
U.S. GAAP gain (loss) on derivative instruments, net on the consolidated statements of operations includes the following components:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
Realized gain (loss) on derivative instruments, net
1,347

 
(3,079
)
 
(62,222
)
 
(44,394
)
Unrealized gain (loss) on derivative instruments, net
60,419

 
(170,738
)
 
(150,842
)
 
(104,546
)
Contractual net interest expense
(26,388
)
 
(46,785
)
 
(80,464
)
 
(138,404
)
Gain (loss) on derivative instruments, net
35,378

 
(220,602
)
 
(293,528
)
 
(287,344
)
(2)
U.S. GAAP realized and unrealized credit derivative income (loss), net on the consolidated statements of operations includes the following components:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
Realized and unrealized gain (loss) on GSE CRT embedded derivatives, net
25,963

 
(3,564
)
 
39,175

 
5,091

GSE CRT embedded derivative coupon interest
5,963

 
6,373

 
18,389

 
18,443

Unrealized gain (loss) on CDS contract
—

 
(96
)
 
—

 
648

CDS premium fee income
—

 
215

 
—

 
722

Realized and unrealized credit derivative income (loss), net
31,926

 
2,928

 
57,564

 
24,904

(3)
U.S. GAAP other investment income (loss) net on the consolidated statements of operations includes the following components:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
FHLBI dividend income
786

 
739

 
2,390

 
2,047

Gain (loss) on foreign currency transactions, net
(1,340
)
 
—

 
(6,007
)
 
(529
)
Other investment income (loss), net
(554
)
 
739

 
(3,617
)
 
1,518

(4)
U.S. GAAP repurchase agreements interest expense on the consolidated statements of operations includes the following components:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
$ in thousands
2016
 
2015
 
2016
 
2015
Interest expense on repurchase agreements outstanding
29,723

 
25,579

 
86,621

 
74,362

Amortization of net deferred (gain) loss on de-designated interest rate swaps
(4,831
)
 
15,724

 
11,331

 
51,182

Repurchase agreements interest expense
24,892

 
41,303

 
97,952

 
125,544

(5)
Core earnings per share attributable to common stockholders is equal to core earnings divided by the basic weighted average number of common shares outstanding.
Core earnings for the three and nine months ended September 30, 2016 decreased from the same period in 2015 primarily due to the deconsolidation of the Company's residential securitizations in December 2015. The residential securitizations contributed $5.6 million and $16.5 million of core earnings in the three and nine months ended September 30, 2015, respectively. In addition to the deconsolidation of residential securitizations, the Company also reduced its overall portfolio balance, resulting in lower net interest income for the three and nine months ended September 30, 2016. Our overall portfolio has reduced as we have reinvested available cash flows to fund share repurchases and reduce leverage.


 
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Core earnings per share attributable to common stockholders reflects the impact of share repurchases over the past twelve months. Since September 30, 2015, we have repurchased 7.9 million shares of common stock at a weighted average share price of $12.72 for a net cost of $100.6 million including acquisition expenses.

Effective Interest Income / Effective Yield/ Effective Interest Expense / Effective Cost of Funds / Effective Net Interest Income / Effective Interest Rate Margin
We calculate effective interest income (and by calculation, effective yield) as U.S. GAAP total interest income adjusted for GSE CRT embedded derivative coupon interest recorded as realized and unrealized credit derivative income (loss), net. We account for GSE CRTs purchased prior to August 24, 2015 as hybrid financial instruments, but we have elected the fair value option for GSE CRTs purchased on or after August 24, 2015. Under U.S. GAAP, coupon interest on GSE CRTs accounted for using the fair value option is recorded as interest income, whereas coupon interest on GSE CRTs accounted for as hybrid financial instruments is recorded as realized and unrealized credit derivative income (loss). We add back GSE CRT embedded derivative coupon interest to our total interest income because we consider GSE CRT embedded derivative coupon interest a current component of our total interest income irrespective of whether we elected the fair value option for the GSE CRT or accounted for the GSE CRT as a hybrid financial instrument.
We calculate effective interest expense (and by calculation, effective cost of funds) as U.S. GAAP total interest expense adjusted for net interest expense on our interest rate swaps that is recorded as gain (loss) on derivative instruments, net and the amortization of net deferred gains (losses) on de-designated interest rate swaps that is recorded as repurchase agreements interest expense. We view our interest rate swaps as an economic hedge against increases in future market interest rates on our floating rate borrowings. We add back the net payments we make on our interest rate swap agreements to our total U.S. GAAP interest expense because we use interest rate swaps to add stability to interest expense. We exclude the amortization of net deferred gains (losses) on de-designated interest rate swaps from our calculation of effective interest expense because we do not consider the amortization a current component of our borrowing costs.
We calculate effective net interest income (and by calculation, effective interest rate margin) as U.S. GAAP net interest income adjusted for net interest expense on our interest rate swaps that is recorded as gain (loss) on derivative instruments, amortization of net deferred gains (losses) on de-designated interest rate swaps that is recorded as repurchase agreements interest expense and GSE CRT embedded derivative coupon interest that is recorded as realized and unrealized credit derivative income (loss), net.
We believe the presentation of effective interest income, effective yield, effective interest expense, effective cost of funds, effective net interest income and effective interest rate margin measures, when considered together with U.S. GAAP financial measures, provide information that is useful to investors in understanding our borrowing costs and operating performance.

 
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The following table reconciles total interest income to effective interest income and yield to effective yield for the following periods:
 
Three Months Ended September 30,
 
2016
 
2015
$ in thousands
Reconciliation
 
Yield/Effective Yield
 
Reconciliation
 
Yield/Effective Yield
Total interest income
118,147

 
2.94
%
 
160,428

 
3.18
%
Add: GSE CRT embedded derivative coupon interest recorded as realized and unrealized credit derivative income (loss), net
5,963

 
0.15
%
 
6,373

 
0.13
%
Effective interest income
124,110

 
3.09
%
 
166,801

 
3.31
%
 
Nine Months Ended September 30,
 
2016
 
2015
$ in thousands
Reconciliation
 
Yield/Effective Yield
 
Reconciliation
 
Yield/Effective Yield
Total interest income
364,093

 
3.10
%
 
495,194

 
3.24
%
Add: GSE CRT embedded derivative coupon interest recorded as realized and unrealized credit derivative income (loss), net
18,389

 
0.16
%
 
18,443

 
0.12
%
Effective interest income
382,482

 
3.26
%
 
513,637

 
3.36
%
Our effective interest income for the three and nine months ended September 30, 2016 decreased primarily due to the deconsolidation of our residential securitizations in December 2015. Interest income on residential loans totaled $28.4 million and $88.0 million in the three and nine months ended September 30, 2015, respectively.
Our effective yield decreased primarily due to the change in portfolio composition and lower available reinvestment yields in the three and nine months ended September 30, 2016 versus the 2015 period.

 
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The following table reconciles total interest expense to effective interest expense and cost of funds to effective cost of funds for the following periods.
 
Three Months Ended September 30,
 
2016
 
2015
$ in thousands
Reconciliation
 
Cost of Funds / Effective Cost of Funds
 
Reconciliation
 
Cost of Funds / Effective Cost of Funds
Total interest expense
33,258

 
0.94
%
 
69,231

 
1.53
 %
Add (Less): Amortization of net deferred gain (loss) on de-designated interest rate swaps
4,831

 
0.14
%
 
(15,724
)
 
(0.35
)%
Add: Contractual net interest expense on interest rate swaps recorded as gain (loss) on derivative instruments, net
26,388

 
0.74
%
 
46,785

 
1.04
 %
Effective interest expense
64,477

 
1.82
%
 
100,292

 
2.22
 %
 
Nine Months Ended September 30,
 
2016
 
2015
$ in thousands
Reconciliation
 
Cost of Funds / Effective Cost of Funds
 
Reconciliation
 
Cost of Funds / Effective Cost of Funds
Total interest expense
122,948

 
1.19
 %
 
211,936

 
1.56
 %
Add (Less): Amortization of net deferred gain (loss) on de-designated interest rate swaps
(11,331
)
 
(0.11
)%
 
(51,182
)
 
(0.38
)%
Add: Contractual net interest expense on interest rate swaps recorded as gain (loss) on derivative instruments, net
80,464

 
0.78
 %
 
138,404

 
1.02
 %
Effective interest expense
192,081

 
1.86
 %
 
299,158

 
2.20
 %
Our effective interest expense and effective cost of funds for the three and nine months ended September 30, 2016 decreased primarily due to the deconsolidation of our residential securitizations in December 2015 and a decrease in net interest paid on interest rate swaps. Interest expense on asset-backed securities issued by the residential securitizations totaled $20.7 million and $64.9 million in the three and nine months ended September 30, 2015, respectively. Net interest paid on interest rate swaps decreased $20.4 million and $57.9 million in the three and nine months ended September 30, 2016 compared to the same periods in 2015 because we repositioned our hedging portfolio commencing in the first quarter of 2016 in response to lower market expectations of an increase in the Federal funds interest rate later this year. During the nine months ended September 30, 2016, we terminated swaps with a notional amount of $5.0 billion. The terminated swaps were predominately maturing in 2016 and offered little protection from rising rates. Additionally, our average invested assets and average repurchase agreement borrowings had decreased due to asset sales to facilitate stock repurchases, further reducing our need for hedging.



 
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The following table reconciles net interest income to effective net interest income and net interest rate margin to effective interest rate margin for the following periods.
 
Three Months Ended September 30,
 
2016
 
2015
$ in thousands
Reconciliation
 
Net Interest Rate Margin / Effective Interest Rate Margin
 
Reconciliation
 
Net Interest Rate Margin / Effective Interest Rate Margin
Net interest income
84,889

 
2.00
 %
 
91,197

 
1.65
 %
Add (Less): Amortization of net deferred (gain) loss on de-designated interest rate swaps
(4,831
)
 
(0.14
)%
 
15,724

 
0.35
 %
Add: GSE CRT embedded derivative coupon interest recorded as realized and unrealized credit derivative income (loss), net
5,963

 
0.15
 %
 
6,373

 
0.13
 %
Less: Contractual net interest expense on interest rate swaps recorded as gain (loss) on derivative instruments, net
(26,388
)
 
(0.74
)%
 
(46,785
)
 
(1.04
)%
Effective net interest income
59,633

 
1.27
 %
 
66,509

 
1.09
 %
 
Nine Months Ended September 30,
 
2016
 
2015
$ in thousands
Reconciliation
 
Net Interest Rate Margin / Effective Interest Rate Margin
 
Reconciliation
 
Net Interest Rate Margin / Effective Interest Rate Margin
Net interest income
241,145

 
1.91
 %
 
283,258

 
1.68
 %
Add (Less): Amortization of net deferred (gain) loss on de-designated interest rate swaps
11,331

 
0.11
 %
 
51,182

 
0.38
 %
Add: GSE CRT embedded derivative coupon interest recorded as realized and unrealized credit derivative income (loss), net
18,389

 
0.16
 %
 
18,443

 
0.12
 %
Less: Contractual net interest expense on interest rate swaps recorded as gain (loss) on derivative instruments, net
(80,464
)
 
(0.78
)%
 
(138,404
)
 
(1.02
)%
Effective net interest income
190,401

 
1.40
 %
 
214,479

 
1.16
 %
Effective net interest income for the three and nine months ended September 30, 2016 decreased $6.9 million and $24.1 million, respectively from the same period in 2015. The decrease in effective net interest income was primarily due to lower net interest income in 2016 driven by the deconsolidation of our residential securitizations in December 2015. Net interest income on our residential securitizations totaled $7.7 million and $23.1 million for the three and nine months ended September 30, 2015.
The increase in effective interest rate margin for the three and nine months ended September 30, 2016 versus 2015 was primarily due to lower net interest paid on interest rate swaps in the 2016 period. Net interest paid on interest rate swaps decreased because we repositioned our hedging portfolio commencing in the first quarter of 2016 in response to lower market expectations of an increase in the Federal funds interest rate later this year.


 
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Repurchase Agreement Debt-to-Equity Ratio
The tables below show the allocation of our equity to our target assets, our debt-to-equity ratio, and our repurchase agreement debt-to-equity ratio as of September 30, 2016 and December 31, 2015. We present a repurchase agreement debt-to-equity ratio, a non-GAAP financial measure of leverage, because the mortgage REIT industry primarily uses repurchase agreements, which typically mature within one year, to finance investments. We believe that presenting our repurchase agreement debt-to-equity ratio, when considered together with our U.S. GAAP financial measure of debt-to-equity ratio, provides information that is useful to investors in understanding our refinancing risks, and gives investors a comparable statistic to those other mortgage REITs who almost exclusively borrow using short-term repurchase agreements that are subject to refinancing risk.
September 30, 2016
$ in thousands
Agency
RMBS
Residential Credit (1)
Commercial Credit (2)
Exchangeable Senior Notes
Total
Investments
10,653,615

2,752,173

2,974,343

—

16,380,131

Cash and cash equivalents (3)
23,907

13,164

10,211

—

47,282

Derivative assets, at fair value (4)
—

—

505

—

505

Other assets
413,516

7,404

65,326

—

486,246

Total assets
11,091,038

2,772,741

3,050,385

—

16,914,164

 
 
 
 
 
 
Repurchase agreements
9,002,003

2,061,035

997,464

—

12,060,502

Secured loans (5)
461,908

—

1,188,092

—

1,650,000

Exchangeable senior notes
—

—

—

396,420

396,420

Derivative liabilities, at fair value
382,237

—

84

—

382,321

Other liabilities
51,625

19,577

14,534

889

86,625

Total liabilities
9,897,773

2,080,612

2,200,174

397,309

14,575,868

 
 
 
 
 
 
Total equity (allocated)
1,193,265

692,129

850,211

(397,309
)
2,338,296

Adjustments to calculate repurchase agreement debt-to-equity:
 
 
 
 
 
Net equity in unsecured assets and exchangeable senior notes (6)
—

—

(306,054
)
397,309

91,255

Collateral pledged against secured loans
(554,125
)
—

(1,425,287
)
—

(1,979,412
)
Secured loans
461,908

—

1,188,092

—

1,650,000

Equity related to repurchase agreement debt
1,101,048

692,129

306,962

—

2,100,139

Debt-to-equity ratio (7)
7.9

3.0

2.6

NA

6.0

Repurchase agreement debt-to-equity ratio (8)
8.2

3.0

3.2

NA

5.7

(1)
Investments in non-Agency RMBS and GSE CRT are included in residential credit.
(2)
Investments in CMBS, commercial loans and investments in unconsolidated joint ventures are included in commercial credit.
(3)
Cash and cash equivalents is allocated based on a percentage of equity for Agency RMBS, residential credit and commercial credit.
(4)
Derivative assets are allocated based on the hedging strategy for each class.
(5)
Secured loans are allocated based on amount of collateral pledged.
(6)
Net equity in unsecured assets and exchangeable senior notes includes commercial loans, investments in unconsolidated joint ventures and exchangeable senior notes.
(7)
Debt-to-equity ratio is calculated as the ratio of total debt (sum of repurchase agreements, secured loans and exchangeable senior notes) to total equity.
(8)
Repurchase agreement debt-to-equity ratio is calculated as the ratio of repurchase agreements to equity related to repurchase agreement debt.



 
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December 31, 2015
$ in thousands
Agency
RMBS
Residential Credit (1)
Commercial Credit (2)
Exchangeable Senior Notes
Total
Investments
9,799,257

3,350,714

3,163,439

—

16,313,410

Cash and cash equivalents (3)
23,484

16,586

13,129

—

53,199

Derivative assets, at fair value (4)
6,795

—

1,864

—

8,659

Other assets
316,072

9,780

66,189

—

392,041

Total assets
10,145,608

3,377,080

3,244,621

—

16,767,309

 
 
 
 
 
 
Repurchase agreements
8,389,643

2,565,515

1,170,890

—

12,126,048

Secured loans (5)
472,983

—

1,177,017

—

1,650,000

Exchangeable senior notes
—

—

—

394,573

394,573

Derivative liabilities, at fair value
238,045

—

103

 
238,148

Other liabilities
46,165

22,540

17,038

5,889

91,632

Total liabilities
9,146,836

2,588,055

2,365,048

400,462

14,500,401

 
 
 
 
 
 
Total equity (allocated)
998,772

789,025

879,573

(400,462
)
2,266,908

Adjustments to calculate repurchase agreement debt-to-equity:
 
 
 
 
 
Net equity in unsecured assets and exchangeable senior notes (6)
—

—

(250,522
)
400,462

149,940

Collateral pledged against secured loans
(558,894
)
—

(1,390,805
)
—

(1,949,699
)
Secured loans
472,983

—

1,177,017

—

1,650,000

Equity related to repurchase agreement debt
912,861

789,025

415,263

—

2,117,149

Debt-to-equity ratio (7)
8.9

3.3

2.7

NA

6.3

Repurchase agreement debt-to-equity ratio (8)
9.2

3.3

2.8

NA

5.7

(1)
Investments in non-Agency RMBS and GSE CRT are included in residential credit.
(2)
Investments in CMBS, commercial loans and investments in unconsolidated joint ventures are included in commercial credit.
(3)
Cash and cash equivalents is allocated based on a percentage of equity for Agency RMBS, residential credit and commercial credit.
(4)
Derivative assets are allocated based on the hedging strategy for each class.
(5)
Secured loans are allocated based on amount of collateral pledged.
(6)
Net equity in unsecured assets and exchangeable senior notes includes commercial loans, investments in unconsolidated joint ventures and exchangeable senior notes.
(7)
Debt-to-equity ratio is calculated as the ratio of total debt (sum of repurchase agreements, secured loans and exchangeable senior notes) to total equity.
(8)
Repurchase agreement debt-to-equity ratio is calculated as the ratio of repurchase agreements to equity related to repurchase agreement debt.

Liquidity and Capital Resources
Liquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to pay dividends, fund investments, repayment of borrowings and other general business needs. Our primary sources of funds for liquidity consist of the net proceeds from our common and preferred equity offerings, net cash provided by operating activities, proceeds from repurchase agreements and other financing arrangements and future issuances of equity and/or debt securities.
We currently believe that we have sufficient liquidity and capital resources available for the acquisition of additional investments, repayments on borrowings, margin requirements and the payment of cash dividends as required for continued qualification as a REIT. We generally maintain liquidity to pay down borrowings under repurchase arrangements to reduce borrowing costs and otherwise efficiently manage our long-term investment capital. Because the level of these borrowings can be adjusted on a daily basis, the level of cash and cash equivalents carried on our condensed consolidated balance sheets is significantly less important than our potential liquidity available under borrowing arrangements. However, there can be no assurance that we will maintain sufficient levels of liquidity to meet any margin calls.
We held cash and cash equivalents of $47.3 million at September 30, 2016 (September 30, 2015: $76.7 million). Our cash and cash equivalents decreased due to normal fluctuations in cash balances related to the timing of principal and interest payments, repayments of debt, and asset purchases and sales. Our operating activities provided net cash of approximately $251.5 million for the nine months ended September 30, 2016 (September 30, 2015: $276.0 million).

 
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Our investing activities provided net cash of $130.7 million in the nine months ended September 30, 2016, a decrease of $224.1 million compared to the nine months ended September 30, 2015. We generated $1.9 billion from principal payments of mortgage-backed and credit risk transfer securities and $660.0 million from the sales of mortgage-backed and credit risk transfer securities during the nine months ended September 30, 2016 compared to $1.9 billion from principal payments of mortgage-backed and credit risk transfer securities, $424.6 million from principal payments on residential loans held-for-investment and $290.6 million from the sales of mortgage-backed and credit risk transfer securities in the nine months ended September 30, 2015. We invested $2.4 billion in mortgage-backed and credit risk transfer securities and $85.0 million in five new commercial loans during the nine months ended September 30, 2016 compared to investments of $1.8 billion in mortgage-backed and credit risk transfer securities, $372.3 million in residential loans held-for-investment, and $105.0 million in commercial loans in the nine months ended September 30, 2015. We also used proceeds from sales and principal repayments to fund termination payments on derivative contracts of $60.7 million during the nine months ended September 30, 2016 compared to $34.1 million in the nine months ended September 30, 2015.
Our financing activities used net cash of $388.1 million for the nine months ended September 30, 2016 compared to using $718.2 million in the nine months ended September 30, 2015. We primarily used cash to pay dividends of $153.6 million (September 30, 2015: $185.3 million) and to make net repayments of repurchase agreements of $65.5 million (September 30, 2015: $710.5 million). We also used cash during the nine months ended September 30, 2016, to repurchase 2,063,451 shares of common stock for $25.0 million during the nine months ended September 30, 2016.
As of September 30, 2016, our wholly-owned subsidiary, IAS Services, had $1.65 billion in outstanding secured advances from the FHLBI. As of September 30, 2016, the FHLBI advances were collateralized by CMBS and Agency RMBS with a fair value of $1.4 billion and $554.1 million, respectively.
As of September 30, 2016, the average margin requirement (weighted by borrowing amount), or the percentage amount by which the collateral value must exceed the loan amount, which we also refer to as the “haircut,” under our repurchase agreements was 4.8% for Agency RMBS, 20.5% for non-Agency RMBS, 25.5% for GSE CRT and 19.1% for CMBS. Across our repurchase agreement facilities, the haircuts range from a low of 4% to a high of 20% for Agency RMBS, a low of 10% to a high of 50% for non-Agency RMBS, a low of 22.5% to a high of 30% for GSE CRT, a low of 15% to a high of 25% for CMBS. Our effective cost of funds (non-GAAP measure) was 1.86% (September 30, 2015: 2.20%) for the nine months ended September 30, 2016. Declines in the value of our securities portfolio can trigger margin calls by our lenders under our repurchase agreements. An event of default or termination event would give some of our counterparties the option to terminate all repurchase transactions existing with us and require any amount due by us to the counterparties to be payable immediately.
Our total debt-to-equity ratio, which includes longer term financing, was 6.0x as of September 30, 2016 (December 31, 2015: 6.3x). We have reduced our debt-to-equity ratio and continued to maintain a relatively stable repurchase agreement debt-to-equity ratio (non-GAAP measure) over the last nine months.
In December 2011, our board of directors approved a common stock share repurchase program. Shares of our common stock may be purchased in the open market, including through block purchases, or through privately negotiated transactions, or pursuant to any trading plan that may be adopted in accordance with Rules 10b5-1 and 10b-18 of the Securities Exchange Act of 1934, as amended. The timing, manner, price and amount of any repurchases will be determined at our discretion and the program may be suspended, terminated or modified at any time for any reason.  The program does not obligate us to acquire any specific number of shares, and all repurchases will be made in accordance with Rule 10b-18, which sets certain restrictions on the method, timing, price and volume of stock repurchases.
During the nine months ended September 30, 2016, we repurchased 2,063,451 shares of our common stock at a weighted average price of $12.12 per share for a net cost of $25.0 million, including acquisition expenses. As of September 30, 2016, the Company had authority to purchase 18,239,082 additional shares of its common stock under its share repurchase program with no expiration date.
Effective April 1, 2016, we replaced our dividend reinvestment stock purchase plan ("DRSPP") with a direct stock purchase plan and dividend reinvestment program administered by an affiliate of our transfer agent, Computershare Trust Company. Prior to termination, we issued 3,201 shares of common stock in 2016 at an average price of $11.08 with total proceeds of approximately $35,000. During the nine months ended September 30, 2015, we issued 10,317 shares at an average price of $15.29 with total proceeds of approximately $158,000. No shares of common stock were issued under the waiver feature of the DRSPP.


 
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Effects of Margin Requirements, Leverage and Credit Spreads
Our securities have values that fluctuate according to market conditions and, as discussed above, the market value of our securities will decrease as prevailing interest rates or credit spreads increase. When the value of the securities pledged to secure a repurchase loan or a secured loan decreases to the point where the positive difference between the collateral value and the loan amount is less than the haircut, our lenders may issue a margin call, which means that the lender will require us to pay the margin call in cash or pledge additional collateral to meet that margin call. Under our repurchase facilities and secured loans, our lenders have full discretion to determine the value of the securities we pledge to them. Most of our lenders will value securities based on recent trades in the market. Lenders also issue margin calls as the published current principal balance factors change on the pool of mortgages underlying the securities pledged as collateral when scheduled and unscheduled paydowns are announced monthly.
We experience margin calls and increased collateral requirements in the ordinary course of our business. In seeking to effectively manage the margin requirements established by our lenders, we maintain a position of cash and unpledged securities. We refer to this position as our liquidity. The level of liquidity we have available to meet margin calls is directly affected by our leverage levels, our haircuts and the price changes on our securities. If interest rates increase as a result of a yield curve shift or for another reason or if credit spreads widen, then the prices of our collateral (and our unpledged assets that constitute our liquidity) will decline, we will experience margin calls, and we will use our liquidity to meet the margin calls. There can be no assurance that we will maintain sufficient levels of liquidity to meet any margin calls or increased collateral requirements. If our haircuts increase, our liquidity will proportionately decrease. In addition, if we increase our borrowings, our liquidity will decrease by the amount of additional haircut on the increased level of indebtedness.
We intend to maintain a level of liquidity in relation to our assets that enables us to meet reasonably anticipated margin calls and increased collateral requirements but that also allows us to be substantially invested in securities. We may misjudge the appropriate amount of our liquidity by maintaining excessive liquidity, which would lower our investment returns, or by maintaining insufficient liquidity, which would force us to liquidate assets into unfavorable market conditions and harm our results of operations and financial condition.
We are subject to financial covenants in connection with our lending, derivatives and other agreements we enter into in the normal course of our business. We intend to continue to operate in a manner which complies with all of our financial covenants. Our lending and derivative agreements provide that we may be declared in default of our obligations if our leverage ratio exceeds certain thresholds and we fail to maintain stockholders’ equity or market value above certain thresholds over specified time periods.
Forward-Looking Statements Regarding Liquidity
Based upon our current portfolio, leverage rate and available borrowing arrangements, we believe that cash flow from operations and available borrowing capacity will be sufficient to enable us to meet anticipated short-term (one year or less) liquidity requirements to fund our investment activities, pay fees under our management agreement, fund our distributions to stockholders and for other general corporate expenses.
Our ability to meet our long-term (greater than one year) liquidity and capital resource requirements will be subject to obtaining additional debt financing. We may increase our capital resources by obtaining long-term credit facilities or through public or private offerings of equity or debt securities, possibly including classes of preferred stock, common stock, and senior or subordinated notes. Such financing will depend on market conditions for capital raises and our ability to invest such offering proceeds. If we are unable to renew, replace or expand our sources of financing on substantially similar terms, it may have an adverse effect on our business and results of operations.

 
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Contractual Obligations
We have entered into an agreement with our Manager pursuant to which our Manager is entitled to receive a management fee and the reimbursement of certain expenses. The management fee is calculated and payable quarterly in arrears in an amount equal to 1.50% of our stockholders’ equity, per annum. Refer to Note 11 - "Related Party Transactions" of our condensed consolidated financial statements for a description of adjustments made to our stockholders' equity for purposes of calculating our management fee. Our Manager uses the proceeds from its management fee in part to pay compensation to its officers and personnel who, notwithstanding that certain of those individuals are also our officers, receive no cash compensation directly from us. We are required to reimburse our Manager for operating expenses related to us incurred by our Manager, including certain salary expenses and other expenses relating to legal, accounting, due diligence and other services. Expense reimbursements to our Manager are made in cash on a monthly basis following the end of each month. Our reimbursement obligation is not subject to any dollar limitation. Refer to Note 11 – “Related Party Transactions” of our condensed consolidated financial statements for details of our reimbursements to our Manager.
Contractual Commitments
As of September 30, 2016, we had the following contractual commitments and commercial obligations:
 
Payments Due by Period
$ in thousands
Total
 
Less than 1
year
 
1-3 years
 
3-5 years
 
After 5
years
Repurchase agreements
12,060,502

 
12,060,502

 
—

 
—

 
—

Secured loans
1,650,000

 
—

 
—

 
400,000

 
1,250,000

Unfunded investments in unconsolidated ventures
16,290

 
2,870

 
13,420

 
—

 
—

Exchangeable senior notes
400,000

 
—

 
400,000

 
—

 
—

Commercial loans
11,822

 
3,259

 
8,563

 
—

 
—

Total (1)
14,138,614

 
12,066,631

 
421,983

 
400,000

 
1,250,000

 
(1)
Excluded from total contractual obligations are the amounts due to our Manager under the management agreement, as those obligations do not have fixed and determinable payments. Refer to "Contractual Obligations" above for further details.
As of September 30, 2016, we have approximately $13.6 million, $30.0 million and $81.4 million in contractual interest payments related to our repurchase agreements, exchangeable senior notes and secured loans, respectively.
Off-Balance Sheet Arrangements
We have committed to invest up to $122.4 million in unconsolidated ventures sponsored by an affiliate of our Manager. The unconsolidated ventures are structured as partnerships, and we invest in the partnerships as a limited partner. As of September 30, 2016, $106.1 million of our commitment has been called. We are committed to fund $16.3 million in additional capital to fund future investments and cover future expenses should they occur.
As of September 30, 2016, we have unfunded commitments on commercial loans of $11.8 million (December 31, 2015: $2.1 million).
Stockholders’ Equity
Prior to the termination of our DRSPP on April 1, 2016, we issued 3,201 shares (2015: 10,317 shares) of common stock at an average price of $11.08 (nine months ended September 30, 2015: $15.29) under the DRSPP in 2016 for total proceeds of approximately $35,000 (2015: $158,000).

 
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Share-Based Compensation
We have currently reserved 1,000,000 shares of common stock for issuance to our independent directors and officers and employees of our Manger and its affiliates under the terms of our 2009 Equity Incentive Plan (the "Incentive Plan"). Unless terminated earlier, the Incentive Plan will terminate in 2019, but will continue to govern the unexpired awards.
We recognized compensation expense of approximately $85,000 (September 30, 2015: $85,000) and approximately $255,000 (September 30, 2015: $255,000) related to our non-executive directors for the three and nine months ended September 30, 2016 and 2015, respectively. During the three months ended September 30, 2016 and 2015, we issued 5,448 shares and 6,152 shares of stock, respectively, pursuant to the Incentive Plan to our non-executive directors. During the nine months ended September 30, 2016 and 2015, we issued 19,356 shares and 16,896 shares of stock, respectively, pursuant to the Incentive Plan to our non-executive directors. The fair market value of the shares granted was determined by the closing stock market price on the date of the grant. The grants vested immediately.
We recognized compensation expense of approximately $75,000 (September 30, 2015: $31,000) and $170,000 (September 30, 2015: $168,000) for the three and nine months ended September 30, 2016 and 2015, respectively, related to awards to employees of our Manager and its affiliates which is reimbursed by our Manager under the management agreement. At September 30, 2016 there was approximately $542,000 of total unrecognized compensation cost related to certain share-based compensation awards that is expected to be recognized over a period of up to 42 months, with a weighted-average remaining vesting period of 17.52 months.
The following table summarizes the activity related to restricted stock awards to employees of our Manager and its affiliates for the three and nine months ended September 30, 2016.
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
 
2016
 
Restricted Stock Units
 
Weighted Average Grant Date Fair Value (1)
 
Restricted Stock Units
 
Weighted Average Grant Date Fair Value (1)
Unvested at the beginning of the period
46,000

 
$
14.40

 
40,814

 
17.29

Shares granted during the period
—

 
—

 
21,099

 
11.28

Shares forfeited during the period
—

 
—

 
—

 
—

Shares vested during the period
—

 
—

 
(15,913
)
 
(17.66
)
Unvested at the end of the period
46,000

 
$
14.40

 
46,000

 
14.40

(1)
The grant date fair value of restricted stock awards is based on the closing market price of our common stock at the grant date.
Dividends
We intend to continue to make regular quarterly distributions to holders of our common stock and preferred stock. U.S. federal income tax law generally requires that a REIT distribute at least 90% of its REIT taxable income annually, determined without regard to the deduction for dividends paid and excluding net capital gains, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its taxable income. Before we pay any dividend, whether for U.S. federal income tax purposes or otherwise, we must first meet both our operating requirements and debt service on our repurchase agreements and other debt payable. If our cash available for distribution is less than our taxable income, we could be required to sell assets or borrow funds to make cash distributions, or we may make a portion of the required distribution in the form of a taxable stock distribution or distribution of debt securities.
Inflation
Virtually all of our assets and liabilities are sensitive to interest rates. As a result, interest rates and other factors influence our performance far more than inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates.
Unrelated Business Taxable Income
We have not engaged in transactions that would result in a portion of our income being treated as unrelated business taxable income.

 
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Other Matters
We believe that we satisfied each of the asset tests in Section 856(c)(4) of the Internal Revenue Code of 1986, as amended (the "Code") for the period ended September 30, 2016. We also believe that our revenue qualifies for the 75% source of income test and for the 95% source of income test rules for the period ended September 30, 2016. Consequently, we believe we met the REIT income and asset test as of September 30, 2016. We also met all REIT requirements regarding the ownership of our common stock and the distribution of dividends of our net income as of September 30, 2016. Therefore, as of September 30, 2016, we believe that we qualified as a REIT under the Code.
At all times, we intend to conduct our business so that neither we nor our Operating Partnership nor the subsidiaries of our Operating Partnership are required to register as an investment company under the 1940 Act. If we were required to register as an investment company, then our use of leverage would be substantially reduced. Because we are a holding company that conducts our business through our Operating Partnership and the Operating Partnership’s wholly-owned or majority-owned subsidiaries, the securities issued by these subsidiaries that are excepted from the definition of “investment company” under Section 3(c)(1) or Section 3(c)(7) of the 1940 Act, together with any other investment securities the Operating Partnership may own, may not have a combined value in excess of 40% of the value of the Operating Partnership’s total assets (exclusive of U.S. government securities and cash items) on an unconsolidated basis, which we refer to as the 40% test. This requirement limits the types of businesses in which we are permitted to engage in through our subsidiaries. In addition, we believe neither we nor the Operating Partnership are considered an investment company under Section 3(a)(1)(A) of the 1940 Act because they do not engage primarily or hold themselves out as being engaged primarily in the business of investing, reinvesting or trading in securities. Rather, through the Operating Partnership’s wholly-owned or majority-owned subsidiaries, we and the Operating Partnership are primarily engaged in the non-investment company businesses of these subsidiaries. IAS Asset I LLC and certain of the Operating Partnership’s other subsidiaries that we may form in the future rely upon the exclusion from the definition of “investment company” under the 1940 Act provided by Section 3(c)(5)(C) of the 1940 Act, which is available for entities “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” This exclusion generally requires that at least 55% of each subsidiary’s portfolio be comprised of qualifying assets and at least 80% be comprised of qualifying assets and real estate-related assets (and no more than 20% comprised of miscellaneous assets). We calculate that as of September 30, 2016, we conducted our business so as not to be regulated as an investment company under the 1940 Act.

 
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ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The primary components of our market risk are related to interest rate, principal prepayment and market value. While we do not seek to avoid risk completely, we believe the risk can be quantified from historical experience and we seek to actively manage that risk, to earn sufficient compensation to justify taking those risks and to maintain capital levels consistent with the risks we undertake.
Interest Rate Risk
Interest rate risk is highly sensitive to many factors, including governmental, monetary and tax policies, domestic and international economic and political considerations, and other factors beyond our control. We are subject to interest rate risk in connection with our investments and our repurchase agreements. Our repurchase agreements are typically of limited duration and will be periodically refinanced at current market rates. We mitigate this risk through utilization of derivative contracts, primarily interest rate swap agreements, TBAs and futures contracts.
Interest Rate Effect on Net Interest Income
Our operating results depend in large part upon differences between the yields earned on our investments and our cost of borrowing and interest rate hedging activities. Most of our repurchase agreements provide financing based on a floating rate of interest calculated on a fixed spread over LIBOR. The fixed spread will vary depending on the type of underlying asset which collateralizes the financing. Accordingly, the portion of our portfolio which consists of floating interest rate assets are match-funded utilizing our expected sources of short-term financing, while our fixed interest rate assets are not match-funded. During periods of rising interest rates, the borrowing costs associated with our investments tend to increase while the income earned on our fixed interest rate investments may remain substantially unchanged. This increase in borrowing costs results in the narrowing of the net interest spread between the related assets and borrowings and may even result in losses. Further, during this portion of the interest rate and credit cycles, defaults could increase and result in credit losses to us, which could adversely affect our liquidity and operating results. Such delinquencies or defaults could also have an adverse effect on the spread between interest-earning assets and interest-bearing liabilities.
Hedging techniques are partly based on assumed levels of prepayments of our RMBS. If prepayments are slower or faster than assumed, the life of the RMBS will be longer or shorter, which would reduce the effectiveness of any hedging strategies we may use and may cause losses on such transactions. Hedging strategies involving the use of derivative securities are highly complex and may produce volatile returns.
Interest Rate Effects on Fair Value
Another component of interest rate risk is the effect that changes in interest rates will have on the market value of the assets that we acquire. We face the risk that the market value of our assets will increase or decrease at different rates than those of our liabilities, including our hedging instruments.
We primarily assess our interest rate risk by estimating the duration of our assets and the duration of our liabilities. Duration measures the market price volatility of financial instruments as interest rates change. We generally calculate duration using various financial models and empirical data. Different models and methodologies can produce different duration numbers for the same securities.
The impact of changing interest rates on fair value can change significantly when interest rates change materially. Therefore, the volatility in the fair value of our assets could increase significantly in the event interest rates change materially. In addition, other factors impact the fair value of our interest rate-sensitive investments and hedging instruments, such as the shape of the yield curve, market expectations as to future interest rate changes and other market conditions. Accordingly, changes in actual interest rates may have a material adverse effect on us.
Prepayment Risk
As we receive prepayments of principal on our investments, premiums paid on these investments are amortized against interest income. In general, an increase in prepayment rates will accelerate the amortization of purchase premiums, thereby reducing the interest income earned on the investments. Conversely, discounts on such investments are accreted into interest income. In general, an increase in prepayment rates will accelerate the accretion of purchase discounts, thereby increasing the interest income earned on the investments.

 
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Extension Risk
We compute the projected weighted average life of our investments based upon assumptions regarding the rate at which the borrowers will prepay the underlying mortgages. In general, when a fixed-rate or hybrid adjustable-rate security is acquired with borrowings, we may, but are not required to, enter into an interest rate swap agreement or other hedging instrument that effectively fixes our borrowing costs for a period close to the anticipated average life of the fixed-rate portion of the related assets. This strategy is designed to protect us from rising interest rates, because the borrowing costs are fixed for the duration of the fixed-rate portion of the related target asset.
However, if prepayment rates decrease in a rising interest rate environment, then the life of the fixed-rate portion of the related assets could extend beyond the term of the swap agreement or other hedging instrument. This could have a negative impact on our results from operations, as borrowing costs would no longer be fixed after the end of the hedging instrument, while the income earned on the hybrid adjustable-rate assets would remain fixed. This situation may also cause the market value of our hybrid adjustable-rate assets to decline, with little or no offsetting gain from the related hedging transactions. In extreme situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses.
Market Risk
Market Value Risk
Our available-for-sale securities are reflected at their estimated fair value with unrealized gains and losses excluded from earnings and reported in other comprehensive income pursuant to ASC Topic 320. The estimated fair value of these securities fluctuates primarily due to changes in interest rates and other factors. Generally, in a rising interest rate environment, the estimated fair value of these securities would be expected to decrease; conversely, in a decreasing interest rate environment, the estimated fair value of these securities would be expected to increase.
The sensitivity analysis table presented below shows the estimated impact of an instantaneous parallel shift in the yield curve, up and down 50 and 100 basis points, on the market value of our interest rate-sensitive investments and net interest income, including net interest paid or received under interest rate swaps, at September 30, 2016, assuming a static portfolio. When evaluating the impact of changes in interest rates, prepayment assumptions and principal reinvestment rates are adjusted based on our Manager’s expectations. The analysis presented utilized assumptions, models and estimates of our Manager based on our Manager’s judgment and experience.
Change in Interest Rates
 
Percentage Change in Projected
Net Interest Income
 
Percentage Change in Projected
Portfolio Value
+1.00%
 
(20.09
)%
 
(1.18
)%
+0.50%
 
(7.01
)%
 
(0.44
)%
-0.50%
 
(2.34
)%
 
0.25
 %
-1.00%
 
(12.13
)%
 
0.29
 %
Certain assumptions have been made in connection with the calculation of the information set forth in the foregoing interest rate sensitivity table and, as such, there can be no assurance that assumed events will occur or that other events will not occur that would affect the outcomes. The base interest rate scenario assumes interest rates at September 30, 2016. The analysis utilizes assumptions and estimates based on management’s judgment and experience. Furthermore, while we generally expect to retain such assets and the associated interest rate risk to maturity, future purchases and sales of assets could materially change our interest rate risk profile.
Given the low interest rates at September 30, 2016, we applied a floor of 0% for all anticipated interest rates included in our assumptions. Because of this floor, we anticipate that any hypothetical interest rate shock decrease would have a limited positive impact on our funding costs; however, because prepayment speeds are unaffected by this floor, we expect that any increase in our prepayment speeds (occurring as a result of any interest rate decrease or otherwise) could result in an acceleration of our premium amortization on Agency and interest-only securities purchased at a premium, and accretion of discount on our non-Agency RMBS purchased at a discount. As a result, because this floor limits the positive impact of any interest rate decrease on our funding costs, hypothetical interest rate decreases could cause the fair value of our financial instruments and our net interest income to decline.
The information set forth in the interest rate sensitivity table above and all related disclosures constitutes forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Actual results could differ significantly from those estimated in the foregoing interest rate sensitivity table.

 
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Real Estate Risk
Residential and commercial property values are subject to volatility and may be adversely affected by a number of factors, including, but not limited to: national, regional and local economic conditions (which may be adversely affected by industry slowdowns and other factors); local real estate conditions (such as the supply of housing stock); changes or continued weakness in specific industry segments; construction quality, age and design; demographic factors; and retroactive changes to building or similar codes. In addition, decreases in property values reduce the value of the collateral and the potential proceeds available to a borrower to repay our loans, which could also cause us to suffer losses.
Credit Risk
We believe that our investment strategy will generally keep our credit losses and financing costs low. However, we retain the risk of potential credit losses on all of our residential and commercial mortgage investments. We seek to manage this risk through our pre-acquisition due diligence process. In addition, we re-evaluate the credit risk inherent in our investments on a regular basis pursuant to fundamental considerations such as GDP, unemployment, interest rates, retail sales, store closings/openings, corporate earnings, housing inventory, affordability and regional home price trends. We also review key loan credit metrics including, but not limited to, payment status, current loan-to-value ratios, current borrower credit scores and debt yields. These characteristics assist in determining the likelihood and severity of loan loss as well as prepayment and extension expectations. We then perform structural analysis under multiple scenarios to establish likely cash flow profiles and credit enhancement levels relative to collateral performance projections. This analysis allows us to quantify our opinions of credit quality and fundamental value, which are key drivers of portfolio management decisions.
Foreign Exchange Rate Risk
We have an investment in a commercial loan denominated in foreign currency and an investment in an unconsolidated joint venture whose net assets and results of operations are exposed to foreign currency translation risk when translated in U.S. dollars upon consolidation. We seek to hedge our foreign currency exposures by purchasing currency forward contracts.
Risk Management
To the extent consistent with maintaining our REIT qualification, we seek to manage risk exposure to protect our investment portfolio against the effects of major interest rate changes. We generally seek to manage this risk by:
•
monitoring and adjusting, if necessary, the reset index and interest rate related to our target assets and our financings;
•
attempting to structure our financing agreements to have a range of different maturities, terms, amortizations and interest rate adjustment periods;
•
using hedging instruments, primarily interest rate swap agreements but also financial futures, options, interest rate cap agreements, floors and forward sales to adjust the interest rate sensitivity of our target assets and our borrowings; and
•
actively managing, on an aggregate basis, the interest rate indices, interest rate adjustment periods, and gross reset margins of our target assets and the interest rate indices and adjustment periods of our financings.

 
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ITEM 4.
CONTROLS AND PROCEDURES.

Our management is responsible for establishing and maintaining disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) that are designed to ensure that information we are required to disclose in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include controls and procedures designed to ensure that the required information is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure.
We have evaluated, with the participation of our principal executive officer and principal financial officer, the effectiveness of our disclosure controls and procedures as of September 30, 2016. Based upon our evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the applicable rules and forms, and that it is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.
There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives.
Changes in Internal Control over Financial Reporting    
There has been no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during the quarter ended September 30, 2016 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.


 
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PART II – OTHER INFORMATION
 
ITEM 1.
LEGAL PROCEEDINGS.
From time to time, we may be involved in various claims and legal actions arising in the ordinary course of business. As of September 30, 2016, we were not involved in any such legal proceedings.
ITEM 1A.
RISK FACTORS.
There were no material changes during the period covered by this Report to the risk factors previously disclosed in our annual report on Form 10-K for the year ended December 31, 2015, as filed with the SEC on February 22, 2016, and our quarterly reports on Form 10-Q for the quarters ended March 31, 2016 and June 30, 2016, as filed with the SEC on May 10, 2016 and August 8, 2016, respectively. Additional risks not presently known, or that we currently deem immaterial, also may have a material adverse effect on our business, financial condition and results of operations.
ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
During the three months ended September 30, 2016, the Company did not repurchase any shares of its common stock.
ITEM 3.
DEFAULTS UPON SENIOR SECURITIES.
None.
ITEM 4.
MINE SAFETY DISCLOSURES.
Not applicable.
ITEM 5.
OTHER INFORMATION.
None.

ITEM 6.
EXHIBITS.
A list of exhibits to this Form 10-Q is set forth on the Exhibit Index and is incorporated herein by reference.


 
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
INVESCO MORTGAGE CAPITAL INC.
 
 
 
November 3, 2016
By:
/s/ Richard J. King
 
 
Richard J. King
 
 
President and Chief Executive Officer
 
 
 
November 3, 2016
By:
/s/ Richard Lee Phegley, Jr.
 
 
Richard Lee Phegley, Jr.
 
 
Chief Financial Officer


 
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EXHIBIT INDEX
Item 6.        Exhibits
 
Exhibit
No.
  
Description
 
 
3.1

  
Articles of Amendment and Restatement of Invesco Mortgage Capital Inc. (incorporated by reference to Exhibit 3.1 to our Quarterly Report on Form 10-Q, filed with the Securities and Exchange Commission on August 12, 2009).
 
 
3.2

  
Articles Supplementary of 7.75% Series A Cumulative Redeemable Preferred Stock (incorporated by reference to Exhibit 3.3 to the Registrant’s Registration Statement on Form 8-A, filed with the SEC on July 23, 2012).
 
 
3.3

  
Articles Supplementary of 7.75% Fixed-to-Floating Series B Cumulative Redeemable Preferred Stock (incorporated by reference to Exhibit 3.3 to the Registrant’s Registration Statement on Form 8-A, filed with the SEC on September 8, 2014).
 
 
3.4

  
Amended and Restated Bylaws of Invesco Mortgage Capital Inc. (incorporated by reference to Exhibit 3.2 to Amendment No. 8 to our Registration Statement on Form S-11 (No. 333-151665), filed with the Securities and Exchange Commission on June 18, 2009).
 
 
 
31.1

  
Certification of Richard J. King pursuant to Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
31.2

  
Certification of Richard Lee Phegley, Jr. pursuant to Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
32.1

  
Certification of Richard J. King pursuant to Rule 13a-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
32.2

  
Certification of Richard Lee Phegley, Jr. pursuant to Rule 13a-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
101

  
The following series of unaudited XBRL-formatted documents are collectively included herewith as Exhibit 101. The financial information is extracted from Invesco Mortgage Capital Inc.’s unaudited condensed consolidated interim financial statements and notes that are included in this Form 10-Q Report.
 
101.INS XBRL Instance Document
 
101.SCH XBRL Taxonomy Extension Schema Document
 
101.CAL XBRL Taxonomy Calculation Linkbase Document
 
101.LAB XBRL Taxonomy Label Linkbase Document
 
101.PRE XBRL Taxonomy Presentation Linkbase Document
 
101.DEF XBRL Taxonomy Definition Linkbase Document


 
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