Edgar Filing: Western Asset Mortgage Capital Corp

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended March 31, 2013

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: 001-35543

Western Asset Mortgage Capital Corporation

(Exact name of Registrant as specified in its charter)

Delaware		27-0298092

(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification Number)

Western Asset Mortgage Capital Corporation

385 East Colorado Boulevard

Pasadena, California 91101

(Address of Registrant’s principal executive offices)

(626) 844-9400

(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 x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, 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 x 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 o

Accelerated filer o

Non-accelerated filer x

(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 under the Securities Exchange Act of 1934). Yes o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.

As of May 13, 2013, there were 24,304,503 shares, par value $0.01, of the registrant’s common stock issued and outstanding.

Table of Contents

TABLE OF CONTENTS

		Page

Part I — FINANCIAL INFORMATION


ITEM 1.	Financial Statements	2

ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	27

ITEM 3.	Quantitative and Qualitative Disclosures about Market Risk	48

ITEM 4.	Controls and Procedures	52


Part II — OTHER INFORMATION		53

ITEM 1.	Legal Proceedings	53

ITEM 1A.	Risk Factors	53

ITEM 2.	Unregistered Sales of Equity Securities and Use of Proceeds	53

ITEM 3.	Defaults Upon Senior Securities	53

ITEM 4.	Mine Safety Disclosures	53

ITEM 5.	Other Information	53

ITEM 6.	Exhibits	54


Signatures		55

Table of Contents

Western Asset Mortgage Capital Corporation

Balance Sheets (Unaudited)

(in thousands—except share and per share data)

	March 31, 2013		December 31, 2012

Assets:
Cash and cash equivalents	$	3,947	$	56,292
Residential mortgage-backed securities, at fair value ($4,341,535 and $5,043,824 pledged as collateral, at fair value, respectively)	4,375,316		5,212,581
Linked transactions, net, at fair value	22,844		-
Investment related receivables	300,365		-
Accrued interest receivable	15,322		17,361
Due from counterparties	39,346		54,142
Derivative assets, at fair value	32,449		24,344
Other assets	329		244
Total Assets	$	4,789,918	$	5,364,964

Liabilities and Stockholders’ Equity:
Liabilities:
Borrowings under repurchase agreements	$	4,054,930	$	4,794,730
Accrued interest payable	6,944		6,561
Investment related payables	219,704		-
Derivative liabilities, at fair value	9,698		4,771
Cash overdraft payable	-		5,666
Accounts payable and accrued expenses	1,542		988
Underwriting and offering costs payable	8		75
Payable to related party	2,113		1,924
Dividend payable	-		27,041
Total Liabilities	4,294,939		4,841,756

Commitments and contingencies

Stockholders’ Equity:
Common stock, $0.01 par value, 500,000,000 shares authorized, 24,304,503 and 24,143,944 shares issued and outstanding, respectively	243		241
Preferred stock, $0.01 par value, 100,000,000 shares authorized and no shares outstanding	-		-
Additional paid-in capital	505,722		505,454
Retained earnings (Accumulated Deficit)	(10,986)		17,513
Total Stockholders’ Equity	494,979		523,208
Total Liabilities and Stockholders’ Equity	$	4,789,918	$	5,364,964

See notes to unaudited financial statements.

Table of Contents

Western Asset Mortgage Capital Corporation

Statement of Operations (Unaudited)

(in thousands—except share and per share data)

	For the three months ended March 31, 2013

Net Interest Income:
Interest income	$	33,750
Interest expense	5,181
Net Interest Income	28,569

Other Income (Loss):
Interest income on cash balances and other income	33
Realized loss on sale of Residential mortgage-backed securities and other securities, net	(11,660)
Other loss on Residential mortgage-backed securities	(2,268)
Unrealized loss on Residential mortgage-backed securities and other securities, net	(54,759)
Gain on linked transactions, net	596
Gain on derivative instruments, net	14,840
Other Income (Loss), net	(53,218)

Operating Expenses:
General and administrative (includes $286 non-cash stock based compensation)	1,737
Management fee – related party	2,113
Total Operating Expenses	3,850

Net loss to Common Stock and participating securities	$	(28,499)

Net Loss per Common Share – Basic	$	(1.18)
Net Loss per Common Share - Diluted	$	(1.18)
Dividends Declared per Share of Common Stock	$	-

See notes to unaudited financial statements.

Table of Contents

Western Asset Mortgage Capital Corporation

Statement of Changes in Stockholders’ Equity (Unaudited)

(in thousands—except shares and share data)

	Common Stock			Additional Paid-			Retained Earnings (Accumulated
	Shares	Par		In Capital			Deficit)		Total
Balance at December 31, 2012	24,143,944	$	241	$	505,454		$	17,513	$523,208
Grants of restricted stock	160,559	2		(2		)	-		-
Vesting of restricted stock	-	-		270			-		270
Net loss	-	-		-			(28,499)		(28,499)
Balance at March 31, 2013	24,304,503	$	243	$	505,722		$	(10,986)	$	494,979

See notes to unaudited financial statements.

Table of Contents

Western Asset Mortgage Capital Corporation

Statement of Cash Flows (Unaudited)

(in thousands)

	For the three months ended March 31, 2013
Cash flows from operating activities:
Net loss	$	(28,499)
Adjustments to reconcile net loss to net cash provided by operating activities:
Premium amortization and (discount accretion), net	8,625
Restricted stock amortization expense	270
Unrealized loss on Residential mortgage-backed securities and other securities, net	54,759
Mark-to-market adjustments on linked transactions	(579)
Mark-to-market adjustments on derivative instruments	1,097
Other loss on Residential mortgage-backed securities	2,268
Realized loss on sale of Residential mortgage-backed securities and other securities, net	11,660
Realized loss on sale of Agency Interest-Only Strips accounted for as derivatives, net	99
Realized loss on TBAs, net	(601)
Changes in operating assets and liabilities:
Decrease in accrued interest receivable	2,039
Increase in other assets	(85)
Increase in accrued interest payable	383
Increase in accounts payable and accrued expenses	554
Increase in payable to related party	189
Net cash provided by operating activities	52,179

Cash flows from investing activities:
Purchase of Residential mortgage-backed securities	(931,007)
Purchase of securities underlying linked transactions	(66,704)
Proceeds from sale of Residential mortgage-backed securities	1,528,357
Principal payments and basis recovered on Residential mortgage-backed securities	79,493
Principal payments on securities underlying linked transactions	569
Payment of premium for option derivatives	(4,675)
Premium received from option derivatives	3,750
Net settlements of TBAs	601
Payment of premium for interest rate swaption	(1,000)
Net cash provided by investing activities	609,384

Cash flows from financing activities:
Payment of offering costs	(67)
Proceeds from repurchase agreement borrowings	11,203,749
Proceeds from repurchase agreements underlying linked transactions	47,895
Repayments of repurchase agreement borrowings	(11,943,549)
Repayments of repurchase agreements underlying linked transactions	(4,025)
Repayment of cash overdraft	(5,666)
Due from counterparties	14,796
Dividends on common stock	(27,041)
Net cash used in financing activities	(713,908)

Net decrease in cash and cash equivalents	(52,345)
Cash and cash equivalents beginning of period	56,292
Cash and cash equivalents end of period	$	3,947

Supplemental disclosure of operating cash flow information:
Interest paid	$	7,090
Supplemental disclosure of non-cash financing/investing activities:
Mortgage-backed securities sold, not settled	$	300,365
Mortgage-backed securities purchased, not settled	$	(219,704)

See notes to unaudited financial statements.

Table of Contents

Western Asset Mortgage Capital Corporation

Notes to Financial Statements (Unaudited)

(in thousands- except share and per share data)

The following defines certain of the commonly used terms in these Notes to Financial Statements: “Agency” or “Agencies” refer to a federally chartered corporation, such as the Federal National Mortgage Association (“Fannie Mae” or “FNMA”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac” or “FHLMC”), or an agency of the U.S. Government, such as the Government National Mortgage Association (“Ginnie Mae” or “GNMA”); references to “RMBS” refer to residential mortgage-backed securities, “Agency RMBS” refer to RMBS issued or guaranteed by the Agencies while “Non-Agency RMBS “ refer to RMBS that are not issued or guaranteed by the Agencies; references to “ARMs” refers to adjustable rate mortgages; and references to “Agency Derivatives” or “Agency Interest-Only Strips” refer to interest-only(“IO”) and inverse interest-only (“IIO”) securities issued as part of or collateralized with Agency RMBS.

Note 1 – Organization

Western Asset Mortgage Capital Corporation (is referred to throughout this report as the “Company”) is a residential real estate finance company that invests in residential mortgage assets in the United States. The Company is primarily focused on investing in, financing and managing Agency RMBS. Although the Company’s core investment strategy is focused on Agency RMBS, the Company has opportunistically supplemented its portfolio with Non-Agency RMBS and may, in the future, opportunistically invest in commercial mortgage-backed securities (“CMBS”) and asset-backed securities (“ABS”).

The Company was organized in the state of Delaware on June 3, 2009. The Company filed a Certificate of Dissolution in Delaware on May 5, 2010 and revoked such dissolution by filing a Certificate of Revocation of Dissolution on March 24, 2011. On March 24, 2011, Western Asset Management Company (“WAM”, or the “Manager”), an investment advisor registered with the Securities and Exchange Commission (“SEC”), made a $1,000 initial capital contribution to the Company. WAM is a wholly-owned subsidiary of Legg Mason, Inc. and is the external manager of the Company. The Company intends to elect and qualify to be taxed as a real estate investment trust or “REIT” commencing with its taxable year ended December 31, 2012.

At December 31, 2011 and through May 14, 2012, the Company complied with the reporting requirements for development stage enterprises and was subject to the risks associated with development stage enterprises. The Company completed its initial public offering and began its core operation on May 15, 2012. The Company incurred organizational, accounting and offering costs in connection with the Company’s initial public offering (the “IPO”) of its common stock and concurrent private placements. In accordance with the Management Agreement (as defined herein in Note 9) between the Company and the Manager, the Company reimbursed the Manager for $1.2 million of offering and other related organization costs, which were paid by the Manager, from the proceeds of the IPO and concurrent private placements. The Manager paid all costs in excess of $1.2 million. The Company ceased reporting as a development stage company on May 15, 2012.

Note 2 – Summary of Significant Accounting Policies

Basis of Presentation

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary have been made to present fairly the Company’s financial position, results of operations and cash flows. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted in accordance with Article 10 of Regulation S-X and the instructions to Form 10-Q. These financial statements should be read in conjunction with the Company’s annual report on Form 10-K for the year ended December 31, 2012, filed with the Securities and Exchange Commission (“SEC”) on April 9, 2013. The results of operations for the period ended March 31, 2013 are not necessarily indicative of the results to be expected for the full year or any future period.

The Company currently operates as one business segment.

Table of Contents

Cash and Cash Equivalents

The Company considers all highly-liquid short term investments with original maturities of 90 days or less when purchased to be cash equivalents. Cash and cash equivalents are exposed to concentrations of credit risk. The Company places its cash and cash equivalents with what it believes to be high credit quality institutions. At times such investments may be in excess of the Federal Deposit Insurance Corporation insurance limit.

Classification of mortgage-backed securities and valuations of financial instruments

Mortgage-backed and US Treasury securities - Fair value election

The Company has elected the fair value option for all of its RMBS and US Treasury securities at the date of purchase, which permits the Company to measure these securities at fair value with the change in fair value included as a component of earnings. In the Manager’s view, this election more appropriately reflects the results of the Company’s operations for a particular reporting period, as financial asset fair value changes are presented in a manner consistent with the presentation and timing of the fair value changes of economic hedging instruments.

Balance Sheet Presentation

The Company’s mortgage-backed securities purchases and sales are recorded on the trade date, which results in an investment related payable (receivable) for RMBS purchased (sold) for which settlement has not taken place as of the balance sheet date. The Company’s RMBS pledged as collateral against borrowings under repurchase agreements, and that are not accounted for as linked transactions, described below, are included in residential mortgage-backed securities on the Balance Sheets, with the fair value of such securities pledged disclosed parenthetically.

Valuation of financial instruments

The Company discloses the fair value of its financial instruments according to a fair value hierarchy (Levels I, II, and III, as defined below). In accordance with GAAP, the Company is required to provide enhanced disclosures regarding instruments in the Level III category (which require significant management judgment), including a separate reconciliation of the beginning and ending balances for each major category of assets and liabilities. GAAP establishes a framework for measuring fair value and expands financial statement disclosure requirements for fair value measurements. GAAP further specifies a hierarchy of valuation techniques, which is based on whether the inputs into the valuation technique are observable or unobservable. The hierarchy is as follows:

Level I — Quoted prices in active markets for identical assets or liabilities.

Level II — Quoted prices for similar assets and liabilities 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 III — Prices are determined using significant unobservable inputs. In situations where quoted prices or observable inputs are unavailable, for example, when there is little or no market activity for an investment at the end of the period, unobservable inputs may be used.

The level in the fair value hierarchy within which a fair measurement in its entirety falls is based on the lowest level input that is significant to the fair value measurement in its entirety.

When available, the Company uses quoted market prices to determine the fair value of an asset or liability. If quoted market prices are not available, the Company consults with independent pricing services or obtains third party broker quotes. If independent pricing service, or third party broker quotes are not available, the Company determines the fair value of the securities using valuation techniques that use, when possible, current market-based or independently-sourced market parameters, such as interest rates and when applicable, estimates of prepayment and credit losses.

Valuation techniques for RMBS may be based upon models that consider the estimated cash flows of the security. The primary inputs to the model include yields for to-be-announced, also known as TBAs, Agency RMBS, the U.S. Treasury market and floating rate indices such as LIBOR, the Constant Maturity Treasury rate and the prime rate as a benchmark yield. The model incorporates the current weighted average maturity and additional pool level information such as prepayment speeds, default frequencies and default severities, if applicable. To the extent, the inputs are observable and timely, the values are categorized in Level II of the fair value hierarchy; otherwise they would be categorized as Level III.

Table of Contents

While linked transactions, described below, are treated as derivatives for GAAP, the securities underlying the Company’s linked transactions are valued using similar techniques to those used for the Company’s securities portfolio. The value of the underlying security is then netted against the carrying amount (which approximates fair value) of the repurchase agreement at the valuation date. Additionally, TBA instruments are similar in form to the Company’s Agency RMBS portfolio, and the Company therefore estimates fair value based on similar methods.

The Company determines the fair value of derivative financial instruments by obtaining quotes from a third party pricing service, whose pricing is subject to review by the Manager’s pricing committee. In valuing its interest rate derivatives, such as swaps and swaptions, the Company considers the creditworthiness of both the Company and its counterparties, along with collateral provisions contained in each derivative agreement, from the perspective of both the Company and its counterparties. All of the Company’s derivatives are subject to bilateral collateral arrangements. The Company also has netting arrangements in place with all derivative counterparties pursuant to standard documentation developed by the International Swap and Derivatives Association. Consequently, no credit valuation adjustment was made in determining the fair value of interest rate derivatives,

In May 2011, the Financial Accounting Standards Board or FASB issued amendments, which were adopted by the Company, to achieve common fair value measurement and disclosure requirements in GAAP and International Financial Reporting Standards. New disclosures, with a particular focus on Level III measurement are required. All transfers between Level I and Level II are required to be disclosed. There were no transfers between hierarchy levels during operations for the three months ended March 31, 2013. Information about when the current use of a non-financial asset measured at fair value differs from its highest and best use is to be disclosed.

Fair value under GAAP represents an exit price in the normal course of business, not a forced liquidation price. If the Company is forced to sell assets in a short period to meet liquidity needs, the prices it receives can be substantially less than their recorded fair values. Furthermore, the analysis of whether it is more likely than not that the Company will be required to sell securities in an unrealized loss position prior to an expected recovery in value (if any), the amount of such expected required sales, and the projected identification of which securities will be sold is also subject to significant judgment, particularly in times of market illiquidity.

Any changes to the valuation methodology will be reviewed by the Company to ensure the changes are appropriate. As markets and products develop and the pricing for certain products becomes more transparent, the Company will continue to refine its valuation methodologies. The methods used by the Company may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while the Company anticipates that its valuation methods will be appropriate and consistent with other market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments can result in a different estimate of fair value at the reporting date. The Company uses inputs that are current as of the measurement date, which may include periods of market dislocation, during which price transparency may be reduced.

Interest income recognition and Impairment

Agency RMBS and Non-Agency RMBS rated AA and higher at the time of purchase

Interest income on mortgage-backed securities is accrued based on the respective outstanding principal balances and corresponding contractual terms. Premiums and discounts associated with Agency RMBS and Non-Agency RMBS rated AA and higher at the time of purchase, are amortized into interest income over the estimated life of such securities using the effective yield method. Adjustments to premium and discount amortization are made for actual prepayment activity. The Company estimates prepayments at least quarterly for its securities and as a result, if prepayments increase (or are expected to increase), the Company will accelerate the rate of amortization on premiums or discounts and make a retrospective adjustment to historical amortization. Alternatively, if prepayments decrease (or are expected to decrease) the Company will reduce the rate of amortization on the premiums or discounts and make a retrospective adjustment to historical amortization.

Table of Contents

The determination as to whether an other-than-temporary impairment exists is subject to management estimates based on consideration of both factual information available at the time of assessment as well as the Company’s estimates of the future performance and projected amount and timing of cash flows expected to be collected on the security. As a result, the timing and amount of an other-than-temporary impairment constitutes an accounting estimate that may change materially over time.

Non-Agency RMBS that are purchased at a discount to par value and are rated below AA at the time of purchase and Agency Interest-Only Strips that are not classified as derivatives

Interest income on Non-Agency RMBS that are purchased at a discount to par value and are rated below AA at the time of purchase and Agency Interest-Only Strips that are not classified as derivatives are recognized based on the effective yield method. The effective yield on these securities is based on the projected cash flows from each security, which is estimated based on the Company’s observation of the then current information and events and will include assumptions related to interest rates, prepayment rates and the timing and amount of credit losses. On at least a quarterly basis, the Company reviews and, if appropriate, makes adjustments to its cash flow projections based on input and analysis received from external sources, internal models, and its judgment about interest rates, prepayment rates, the timing and amount of credit losses (if applicable), and other factors. Changes in cash flows from those originally projected, or from those estimated at the last evaluation, may result in a prospective change in the yield/interest income recognized on such securities. Actual maturities of the securities are affected by the contractual lives of the associated mortgage collateral, periodic payments of scheduled principal, and prepayments of principal. Therefore, actual maturities of the securities will generally be shorter than stated contractual maturities.

Based on the projected cash flow of the Non-Agency RMBS purchased at a discount to par value, the Company may designate a portion of such purchase discount as credit protection against future credit losses and, therefore, not accrete such amount into interest income. The amount designated as credit discount may be adjusted over time, based on the actual performance of the security, its underlying collateral, actual and projected cash flow from such collateral, economic conditions and other factors. If the performance of a security with a credit discount is more favorable than forecasted, a portion of the amount designated as credit discount may be accreted into interest income prospectively.

In addition, an other-than-temporary impairment is deemed to have occurred when there is an adverse change in the expected cash flows (principal or interest) to be received and the fair value of the security is less than its carrying amount. In determining whether an adverse change in cash flows occurred, the present value of the remaining cash flows, as estimated at the initial transaction date (or the last date previously revised), is compared to the present value of the expected cash flows at the current reporting date. The estimated cash flows reflect those a “market participant” would use and are discounted at a rate equal to the current yield used to accrete interest income. These adjustments are reflected in the Company’s Statement of Operations as Other loss on Residential mortgage-backed securities.

For any RMBS that are in an unrealized loss position at March 31, 2013 such RMBS are not considered other than temporarily impaired because the Company has the ability and intent to hold the investments to maturity or for a period of time sufficient for a forecasted market price recovery up to or above the cost of the investment and the Company is not required to sell the security for regulatory or other reasons.

Sales of securities

Sales of securities are driven by the Company’s portfolio management process. The Company seeks to mitigate risks including those associated with prepayments and will opportunistically rotate the portfolio into securities the Company’s manager believe have more favorable attributes. Strategies may also be employed to manage net capital gains, which need to be distributed for tax purposes. Realized gains or losses on sales of securities and derivatives, inclusive of linked transactions are included in the net realized gain line item on the Statement of Operations, and are recorded at the time of disposition. The cost of positions sold is calculated using the specific identification method.

Table of Contents

Due from counterparties/Due to counterparties

Due from counterparties represents cash posted with its counterparties as collateral for the Company’s interest rate swaps and repurchase agreements. Due to counterparties represents cash posted with the Company by its counterparties as collateral under the Company’s interest rate swaps, interest rate swaptions and repurchase agreements. Due from counterparties and Due to counterparties are carried at cost, which approximates fair value.

Derivatives and hedging activities

Subject to maintaining its qualification as a REIT for U.S. federal income tax purposes, the Company utilizes derivative financial instruments, including interest rate swaps, swaptions, U.S. treasuries, to-be-announced securities (“TBAs”) and Agency Interest-Only Strips to hedge the interest rate risk associated with its portfolio and related borrowings. Derivatives are used for hedging purposes rather than speculation. The Company determines the fair value of its derivative positions and obtains quotations from a third party to facilitate the process of determining these fair values. If the Company’s hedging activities do not achieve the desired results, reported earnings may be adversely affected.

GAAP requires an entity to recognize all derivatives as either assets or liabilities and to measure those instruments at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives are classified as either hedges of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge) or hedges of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge). Fair value adjustments are recorded in earnings immediately, if the Company does not elect hedge accounting for a derivative instrument.

The Company elected not to apply hedge accounting for its derivative instruments and records the change in fair value and net interest rate swap payments (including accrued amounts) related to interest rate swaps in Gain on derivative instruments, net in its Statement of Operations.

The Company also invests in Agency Interest-Only Strips, Agency Inverse Interest-Only Strips, swaptions and TBAs. The Company evaluates the terms and conditions of its holdings of Agency Interest-Only Strips, Agency Inverse Interest-Only Strips, swaptions and TBAs to determine if these instruments have the characteristics of an investment or should be considered a derivative under GAAP. Accordingly, Agency Interest-Only Strips, Agency Inverse Interest-Only Strips, swaptions and TBAs having the characteristics of derivatives are accounted for at fair value with such changes recognized in Gain on derivative instruments, net in its Statement of Operations, along with any interest earned (including accrued amounts). The carrying value of these Agency Interest-Only Strips, Agency Inverse Interest-Only Strips, swaptions and TBAs is included in Residential mortgage-backed securities on the Balance Sheet.

The Company evaluates all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. Derivative instruments are recorded at fair value and are re-valued at each reporting date, with changes in the fair value together with interest earned (including accrued amounts) reported in loss on derivatives in the statements of operations.

Repurchase agreements

Mortgage-backed securities sold under repurchase agreements are treated as collateralized financing transactions, unless they meet sales treatment. Securities financed through a repurchase agreement remain on the Company’s Balance Sheet as an asset and cash received from the lender is recorded in the Company’s Balance Sheet as a liability, unless they are accounted for as linked transactions, described below. Interest paid in accordance with repurchase agreements is recorded as interest expense, unless they are accounted for as linked transactions, described below. The Company reflects all proceeds from repurchase agreement borrowings and repayment of repurchase agreement borrowings on a gross basis on the Statement of Cash Flows.

Linked Transactions

In instances where the Company acquires securities through repurchase agreements with the same counterparty from which the securities were purchased, the Company accounts for the purchase commitment and repurchase agreement on a net basis and records a forward commitment to purchase securities as a derivative instrument if the transaction does not comply with the criteria for gross presentation. Such forward commitments are recorded at fair value with subsequent changes in fair value recognized in Gain on linked transactions, net on its Statement of Operations. If the transaction complies with the criteria for gross presentation, the Company records the assets and the related financing on a gross basis in its Balance Sheet and the corresponding interest income and interest expense in its Statement of Operations.

Table of Contents

Share-based compensation

The Company accounts for share-based compensation to its independent directors, to its employees, to its Manager and to employees of its Manager and its affiliates using the fair value based methodology prescribed by GAAP. Compensation cost related to restricted common stock issued to the Company’s independent directors and employees of the Company is measured at its fair value at the grant date, and amortized into expense over the service period on a straight-line basis. Compensation cost related to restricted common stock issued to the Manager and to employees of the Manager and its affiliates is initially measured at fair value at the grant date, and amortized into expense over the vesting period on a straight-line basis and re-measured on subsequent dates to the extent the awards are unvested.

Warrants

The Company evaluates all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the statements of operations. Financial instruments without these features are recorded as a component of equity. For the Company’s warrants, the Company uses a variation of the adjusted Black-Scholes option valuation model to record the financial instruments at their relative fair values at issuance. The warrants issued with the Company’s common stock in the private placement to certain accredited institutional investors on May 15, 2012, were evaluated by the Company and were recorded at their relative fair value as a component of equity at the date of issuance.

Income taxes

The Company intends to elect and qualify to be taxed as a REIT commencing with its taxable year ended December 31, 2012. Accordingly, the Company will generally not be subject to corporate U.S. federal or state income tax to the extent that the Company makes qualifying distributions to stockholders, and provided that the Company satisfies, on a continuing basis, through actual investment and operating results, the REIT requirements including certain asset, income, distribution and stock ownership tests. If the Company fails to qualify as a REIT, and does not qualify for certain statutory relief provisions, the Company will be subject to U.S. federal, state and local income taxes and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year in which the Company lost its REIT qualification. Accordingly, the failure to qualify as a REIT could have a material adverse impact on the Company’s results of operations and amounts available for distribution to stockholders.

The dividends paid deduction for qualifying dividends paid to stockholders is computed using the Company’s taxable income as opposed to net income reported on the financial statements. Taxable income, generally, will differ from net income reported on the financial statements because the determination of taxable income is based on tax provisions and not GAAP.

The Company may create and elect to treat certain subsidiaries as Taxable REIT Subsidiaries (“TRS”). In general, a TRS may hold assets and engage in activities that the Company cannot hold or engage in directly and generally may engage in any real estate or non-real estate-related business. A TRS is subject to U.S. federal, state and local corporate income taxes, and its value may not exceed 25% of the value of the Company. While a TRS will generate net income, a TRS can declare dividends to the Company, which will be included in the Company’s taxable income and necessitate a distribution to its stockholders. Conversely, if the Company retains earnings at the TRS level, no distribution is required and it can increase book equity of the consolidated entity. As of December 31, 2012, the Company did not have a TRS, or any other subsidiary.

The Company evaluates uncertain tax positions, if any, and classifies interest and penalties, if any, related to unrecognized tax benefits as a component of the provision for income taxes.

Offering costs

Offering costs borne by the Company in connection with the IPO and concurrent private placements completed on May 15, 2012 as well as its follow-on public stock offering completed on October 3, 2012 are reflected as a reduction of additional paid-in-capital.

Earnings per share

GAAP requires use of the two-class method of computing earnings per share for all periods presented for each class of common stock and participating securities as if all earnings for the period had been distributed. Under the two-class method, during periods of net income, the net income is first reduced for dividends declared on all classes of securities to arrive at undistributed earnings. During periods of net losses, the net loss is reduced for dividends declared on participating securities only if the security has the right to participate in the earnings of the entity and an objectively determinable contractual obligation to share in net losses of the entity.

Table of Contents

The remaining earnings are allocated to common stockholders and participating securities, to the extent that each security shares in earnings, as if all of the earnings for the period had been distributed. Each total is then divided by the applicable number of shares to arrive at basic earnings per share. For the diluted earnings, the denominator includes all outstanding common shares and all potential common shares assumed issued if they are dilutive. The numerator is adjusted for any changes in income or loss that would result from the assumed conversion of these potential common shares.

Comprehensive Income (Loss)

The Company has none of the components of comprehensive income (loss) and therefore comprehensive income (loss) is not presented.

Accounting standards applicable to emerging growth companies

The JOBS Act contains provisions that relax certain requirements for “emerging growth companies”, which includes the Company. For as long as the Company is an emerging growth company, which may be up to five full fiscal years, unlike other public companies, the Company will not be required to: (i) comply with any new or revised financial accounting standards applicable to public companies until such standards are also applicable to private companies under Section 102(b)(1) of the JOBS Act; (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of the Company’s system of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act; (iii) comply with any new requirements adopted by the PCAOB requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer; or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise.

As noted above, under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards that have different effective dates for public and private companies until such time as those standards apply to private companies. The Company intends to take advantage of such extended transition period. Since the Company will not be required to comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies, its financial statements may not be comparable to the financial statements of companies that comply with public company effective dates. If the Company were to elect to comply with these public company effective dates, such election would be irrevocable pursuant to Section 107 of the JOBS Act.

Recent accounting pronouncements

Accounting Standards Adopted in 2013

In December 2011, the FASB issued guidance requiring additional disclosure information about offsetting and related arrangements. Further in December 2012, the FASB proposed an update intended to address implementation of the December 2011 guidance. In January 2013, the FASB issued guidance to limit the scope of the new balance sheet and offsetting disclosure requirements of prior guidance related to certain derivatives (including bifurcated embedded derivatives,) repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions. Entities will be required to disclose both gross information and net information about both instruments and transactions eligible for offset in the balance sheet as well as instruments and transactions subject to an agreement similar to a master netting arrangement. This scope would include derivatives, sale and repurchase agreements and reverse sale and repurchase agreements and securities lending arrangements. The objective of this disclosure is to facilitate comparison between those entities that prepare their financial statements on the basis of GAAP and those entities that prepare their financial statements on the basis of International Financial Reporting Standards. The guidance is effective for periods beginning on or after January 1, 2013 and interim periods within those annual periods. While this guidance did result in certain additional disclosures, it did not have a material impact on the Company’s financial statements.

Note 3 – Fair Value of Financial Instruments

Fair Value Accounting Elections

The Company has elected the fair value option for all of its RMBS, and as a result, all changes in the fair value of such securities are reflected in the results of operations.

Table of Contents

Financial Instruments carried at Fair Value

The following tables present the Company’s financial instruments, carried at fair value as of March 31, 2013 and December 31, 2012, based upon the valuation hierarchy (dollars in thousands):

	March 31, 2013
	Fair Value
	Level I		Level II		Level III		Total
Assets
Agency RMBS	$	-	$	4,145,085	$	-	$	4,145,085
Agency Interest-Only Strips accounted for as derivatives, included in RMBS	-		80,826		-		80,826
Non-Agency RMBS			149,405		-		149,405
Subtotal			4,375,316		-		4,375,316
Derivative assets	-		32,449		-		32,449
Non-Agency linked transactions			22,844		-		22,844
Total	$	-	$	4,430,609	$	-	$	4,430,609

Liabilities
Derivative liabilities	$	-	$	9,698	$	-	$	9,698
Total	$	-	$	9,698	$	-	$	9,698

	December 31, 2012
	Fair value
	Level I		Level II		Level III		Total
Assets
Agency RMBS	$	-	$	5,118,121	$	-	$	5,118,121
Non-Agency RMBS			19,073				19,073
Agency Interest-Only Strips accounted for as derivatives, included in RMBS	-		75,387		-		75,387
Subtotal			5,212,581				5,212,581
Derivative assets	-		24,344		-		24,344
Total	$	-	$	5,236,925	$	-	$	5,236,925

Liabilities
Derivative liabilities	$	-	$	4,771	$	-	$	4,771
Total	$	-	$	4,771	$	-	$	4,771

The Company uses third party pricing services to price its RMBS and derivative instruments. Where available, prices from multiple third party pricing services are compared against each other. Where available, third party pricing is compared against bid/offer pricing from broker-dealers. Finally, trade execution prices are compared to the most recently available price from third party pricing services.

Table of Contents

Other Fair Value Disclosures

Cash and cash equivalents as well as Due from counterparties and Due to counterparties on the Company’s Balance Sheets are reflected at cost which approximates fair value.

The fair value of the repurchase agreements is a Level II fair value measurement, based on an expected present value technique. This method discounts future estimated cash flows using rates the Company determined best estimated current market interest rates that would be offered for loans with similar characteristics and credit quality. The use of different market assumptions or estimation methodologies can have a material effect on the fair value amounts. At March 31, 2013, the Company’s borrowings under repurchase agreements had a fair value of approximately $4.1 billion and a carrying value of approximately $4.1 billion.

Note 4 – Residential Mortgage-Backed Securities

The following table presents certain information about the Company’s investment portfolio at March 31, 2013 and December 31, 2012 (dollars in thousands). Real estate securities that are accounted for as a component of linked transactions are not reflected in the tables set forth in this note. See Note 7 for further details.

	March 31, 2013

	Principal Balance (1)		Unamortized Premium (Discount), net		Non-Accretable Discount	Amortized Cost (1)		Unrealized Gain (Loss ), net			Estimated Fair Value (1)		Net Weighted Average Coupon (2)
Agency RMBS:
20-Year Mortgage	$	864,366	$	46,027	$	$	910,393	$	(3,876	)	$	906,517	3.1%
30-Year Mortgage	2,831,981		246,336			3,078,317		(39,100		)	3,039,217		3.7%
Agency Interest Only- Strips	N/A		N/A			200,516		(1,165		)	199,351		4.3%	(3)

Table of Contents

Agency Interest-Only Strips, accounted for as derivatives (4)	N/A		N/A					N/A		N/A		80,826		5.0%	(3)
Non-Agency RMBS	273,525		(6,951)		(120,480		)	146,094		3,311		149,405		1.4%
Total	$	3,969,872	$	285,412	$	(120,480	)	$	4,335,320	$	(40,830)	$	4,375,316	3.7%

	December 31, 2012

	Principal Balance (1)		Unamortized Premium (Discount), net		Non-Accretable Discount			Amortized Cost		Unrealized Gain (Loss), net		Estimated Fair Value		Net Weighted Average Coupon (2)
Agency RMBS:
20-Year Mortgage	$	299,251	$	20,460	$			$	319,711	$	(827)	$	318,884	3.2%
30-Year Mortgage	4,180,104		352,378					4,532,482		17,489		4,549,971		3.7%
CMO – Fixed rate	66,000		9,776					75,776		(1,546)		74,230		6.5%
Agency Interest Only- Strips	N/A		N/A					176,093		(1,057)		175,036		4.5%	(3)
Agency Interest-Only Strips, accounted for as derivatives (4)	N/A		N/A					N/A		N/A		75,387		4.9%	(3)
Non-Agency RMBS	37,372		(5,511)		(12,659		)	19,202		(129)		19,073		0.5%
Total	$	4,582,727	$	377,103	$	(12,659	)	$	5,123,264	$	13,930	$	5,212,581	3.9%

(1) Includes unsettled purchases with an aggregate cost of $211,736 and fair value of $212,732 at March 31, 2013.

(2) Net weighted average coupon as of March 31, 2013 and December 31, 2012 is presented, net of servicing and other fees.

(3) Agency Interest-Only Strips and Agency Inverse Interest-Only Strips, accounted for as derivatives have no principal balances and earn contractual interest based on a notional balance. The notional balance is used solely to determine interest distributions on interest-only class of securities.

(4) Interest on these securities is reported as a component of Gain on derivative instruments, net.

Weighted average expected remaining term to maturity of the investment portfolio is 9.4 years.

The components of the carrying value of the Company’s investment portfolio are as follows:

	March 31, 2013		December 31, 2012

Principal balance	$	3,969,872	$	4,582,727
Amortized cost of IOs and IIOs	200,516		176,093
Carrying value of Agency Interest-Only Strips accounted for as derivatives	80,826		75,387
Unamortized premium	292,363		382,614
Unamortized discount	(6,951)		(5,511)
Non-Accretable discount	(120,480)		(12,659)
Gross unrealized gains	8,385		25,395
Gross unrealized losses	(49,215)		(11,465)
Fair value	$	4,375,316	$	5,212,581

As of March 31, 2013, the Company held Agency RMBS with a fair value of approximately $3.4 billion in an unrealized loss position of approximately $49.1 million. As of March 31, 2013, the Company held Non-Agency RMBS with a fair value of approximately $24.6 million in an unrealized loss position of approximately $159 thousand. As of March 31, 2013, the Company held no investments in an unrealized loss position for greater than one year. At March 31, 2013, the Company identified two securities it intended to sell and as a result the Company recognized an impairment charge of approximately $1.1 million on RMBS which is included in Other loss on Residential mortgage-based securities and other securities, net, held at March 31, 2013. At March 31, 2013, the Company did not intend to sell any other of its Agency RMBS that were in an unrealized loss position, and it is “more likely than not” that the Company will not be required to sell these RMBS before recovery of their amortized cost basis, which may be at their maturity.

The Company assesses its Agency RMBS and Non-Agency RMBS rated AA and higher at the time of purchase for other-than-temporary impairment on at least 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.” In deciding on whether or not a security is other than temporarily impaired, the Company considers several factors, including the nature of the investment, communications (if any) from the trustees of securitizations regarding the credit quality of the security, the severity and duration of the impairment, the cause of the impairment, and the Company’s intent that it is more likely than not that the Company can hold the security until recovery of its cost basis. The Company’s prepayment speed estimate is the primary assumption used to determine other-than temporary-impairments for Agency IOs and IIOs for the three months ended March 31, 2013. The Company recorded other than temporary impairments for the three months ended March 31, 2013 of approximately $2.3 million for Agency IOs, Agency IIOs and 20-year Agency RMBS which is reported as Other loss on Residential mortgage-backed securities in the Company’s Statement of Operations.

Table of Contents

For Non-Agency RMBS that are purchased at a discount to par value and are rated below AA at the time of purchase and Agency Interest-Only Strips that are not classified as derivatives, an other-than-temporary impairment is deemed to have occurred when there is an adverse change in the expected cash flows (principal or interest) to be received and the fair value of the beneficial interest is less than its carrying amount. These adjustments are reflected in the Company’s Statement of Operations as Other loss on Residential mortgage-backed securities. In determining whether an adverse change in cash flows occurred, the present value of the remaining cash flows, as estimated at the initial transaction date (or the last date previously revised), is compared to the present value of the expected cash flows at the current reporting date. The estimated cash flows reflect those a “market participant” would use and are discounted at a rate equal to the current yield used to accrete interest income. If an other-than-temporary impairment is recognized as a result of this analysis, the yield is maintained at the current accretion rate. The last revised estimated cash flows are then used for future impairment analysis purposes. The Company recorded no other than temporary impairments for the three months ended March 31, 2013 for Non-Agency RMBS.

The following table presents components of interest income on the Company’s RMBS (dollars in thousands).

	For the three months ended March 31, 2013

			Net (Premium
	Coupon		Amortization/ Amortization Basis) Discount		Interest
	Interest		Amortization		Income
Agency RMBS	$	50,519	$	(18,349)	$	32,170
Non-Agency RMBS	482		1,098		1,580
Total	$	51,001	$	(17,251)	$	33,750

The Company sold Agency RMBS during the three months ended March 31, 2013 for gross proceeds of approximately $1.8 billion realizing net losses of approximately $11.8 million, comprised of gross gains of approximately $8.6 million and gross losses of approximately $20.4 million.

Note 5 – Borrowings under Repurchase Agreements

As of March 31, 2013, the Company had master repurchase agreements with 17 counterparties and was in discussions with additional financial institutions in order to potentially provide the Company with additional repurchase agreement capacity. As of March 31, 2013, the Company had borrowings under repurchase agreements with 14 counterparties. For the three months ended March 31, 2013, the Company had average borrowings under its repurchase agreements of approximately $4.6 billion, had a maximum month-end balance during the period of approximately $4.8 billion and accrued interest payable of approximately $1.5 million.

The repurchase agreements bear interest at a contractually agreed-upon rate and typically have terms ranging from one month to three months. The Company’s repurchase agreement borrowings are accounted for as secured borrowings when the Company maintains effective control of the financed assets. Under the repurchase agreements, the respective lender retains the right to determine the fair value of the underlying collateral. A reduction in the value of pledged assets requires the Company to post additional securities as collateral, pay down borrowings or establish cash margin accounts with the counterparties in order to re-establish the agreed-upon collateral requirements, referred to as margin calls. The inability of the Company to post adequate collateral for a margin call by the counterparty, in a timeframe as short as the close of the same business day, could result in a condition of default under the Company’s repurchase agreements, thereby enabling the counterparty to liquidate the collateral pledged by the Company, which may have an adverse effect on the Company’s financial condition and results of operations. All of the Company’s repurchase agreement counterparties are either U.S. financial institutions or the U.S. broker-dealer subsidiaries of foreign financial institutions.

Further, if the Company is unable to renew, replace or expand repurchase financing with other sources of financing on substantially similar terms it may have an adverse effect on the Company’s business and results of operations, due to the long term nature of the Company’s investments and relatively short-term maturities of the Company’s repurchase agreements. The financial covenants of certain of the repurchase agreements require the Company to maintain certain equity and leverage metrics, the most restrictive of which include a limit on leverage based on the composition of the Company’s portfolio. The Company is in compliance with these covenants for the three months ended and at March 31, 2013.

Table of Contents

The following tables summarize certain characteristics of the Company’s repurchase agreements at March 31, 2013 and December 31, 2012 (dollars in thousands):

	March 31, 2013
RMBS Pledged	Repurchase Agreement Borrowings		Weighted Average Interest Rate on Borrowings Outstanding at end of period		Weighted Average Remaining Maturity (days)
Agency RMBS	$	3,975,546	0.42	%	23
Non-Agency RMBS	79,384		1.84	%	51
Total	$	4,054,930	0.45	%	24

	December 31, 2012
RMBS Pledged	Repurchase Agreement Borrowings		Weighted Average Interest Rate on Borrowings Outstanding at end of period		Weighted Average Remaining Maturity (days)
Agency RMBS	$	4,794,730	0.48	%	19
Total	$	4,794,730	0.48	%	19

At March 31, 2013, repurchase agreements collateralized by RMBS had the following remaining maturities.


(dollars in thousands)	Balance

Overnight	$	-
1 to 29 days	3,017,438
30 to 59 days	475,513
60 to 89 days	561,979
90 to 119 days	-
Greater than or equal to 120 days	-

Total	$	4,054,930

As discussed in Note 2, for any transactions determined to be linked, the initial transfer and repurchase financing will be recorded as a forward commitment to purchase assets. At March 31, 2013, the Company had repurchase agreements of approximately $43.9 million that were accounted for as linked transactions. At December 31, 2012, the Company had no transactions determined to be linked. These linked repurchase agreements are not included in the above tables. See Note 7 for details.

At March 31, 2013, the following table reflects amounts at risk under its repurchase agreements greater than 10% of the Company’s equity with any counterparty, excluding linked transactions.

	March 31, 2013		(dollars in thousands)
Counterparty	Amount at Risk		Weighted Average Remaining Maturity (days)	Percentage of Stockholders’ Equity
JP Morgan	$	54,815	13	11.1%

At March 31, 2013, the Company had repurchase agreements determined to be linked. The amount at risk including linked transactions to JP Morgan is $59.2 million, with 13 weighted average remaining days to maturity, representing approximately 12.0% of stockholders’ equity and Credit Suisse is $53.5 million with 63 weighted average remaining days to maturity, representing approximately 10.8% of stockholders’ equity.

Table of Contents

Note 6 – Collateral Positions

The following tables summarize the Company’s collateral positions, with respect to its borrowings under repurchase agreements, derivatives and clearing margin account at March, 31, 2013 and December 31, 2012 (dollars in thousands):

	March 31, 2013
	Assets Pledged- Fair Value		Accrued Interest		Fair Value of Assets Pledged and Accrued Interest
Assets pledged for borrowings under repurchase agreements:
Agency RMBS	$	4,211,798	$	13,353	$	4,225,150
Non-Agency RMBS	129,737		259		129,996
Cash (1)	18,269		-		18,269
Cash collateral for derivatives (1):	21,077		-		21,077
Total	$	4,380,881	$	13,612	$	4,394,492

	December 31, 2012
	Assets Pledged - Fair Value		Accrued Interest, as revised(2)		Fair Value of Assets Pledged and Accrued Interest, as revised(2)
Assets pledged for borrowings under repurchase agreements:
Agency RMBS	$	5,043,824	$	15,552	$	5,059,376
Cash(1)	35,982		-		35,982
Cash collateral for derivatives(1):	18,160		-		18,160
Total	$	5,097,966	$	15,552	$	5,113,518

(1) Cash posted as collateral is included in Due from counterparties on the Company’s Balance Sheets.

(2) The accrued interest related to Agency RMBS was incorrectly disclosed as $67,551 in prior disclosure, and has been revised above.

A reduction in the value of pledged assets typically results in the repurchase agreement counterparties, derivative counterparties and clearing margin counterparties initiating a daily margin call. At March 31, 2013 and December 31, 2012, RMBS held by counterparties as security for repurchase agreements totaled approximately $4.3 billion and $5.0 billion, respectively. Cash collateral held by counterparties at March 31, 2013 and December 31, 2012 was approximately $39.3 and $54.1 million, respectively.

Note 7 – Derivative Instruments

The Company’s derivatives currently include interest rate swaps (“interest rate swaps”), interest rate swaptions, TBAs, linked transactions, options and Agency Interest-Only Strips that are classified as derivatives.

Interest rate swaps and interest rate swaptions

The Company is exposed to certain risk arising from both its business operations and economic conditions. Specifically, the Company’s primary source of debt funding is repurchase agreements and the Company enters into derivative financial instruments to manage exposure to variable cash flows on portions of its borrowings under those repurchase agreements. Since the interest rates on repurchase agreements typically change with market interest rates such as the London interbank offered rate or LIBOR, the Company is exposed to constantly changing interest rates, which accordingly affects cash flows associated with these rates on its borrowings. To mitigate the effect of changes in these interest rates, the Company enters into interest rate swap agreements which help to mitigate the volatility in the interest rate exposures and their related cash flows. 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 interest rate swap without exchange of the underlying notional amount.

While the Company has not elected to account for its interest rate swap derivative instruments as “hedges” under GAAP, it does not use derivatives for speculative purposes, but rather uses such instruments to manage interest rate risk and views them as economic hedges. Changes in the fair value of derivatives not designated in hedging relationships are recorded directly in earnings together with or including periodic net interest settlement amounts.

Table of Contents

The Company’s interest rate swap, interest rate swaptions, TBA derivative instruments, linked transactions and options consisted of the following at March 31, 2013 and December 31, 2012 (dollars in thousands):

			March 31, 2013
Derivative Instrument	Designation	Balance Sheet Location	Notional Amount		Fair Value, excluding accrued interest		Accrued Interest Payable, net
Interest rate swaps, assets	Non-Hedge	Derivative assets, at fair value	$	1,650,000	$	15,478	$	4,944
Interest rate swaptions, assets	Non-Hedge	Derivative assets, at fair value	910,000		9,581		-
Options, assets	Non-Hedge	Derivative assets, at fair value	1,000,000		2,386		-
TBA securities, assets	Non-Hedge	Derivative assets, at fair value	426,500		5,004		-
Total derivative instruments, assets			3,986,500		32,449		4,944
Interest rate swaps, liabilities	Non-Hedge	Derivative liability, at fair value	923,750		(5,971)		371
Options, liabilities	Non-Hedge	Derivative liability, at fair value	1,000,000		(1,784)		-
TBA securities, liabilities	Non-Hedge	Derivative liability, at fair value	490,000		(1,943)		-
Total derivative instruments, liabilities			2,413,750		(9,698)		371
Linked transactions (1)	Non-Hedge	Linked transactions, net, at fair value	105,234		22,844		42
Total derivative instruments			$	6,505,484	$	45,595	$	5,357

(1) Notional amount represents the current face of the securities comprising the linked transactions.

			December 31, 2012
Derivative Instrument	Designation	Balance Sheet Location	Notional Amount		Fair Value, excluding accrued interest		Accrued Interest Payable, net
Interest rate swaps, assets	Non-Hedge	Derivative assets, at fair value	$	1,827,300	$	11,201	$	2,519
Interest rate swaptions, assets	Non-Hedge	Derivative assets, at fair value	520,000		10,087		-
TBA securities, assets	Non-Hedge	Derivative assets, at fair value	425,000		3,056		-
Total derivative instruments, assets			2,772,300		24,344		2,519
Interest rate swaps, liabilities	Non-Hedge	Derivative liability, at fair value	984,500		(3,552)		588
TBA securities, liabilities	Non-Hedge	Derivative liability, at fair value	425,000		(1,219)		-
Total derivative instruments, liabilities			1,409,500		(4,771)		588
Total derivative instruments			$	4,181,800	$	19,573	$	3,107

The following tables summarize the average fixed pay rate and average maturity for the Company’s interest rate swaps as of March 31, 2013 and December 31, 2012 (excludes interest rate swaptions) (dollars in thousands):

	March 31, 2013
Remaining Interest Rate interest rate swap Term	Notional Amount		Average Fixed Pay Rate		Average Maturity (Years)	Forward Starting

Greater than 1 year and less than 3 years	$	572,300	0.4	%	2.1	40.6	%
Greater than 3 years and less than 5 years	394,500		0.8		4.6	-
Greater than 5 years	1,606,950		1.9		10.7	31.7

Total	$	2,573,750	1.4	%	7.9	28.8	%

	December 31, 2012
Remaining Interest Rate interest rate swap Term	Notional Amount		Average Fixed Pay Rate		Average Maturity (Years)	Forward Starting

Greater than 1 year and less than 3 years	$	762,800	0.4	%	2.3	22.7	%
Greater than 3 years and less than 5 years	439,500		0.8		4.8	10.2
Greater than 5 years	1,609,500		1.7		10.2	30.1

Total	$	2,811,800	1.2	%	7.2	25.0	%

The Company’s agreements with certain of its interest rate swap counterparties may be terminated at the option of the counterparty if the Company does not maintain certain equity and leverage metrics, the most restrictive of which contain provisions which become more restrictive based upon portfolio composition. Through March 31, 2013, the Company was in compliance with the terms of such financial tests.

At March 31, 2013, the Company held three swaptions with notional amounts of $445.0 million, $75.0 million and $390.0 million, respectively, that expire in six months, four months and 15 days, respectively. If exercised, the Company can enter into a 20 year fixed pay swap agreement, a 10 year fixed pay swap agreement and a 10 year fixed pay swap agreement, respectively at a predetermined strike price.

At March 31, 2013, the Company purchased put options for TBAs with a total notional amount of $1.0 billion and sold put options for TBAs with a total notional amount of $1.0 billion. The Company paid premiums of approximately $4.7 million for the put options purchased and received premiums of approximately $3.7 million for the put options sold. The purchase and sold put options expire in May 2013. The fair value of the purchased put options and put options sold is approximately $2.4 million and approximately $1.8 million, respectively at March 31, 2013.

Table of Contents

The Company has minimum collateral posting thresholds with certain of its derivative counterparties, for which it typically pledges cash. As of March 31, 2013 and December 31, 2012, the Company had cash pledged as collateral of approximately $21.1 and $18.2 million, respectively, which is reported on the Balance Sheets as Due from counterparties. As of March 31, 2013, the Company has swaps with two counterparties that are based in England and Switzerland with fair values in an asset position of approximately $1.0 million and fair values in a liability position of approximately $515 thousand and notional balances of $635.7 million and $1.2 billion, respectively.

Agency Interest-Only Strips

The Company also invests in Agency Interest-Only Strips. The Company has evaluated the terms and conditions of its holdings of Agency Interest-Only Strips to determine if these instruments have the characteristics of investments or would be considered derivatives under GAAP. Accordingly, Agency Interest-Only Strips having the characteristics of derivatives have been accounted for at fair value with changes in recognized in Gain on derivative instruments, net in the Statement of Operations, along with any interest received. The carrying value of these Agency Interest-Only Strips is included in Residential mortgage-backed securities on the Balance Sheet.

To-be-announced securities

The Company also purchased or shorted TBAs. As of March 31, 2013 and December 31, 2012, the Company had contracts to purchase (“long position”) and sell (“short position”) TBAs on a forward basis. Following is a summary of the Company’s long and short TBA positions reported in Derivative assets, at fair value on the Balance Sheets as of March 31, 2013 and December 31, 2012 (dollars in thousands):

		March 31, 2013				December 31, 2012
		Notional Amount		Fair Value		Notional Amount		Fair Value
Purchase contracts, asset	$		601,500	$	4,422	$	425,000	$	3,056
Sale contracts, asset		(175,000)		582
TBA securities, asset		426,500		5,004		425,000		3,056
Purchase contracts, liability		-		-		--		-
Sale contracts, liability		(490,000)		(1,943)		(425,000)		(1,219)
TBA securities, liability		(490,000)		(1,943)		(425,000)		(1,219)
TBA securities, net	$		(63,500)	$	3,061	$	-	$	1,837

		Notional Amount as of December 31, 2012		Additions		Settlement, Termination, Expiration or Exercise		Notional Amount as of March 31, 2013
Purchase of TBAs	$		425,000	1,191,500		$	(1,015,000)	$	601,500
Sale of TBAs	$		425,000	1,255,000		$	(1,015,000)	$	665,000

The following table summarizes the effect of interest rate swaps, swaptions, options, Agency Interest-Only Strips as derivatives and TBAs reported in Gain on derivative instruments, net on the Company’s Statement of Operations for the three months ended March 31, 2013 (dollars in thousands):

Description	Realized Gain (Loss), net		Contractual interest income (expense), net(1)		Basis Recovery		Mark-to- market adjustments		Total

Interest rate swaps	$	18,258	$	(4,582)	$	-	$	1,858	$	15,534
Interest rate swaptions	-		-		-		(1,506)		(1,506)
Agency Interest-Only Strips and Agency Inverse Interest-Only Strips- accounted for as derivatives	(99)		5,943		(4,185)		(2,348)		(689)
Options	-		-		-		(324)		(324)
TBAs	601		-		-		1,224		1,825
Total	$	18,760	$	1,361	$	(4,185)	$	(1,096)	$	14,840

(1) Contractual interest income (expense), net on derivative instruments includes interest settlement paid or received.

Table of Contents

Linked Transactions

As discussed in Note 2, when the initial transfer of a financial asset and repurchase financing are entered into contemporaneously with, or in contemplation of, one another, the transaction will be considered linked unless all of the criteria found in the guidance are met at the inception of the transaction. If the transaction is determined to be linked, the Company records the initial transfer and repurchase financing on a net basis and records a forward commitment to purchase assets as a derivative instrument with changes in market value being recorded on the Statement of Operations. While linked transactions are treated as derivatives for GAAP, the fair value of linked transactions reflects the value of the underlying security’s fair market value netted with the respective linked repurchase agreement borrowings. For the quarter ended March 31, 2013, the Company has no transactions became unlinked. The Company had no linked transactions at December 31, 2012.

The following table presents certain information related to the securities and repurchase agreements accounted for as part of linked transaction which is reported in Linked transactions, net, at fair value on the Balance Sheet and in Gain on linked transactions, net on the Statement of Operations for the year ended March 31, 2013 (dollars in thousands):

								For the Year Ended March 31, 2013
Instrument	Current Face		Amortized Cost			Fair Value		Net Interest Income(1) (Expense)		Mark-to-market adjustments on linked transactions		Net Realized Gain		Gain on linked transactions, net	Weighted Average Coupon / Cost of Funds		Weighted Average Life (years)/ Weighted Average days to Maturity
Non-Agency RMBS	$	105,234	$	66,393	$	66,715	$	435	$	250	$	-	$	685	0.8	%	6.7 years
Non-Agency Repurchase Agreement	(43,871)		(43,871)			(43,871)		(89)		-		-		(89)	1.85	%	37 days
Linked transactions, net, at fair value	$	61,363	$	22,522	$	22,844	$	346	$	250	$	-	$	596	n/a		n/a

(1) Net interest income includes accretion of $329 thousand.

At March 31, 2013, the Company had posted cash of approximately $21.1 million pledged as collateral against its derivatives. The Company also pledged assets accounted for within linked transactions with a fair value of approximately $66.7 million as collateral against the related linked repurchase agreements. The Company reduces credit risk on the majority of its derivative instruments by entering into agreements that permit the closeout and netting of transactions with the same counterparty upon occurrence of certain events.

Note 8 — Offsetting Assets and Liabilities

The following tables present information about certain assets and liabilities that are subject to master netting agreements (or similar agreements) and can potentially be offset on the Company’s balance sheets at March 31, 2013 and December 31, 2012:

Offsetting of Derivative Assets

As of March 31, 2013

								Gross Amounts Not Offset in the Balance Sheet
$s in thousands Description		Gross Amounts of Recognized Assets		Gross Amounts Offset in the Balance Sheet		Net Amounts of Assets presented in the Balance Sheet		Financial Instruments (1)		Cash Collateral Received		Net Amount
Agency Interest-Only Strips, accounted for as derivatives included in RMBS	$	80,826	$	-	$	80,826	$	(54,161)	$	-	$	26,665
Derivative asset, at fair value		32,449		-		32,449		(6,604)		-		25,845
Linked Transactions		66,715		(43,871)		22,844		-		-		22,844
Total	$	179,990	$	(43,871)	$	136,119	$	(60,765)	$	-	$	75,354

Offsetting of Derivative Liabilities and Repurchase agreements

As of March 31, 2013

								Gross Amounts Not Offset in the Balance Sheet
$s in thousands Description		Gross Amounts of Recognized Liabilities		Gross Amounts Offset in the Balance Sheet		Net Amounts of Liabilities presented in the Balance Sheet		Financial Instruments (1)		Cash Collateral Pledged(1)		Net Amount
Derivative liability, at fair value(2)	$	9,698	$	-	$	9,698	$	(6,604)	$	(1,101)	$	1,993
Repurchase Agreements(3)		4,054,930		-		4,054,930		(4,054,930)		-		-
	$	4,064,628	$	-	$	4,064,628	$	(4,061,534)	$	(1,101)	$	1,993

Table of Contents

Offsetting of Derivative Assets

As of December 31, 2012

								Gross Amounts Not Offset in the Balance Sheet
$s in thousands Description		Gross Amounts of Recognized Assets		Gross Amounts Offset in the Balance Sheet		Net Amounts of Assets presented in the Balance Sheet		Financial Instruments (1)		Cash Collateral Received		Net Amount
Agency Interest-Only Strips, accounted for as derivatives included in RMBS	$	75,387	$	-	$	75,387	$	(46,686)	$	-	$	28,701
Derivative asset, at fair value		24,344		-		24,344		(3,552)		-		20,792
Total	$	99,731	$	-	$	99,731	$	(50,238)	$	-	$	49,493

Offsetting of Derivative Liabilities and Repurchase agreements

As of December 31, 2012

								Gross Amounts Not Offset in the Balance Sheet
$s in thousands Description		Gross Amounts of Recognized Liabilities		Gross Amounts Offset in the Balance Sheet		Net Amounts of Liabilities presented in the Balance Sheet		Financial Instruments (1)		Cash Collateral Pledged(1)		Net Amount
Derivative liability, at fair value(2)	$	4,771	$	-	$	4,771	$	(3,552)	$	-	$	1,219
Repurchase Agreements(3)		4,794,730		-		4,794,730		(4,794,730)				-
Total	$	4,799,501	$	-	$	4,799,501	$	(4,798,282)	$	-	$	1,219

(1) Amounts disclosed in the Financial Instruments column of the table above represents collateral pledged that is available to be offset against liability balances associated with repurchase agreement and derivative transactions. Amounts disclosed in the Cash Collateral Pledged column of the table above represents amounts pledged as collateral against derivative transactions.

(2) Cash collateral pledged against the Company’s Swaps was approximately $21.1 million and $18.2 million at March 31, 2013 and December 31, 2012, respectively.

(3) The fair value of securities pledged against the Company’s repurchase agreements was approximately $4.4 billion and $5.1 billion at March 31, 2013 and December 31, 2012, respectively.

Certain of the Company’s repurchase agreement and derivative transactions are governed by underlying agreements that generally provide for a right of setoff in the event of default or in the event of a bankruptcy of either party to the transaction.

Note 9 — Related Party Transactions

Management Agreement

In connection with the Company’s IPO in May 2012, the Company entered into a management agreement (the “Management Agreement”) with the Manager, which describes the services to be provided by the Manager and compensation for such services. The Manager is responsible for managing the Company’s operations, including: (i) performing all of its day-to-day functions other than those provided by the Company’s chief financial officer; (ii) determining investment criteria in conjunction with the board of directors; (iii) sourcing, analyzing and executing investments, asset sales and financings; (iv) performing asset management duties; and (v) performing financial and accounting management, subject to the direction and oversight of the Company’s board of directors. Pursuant to the terms of the Management Agreement, the Manager is paid a management fee equal to 1.50% per annum of the Company’s stockholders’ equity (as defined in the Management Agreement), calculated and payable (in cash) quarterly in arrears. For purposes of calculating the management fee, “stockholders’ equity” means the sum of the net proceeds from any issuances of the Company’s 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, calculated in accordance with GAAP, at the end of the most recently completed fiscal quarter (without taking into account any non-cash equity compensation expense incurred in current or prior periods), less any amount paid for repurchases of the Company’s shares of common stock, excluding any unrealized gains, losses or other non-cash items, including OTTI charges included in other loss on RMBS, unrealized gain on RMBS and other securities and non-cash portion of Loss on derivative instruments, that have impacted stockholder’s equity as reported in the Company’s financial statements prepared in accordance with GAAP, regardless of whether such items are included in other comprehensive income or loss, or in net income, and excluding one-time events pursuant to changes in GAAP and certain other non-cash charges after discussions between the Manager and the Company’s independent directors and after approval by a majority of the Company’s independent directors. However, if the Company’s stockholders’ equity for any given quarter is negative based on the calculation described above, the Manager will not be entitled to receive any management fee for that quarter.

Table of Contents

In addition, the Company may be required to reimburse the Manager for certain expenses as described below. Expense reimbursements to the Manager are made in cash on a monthly basis following the end of each month. The Company’s reimbursement obligation is not subject to any dollar limitation. Because the Manager’s personnel perform certain legal, accounting, due diligence tasks and other services that outside professionals or outside consultants otherwise would perform, the Manager may be paid or reimbursed for the documented cost of performing such tasks, provided that such costs and reimbursements are in amounts which are no greater than those which would be payable to outside professionals or consultants engaged to perform such services pursuant to agreements negotiated on an arm’s-length basis.

The Management Agreement may be amended, supplemented or modified by agreement between the Company and the Manager. The initial term of the Management Agreement expires on May 15, 2015 and it is automatically renewed for one-year terms on each anniversary thereafter unless previously terminated as described below. The Company’s independent directors will review the Manager’s performance and any fees payable to the Manager annually and, following the initial term, the Management Agreement may be terminated annually upon the affirmative vote of at least two-thirds of the Company’s independent directors, based upon: (i) the Manager’s unsatisfactory performance that is materially detrimental to the Company; or (ii) the Company’s determination that any fees payable to the Manager are not fair, subject to the Manager’s right to prevent such termination due to unfair fees by accepting a reduction of management fees agreed to by at least two-thirds (2/3) of the Company’s independent directors. The Company will provide the Manager 180 days prior notice of any such termination. Unless terminated for cause, the Company will pay the Manager a termination fee equal to three times the average annual management fee earned by the Manager during the prior 24-month period immediately preceding the date of termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination.

The Company may also terminate the Management Agreement at any time, including during the initial term, without the payment of any termination fee, with 30 days prior written notice from the Company’s board of directors for cause, which will be determined by a majority of the Company’s independent directors, which is defined as: (i) the Manager’s continued material breach of any provision of the Management Agreement (including the Manager’s failure to comply with the Company’s investment guidelines); (ii) the Manager’s fraud, misappropriation of funds, or embezzlement against the Company; (iii) the Manager’s gross negligence in the performance of its duties under the Management Agreement; (iv) the occurrence of certain events with respect to the bankruptcy or insolvency of the Manager, including an order for relief in an involuntary bankruptcy case or the Manager authorizing or filing a voluntary bankruptcy petition; (v) the Manager is convicted (including a plea of nolo contendere) of a felony; or (vi) the dissolution of the Manager.

For the three months ended March 31, 2013, the Company incurred approximately $2.1 million in management fees. In addition to the management fee, the Company is also responsible for reimbursing the Manager for certain expenses paid by the Manager on behalf of the Company and for certain services provided by the Manager to the Company. For the three months ended March 31, 2013, the Company recorded expenses included in general and administrative expense totaling approximately $9 thousand related to salary or employee benefits associated with the Company’s sole employee paid by the Manager on behalf of the Company. Notwithstanding the foregoing, any such expenses incurred by the Manager and reimbursed by the Company are typically included in the Company’s general and administrative expense on its Statement of Operations, or may be reflected on the Balance Sheet and associated statement of changes in stockholders’ equity, based on the nature of the item. At March 31, 2013 and December 31, 2012, approximately $2.1 million and $1.9 million, respectively, for management fees incurred but not yet paid was included in payable to related party on the Balance Sheets.

Note 10 – Share-Based Payments

In conjunction with the Company’s IPO and concurrent private placement, the Company’s board of directors approved the Western Asset Mortgage Capital Corporation Equity Plan (the “Equity Plan “) and the Western Asset Manager Equity Plan (the “Manager Equity Plan” and collectively the “Equity Incentive Plans”).

On May 15, 2012, the Company granted 51,159 shares of restricted common stock to the Manager under the Manager Equity Plan that is equal to 0.5% of the aggregate number of shares of common stock sold in the IPO and units sold in the concurrent private placement to certain institutional accredited investors. These shares vest on each of the first, second and third anniversaries of the grant date.

Table of Contents

On May 15, 2012, the Company granted a total of 4,500 shares (1,500 each) of restricted common stock under the Equity Plan to the Company’s three independent directors. These restricted shares will vest in full on the first anniversary of the grant date.

On June 25, 2012, the Company granted 10,455 shares of restricted common stock to its chief financial officer under the Equity Plan. One-third of these restricted shares vested on January 1, 2013, one-third will vest on January 1, 2014 and the remaining one-third will vest on January 1, 2015.

On March 1, 2013, the Company granted a total of 150,000 shares of restricted common stock to the Manager under the Manager Equity Plan. These shares vest on each of the first, second and third anniversaries of the grant date.

On March 1, 2013, the Company granted 10,559 shares of restricted common stock to its chief financial officer under the Equity Plan. One-third of these restricted shares will vest on January 1, 2014, one-third will vest on January 1, 2015 and the remaining one-third will vest on January 1, 2016.

The Equity Incentive Plans include provisions for grants of restricted common stock and other equity-based awards to the Manager, its employees and employees of its affiliates and to the Company’s directors, officers and employees. The Company can issue up to 3.0% of the total number of issued and outstanding shares of its common stock (on a fully diluted basis) at the time of each award (other than any shares previously issued or subject to awards made pursuant to one of our Equity Incentive Plans) under these Equity Incentive Plans. At May 15, 2012, there were 308,335 shares of common stock initially reserved for issuance under the Equity Incentive Plans. Upon the completion of the October 3, 2012 follow-on common stock offering, the number of shares of common stock available for issuance under the Equity Incentive Plans increased to 722,335, inclusive of the 226,673 enumerated above. The Company recognized stock-based compensation expense of approximately $286 thousand for the three months ended March 31, 2013 and has unamortized compensation expense of approximately $4.1 million and $1.2 million at March 31, 2013 and December 31, 2012.

All restricted common shares granted possess all incidents of ownership, including the right to receive dividends and distributions, and the right to vote. The award agreements include restrictions whereby the restricted shares cannot be sold, assigned, transferred, pledged, hypothecated or otherwise disposed of prior to the lapse of restrictions under the respective award agreement. The restrictions lapse on the unvested restricted shares awarded when vested, subject to the grantee’s continuing to provide services to the Company as of the vesting date. Unvested restricted shares and rights to dividends thereon are forfeited upon termination of grantee.

The following is a summary of restricted common stock vesting dates as of March 31, 2013 and December 31, 2012:

	March 31, 2013	December 31, 2012

Vesting Date	Shares Vesting	Shares Vesting
January 2013	-	3,485
May 2013	21,553	21,553
January 2014	7,005	3,485
March 2014	50,000	-
May 2014	17,053	17,053
January 2015	7,005	3,485
March 2015	50,000	-
May 2015	17,053	17,053
January 2016	3,519	-
March 2016	50,000	-
	223,188	66,114

The following table presents information with respect to the Company’s restricted stock for the period ended March 31, 2013:

	Shares of Restricted Stock	Weighted Average Grant Date Fair Value (1)
Outstanding at beginning of period	66,114	$	19.86
Granted	160,559	$	21.31
Cancelled/forfeited	-	$	-
Outstanding at March 31, 2013	226,673	$	20.89
Unvested at March 31, 2013	223,188	$	20.92

(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.

Table of Contents

Note 11 – Shareholders Equity

On May 9, 2012, the Company entered into: (i) a binding underwriting agreement with a group of underwriters to sell 8.0 million shares of the Company’s common stock for $20.00 per share for an aggregate offering price of $160.0 million; (ii) unit purchase agreements, pursuant to a private placement, with certain institutional accredited investors to sell 2,231,787 warrant units for $20.00 per unit for an aggregate offering price of approximately $44.6 million; and (iii) an agreement to sell 46,043 shares of the Company’s common stock, for $20.00 per share to our Manager’s deferred compensation plan in another private placement for an aggregate offering price of approximately $0.9 million.

Each of the aforementioned warrant units consists of one share of the Company’s common stock and a warrant to purchase 0.5 of a share of the Company’s common stock. At the time of issuance, each warrant had an exercise price of $20.50 per share, subject to adjustment upon the occurrence of customary events triggering an anti-dilution adjustment and certain sales of the Company’s common stock (see discussion below). In addition, the warrants are subject to certain limitations on exercise. The warrants expire on May 15, 2019. On October 3, 2012, as a result of the follow-on offering the exercise price of the warrants was reduced from $20.50 to $19.44.

The net proceeds to the Company from the IPO and two concurrent private placements were approximately $204.4 million, net of offering expenses of $1.2 million for which the Company agreed to be responsible. The Manager agreed to be responsible for all offering expenses in excess of $1.2 million, including the underwriting discount and the placement agent fees in the two private placements (in the aggregate, approximately $7.8 million).

On September 27, 2012, the Company entered into a binding agreement with a group of underwriters to sell an incremental 12.0 million shares of the Company’s common stock, effective as of September 28, 2012, which closed on October 3, 2012. The agreement provided the underwriters with the right to purchase an additional 1.8 million shares (15% of 12.0 million) during the succeeding thirty (30) days. The shares were offered to the market at a price of $22.20 per share and the underwriters exercised their option to purchase the incremental 1.8 million shares on September 28, 2012. Net proceeds to the Company were approximately $301.0 million after subtracting underwriting commissions and offering expenses of approximately $4.8 million. In addition the Company incurred offering costs of approximately $559 thousand.

On November 19, 2012, the Board of Directors of the Company approved the repurchase of up to 2.4 million shares of its common stock through December 31, 2013, either in the open market or through privately-negotiated transactions. The repurchase program is expected to be completed during 2013, and does not obligate the Company to acquire any particular amount of common stock. The Company made no share repurchases for the three months ended March 31, 2013.

Note 12 – Net Income per Common Share

The table below presents basic and diluted net income per share of common stock for the three months ended March 31, 2013 (dollars, other than shares and per share amounts, in thousands):

	Three Months Ended March 31, 2013
Numerator:
Net loss attributable to common stockholders and participating securities for basic and diluted earnings per share	$	(28,499)

Denominator:
Weighted average common shares outstanding for basic earnings per share	24,206,170
Weighted average diluted shares outstanding (stock awards)	-
Weighted average diluted shares outstanding (warrants)	-
Weighted average common share outstanding for diluted earnings per share	24,206,170

Basic earnings per common share	$	(1.18)

Diluted earnings per common share	$	(1.18)

Table of Contents

The following potential common shares were excluded from diluted earnings per share for the three months ended March 31, 2013 as the Company had a net loss for the period: 11,463 related to stock awards and 121,357 for outstanding warrants to purchase the Company’s stock.

Note 13 – Income Taxes

Based on the Company’s analysis of any potential uncertain income tax positions, the Company concluded that it does not have any uncertain tax positions that meet the recognition or measurement criteria as of March 31, 2013. In the event that the Company incurs income tax related interest and penalties, the Company’s policy is to classify them as a component of provision for income taxes.

Note 14 – Contingencies

From time to time, the Company may become involved in various claims and legal actions arising in the ordinary course of business. Management is not aware of any material contingencies at March 31, 2013.

Note 15 – Subsequent Events

On April 1, 2013, the Company declared a dividend of $0.95 per share payable to shareholders of record as of April 12, 2013 and payable on April 30, 2013.

Table of Contents

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

FORWARD-LOOKING INFORMATION

The Company makes forward-looking statements herein and will make forward-looking statements in future filings with the Securities and Exchange Commission (the “SEC”), press releases or other written or oral communications within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). For these statements, the Company claims the protections of the safe harbor for forward-looking statements contained in such sections. Forward-looking statements are subject to substantial risks and uncertainties, many of which are difficult to predict and are generally beyond the Company’s control. These forward-looking statements include information about possible or assumed future results of the Company’s business, financial condition, liquidity, results of operations, plans and objectives. When the Company uses the words “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” or similar expressions, the Company intends to identify forward-looking statements. Statements regarding the following subjects, among others, may be forward-looking: market trends in the Company’s industry, interest rates, real estate values, the debt securities markets, the U.S. housing market or the general economy or the demand for residential mortgage loans; the Company’s business and investment strategy; the Company’s projected operating results; actions and initiatives of the U.S. Government and changes to U.S. Government policies and the execution and impact of these actions, initiatives and policies; the state of the U.S. economy generally or in specific geographic regions; economic trends and economic recoveries; the Company’s ability to obtain and maintain financing arrangements, including securitizations; the current potential return dynamics available in Agency residential mortgage-backed securities (“RMBS”) (as defined herein) return dynamics available; the level of government involvement in the U.S. mortgage market; the anticipated default rates on Agency and Non-Agency RMBS (as defined herein); the loss severity on Non-Agency RMBS; the return of the Non-Agency RMBS securitization market; general volatility of the securities markets in which the Company participates; changes in the value of the Company’s assets; the Company’s expected portfolio of assets; the Company’s expected investment and underwriting process; interest rate mismatches between the Company’s target assets and any borrowings used to fund such assets; changes in interest rates and the market value of the Company’s target assets; changes in prepayment rates on the Company’s target assets; effects of hedging instruments on the Company’s target assets; rates of default or decreased recovery rates on the Company’s target assets; the degree to which the Company’s hedging strategies may or may not protect the Company from interest rate volatility; impact of and changes in governmental regulations, tax law and rates, accounting guidance and similar matters; the Company’s ability to maintain the Company’s qualification as a real estate investment trust for U.S. federal income tax purposes; the Company’s ability to maintain its exemption from registration under the Investment Company Act of 1940, as amended (the “1940 Act”); the availability of opportunities to acquire Agency RMBS, Non-Agency RMBS, residential mortgage loans and other residential mortgage assets; the availability of qualified personnel; estimates relating to the Company’s ability to make distributions to its stockholders in the future; and the Company’s understanding of its competition.

The forward-looking statements are based on the Company’s beliefs, assumptions and expectations of its future performance, taking into account all information currently available to it. Forward-looking statements are not predictions of future events. These beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to the Company. Some of these factors are described in Item “1A - Risk Factors” in the Company’s annual report on Form 10-K for the year ended December 31, 2012, as filed on April 9, 2013 with the SEC. These and other risks, uncertainties and factors, including those described in the annual, quarterly and current reports that the Company files with the SEC, could cause its actual results to differ materially from those included in any forward-looking statements the Company makes. All forward-looking statements speak only as of the date they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect the Company. Except as required by law, the Company is not obligated to, and does 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 the Company’s financial statements and the accompanying notes to the Company’s financial statements, which are included in Item 1 of this Quarterly Report on Form 10-Q, as well as the information contained in the Company’s annual report on Form 10-K for the year ended December 31, 2012, as filed on April 9, 2013 with the SEC.

The following defines certain of the commonly used terms in the Management’s Discussion and Analysis of Financial Condition and Results of Operations: “Agency” or “Agencies” refer to a federally chartered corporation, such as the Federal National Mortgage Association (“Fannie Mae” or “FNMA”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac” or “FHLMC”), or an agency of the U.S. Government, such as the Government National Mortgage Association (“Ginnie Mae” or “GNMA”); references to “RMBS” refer to residential mortgage-backed securities, “Agency RMBS” refer to RMBS issued or guaranteed by the Agencies while “Non-Agency RMBS “ refer to RMBS that are not issued or guaranteed by the Agencies; references to “ARMs” refers to adjustable rate mortgages; and references to “Agency Derivatives” or “Agency Interest-Only Strips” refer to interest-only(“IO”) and inverse interest-only (“IIO”) securities issued as part of or collateralized with Agency RMBS.

Table of Contents

Overview

Western Asset Mortgage Capital Corporation (the “Company” unless otherwise indicated or except where the context otherwise requires “we”, “us” or “our”) is primarily focused on investing in, financing and managing Agency RMBS. Although our core investment strategy is focused on Agency RMBS, we have opportunistically supplemented our portfolio with Non-Agency RMBS and may, in the future, opportunistically invest in commercial mortgage-backed securities (“CMBS”) and asset-backed securities (“ABS”), which we, collectively, refer to as our Additional Target Assets. We finance investments in Agency RMBS and our Additional Target Assets primarily through the use of repurchase agreements.

We were organized as a Delaware corporation on June 3, 2009, but did not commence operations until the completion of our IPO on May 15, 2012. We intend to elect and qualify to be taxed as a real estate investment trust (“REIT”), commencing with our taxable year ended December 31, 2012. We generally will not be subject to U.S. federal income taxes on our taxable income to the extent that we annually distribute all of our net taxable income to stockholders and maintain our intended qualification as a REIT. We also intend to operate our business in a manner that will permit us to maintain our exemption from registration under the Investment Company Act of 1940 (“1940 Act”).

We are externally managed and advised by Western Asset Management Company (“WAM”, or the “Manager”), an SEC-registered investment advisor and a wholly-owned subsidiary of Legg Mason, Inc. Our Manager is responsible for administering our business activities and our day-to-day operations, subject to the supervision of our board of directors.

On May 9, 2012, we entered into: (i) a binding underwriting agreement with a group of underwriters to sell 8.0 million shares of our common stock for $20.00 per share in our initial public offering (“IPO”) for an aggregate offering price of $160.0 million; (ii) unit purchase agreements, pursuant to a private placement, with certain institutional accredited investors to purchase 2,231,787 warrant units for $20.00 per unit for an aggregate offering price of approximately $44.6 million; and (iii) a security purchase agreement to sell 46,043 shares of our common stock for $20.00 per share to our Manager’s deferred compensation plan in another private placement for an aggregate offering price of approximately $0.9 million.

The net proceeds from our IPO and concurrent private placements were received on May 15, 2012. The net proceeds to us were approximately $204.4 million, net of offering expenses of $1.2 million for which we agreed to be responsible. Our Manager agreed to be responsible for all offering expenses in excess of $1.2 million, including the underwriting discount and the placement agent fees in the two private placements (in the aggregate, approximately $7.8 million).

On October 3, 2012, we completed a follow-on public offering of 13.8 million shares of common stock, at a price of $22.20 per share. We received net proceeds of approximately $301.0 million, net of underwriting commissions and offering expenses of approximately $5.4 million.

On October 3, 2012, as a result of the follow-on public offering of common stock the exercise price of each of the outstanding warrants was reduced from $20.50 to $19.44.

We have invested the proceeds of our IPO, concurrent private placements and follow-on public offerings primarily in Agency RMBS, including Mortgage pass-through certificates, Agency derivatives, Agency Interest-Only Strips, Agency Inverse Interest-Only Strips, and Agency CMOs, as well as Non-Agency RMBS. We have also used “to-be-announced” forward contracts, or TBAs, in order to invest in Agency RMBS. Pursuant to these TBAs, we agree to purchase, for future delivery, Agency RMBS with certain principal and interest terms. At March 31, 2013, our portfolio was comprised of approximately $4.2 billion of Agency RMBS, approximately $149.4 million of Non-Agency RMBS, exclusive of linked transactions. In addition, at March 31, 2013, our linked transactions include approximately $66.7 million of Non-Agency RMBS.

We use leverage, currently comprised of borrowings under repurchase agreements, as part of our business strategy in order to increase potential returns to stockholders. We accomplish this by borrowing against existing mortgage-backed securities through repurchase agreements. Our investment guidelines contain no limits on the maximum amount of leverage that we may use, and we are not required to maintain any particular debt-to-equity leverage ratio. We may also change our financing strategy and leverage without the consent of stockholders.

As of March 31, 2013, we had entered into master repurchase agreements with 17 counterparties and are in discussions with other financial institutions for additional repurchase agreement capacity. As of March 31, 2013, we had approximately $4.1 billion of borrowings, excluding borrowings on linked transactions, outstanding under our repurchase agreements collateralized by approximately $4.3 billion of RMBS. In addition, at March 31, 2013, our linked transactions include approximately $43.9 million of borrowings under repurchase agreements collateralized by approximately $66.7 million of Non-Agency RMBS.

Table of Contents

We have entered into swaps to effectively fix (for the life of the swap) the floating interest rate of approximately $2.6 billion of borrowings under our repurchase agreements. In addition, as of March 31, 2013, we also owned swaptions on approximately an incremental $0.9 billion of borrowings. As of March 31, 2013, our aggregate GAAP debt-to-equity ratio was approximately 8.2 to 1.

Recent Market Conditions and Strategy

Our business is affected by general U.S. residential real estate fundamentals and the overall U.S. economic environment. In particular, our strategy is influenced by the specific characteristics of these markets, including prepayment rates and interest rate levels. We expect the results of our operations to be affected by various factors, many of which are beyond our control. Our results of operations will primarily depend on, among other things, the level of our net interest income, the market value of our investment portfolio and the supply of and demand for mortgage-related securities. Our net interest income, which includes the amortization of purchase premiums and accretion of discounts, will vary primarily as a result of changes in interest rates, borrowing costs, and prepayment speeds on our RMBS investments, which is a measurement of how quickly borrowers pay down the unpaid principal balance on their residential mortgage loans.

The current economic and market outlook are shaped in a significant manner by the unprecedented level of fiscal and monetary stimulus that the U.S. Government and U.S. Federal Reserve Board provided in the aftermath of the 2008 credit crisis. The current rate environment is characterized by a steep yield curve with the spread between two-year U.S. Treasury Notes and ten-year U.S. Treasury Notes well above the average spread over the last three decades. The U.S. Federal Reserve Board has maintained a near-zero target for the federal funds rate, and has reiterated its commitment to fulfilling its mandate to promote higher growth and lower unemployment and to maintain price stability in the U.S. economy. In December 2012, the U.S. Federal Reserve Board reaffirmed its commitment to maintain its accommodative policies so long as the U.S. unemployment rate exceeded 6.5% and inflation remained below 2.5%. In a press release issued on May 1, 2013, subsequent to its two day policy meeting, the Federal Reserve reiterated this position.

It is our Manager’s view that while recent economic data suggests an improvement in U.S. economic growth, the significant mortgage debt burden, run-off of fiscal stimulus and budget discipline at both the U.S. federal and state level will serve as an impediment to real GDP and employment growth during the balance of 2013. Recent headline inflation data has been relatively modest and we do not believe core rates will increase meaningfully, largely due to a plentiful supply of labor, thereby effectively eliminating wage pressure, and low rates of resource utilization. In its May 1, 2013 press release, the U.S. Federal Reserve reached a similar conclusion, stating that while economic activity has been expanding at a moderate pace and that labor market conditions have shown some improvement, the unemployment rate still remains elevated and longer-term inflation have remained stable. For these reasons, and considering its dual mandate to manage both inflation and unemployment, we believe that the U.S. Federal Reserve Board will exercise patience before unwinding any form of monetary stimulus now in effect. We expect this type of muted recovery to keep the yield curve relatively steep and, barring any system shocks to the capital markets, provide for the strong demand for Agency RMBS to continue.

We believe investors continue to seek incremental spreads relative to U.S. Treasury Notes in a low yield environment and financial institutions continue to prefer high quality, liquid Agency RMBS. Yield spreads on Agency RMBS remain attractive relative to historical spread levels. As the capital markets have recovered, commercial banks have re-entered the secured lending market, which has quickened the pace of asset recovery, and the return to more normalized credit spreads. Financing of Agency and Non-Agency RMBS is currently widely available through, among other vehicles, repurchase agreements. Haircuts, or the discount attributed to the value of securities sold under repurchase agreements, ranging from a low of 3.0% to a high of 5.5% for Agency RMBS, depending on the specific security used as collateral for such repurchase agreements, while haircuts for IOs and IIOs can be as high as 30% and haircuts for Non-Agency RMBS ranging from a low of 30% to a high of 50%.

Toward the end of the 2012 our Manager established a small position of Non-Agency RMBS. Our Manager believes that Non-Agency RMBS can serve as a diversifying hedge in the event interest rates rise. During the three months ended March 31, 2103 our Manager has increased our position in Non-Agency RMBS and may continue to do so while maintaining Agency RMBS as the primary investments for the Company.

The U.S. government, through the FHA, the Federal Deposit Insurance Corporation, or FDIC, and the U.S. Treasury, has commenced or proposed implementation of programs designed to provide homeowners with assistance in avoiding residential mortgage loan foreclosures. These loan modification and refinance programs, future U.S. federal, state and/or local legislative or regulatory actions that result in the modification of outstanding mortgage loans, as well as changes in the requirements necessary to qualify for refinancing mortgage loans with FNMA, FHLMC or GNMA, may adversely affect the value of, and the returns on, residential mortgage loans, RMBS, real estate-related securities and various other asset classes in which we may invest. In addition to the foregoing, the U.S. Congress and/or various states and local legislators may enact additional legislation or regulatory action designed to address the current economic crisis or for other purposes that could have a material adverse effect on our ability to execute our business strategies.

Table of Contents

On January 4, 2012, the U.S. Federal Reserve Board released a report titled “The U.S. Housing Market: Current Conditions and Policy Considerations” to Congress providing a framework for thinking about certain issues and tradeoffs that policy makers might consider. It is unclear how future legislation may impact the housing finance market and the investing environment for agency securities as the method of reform is undecided and has not yet been defined by the regulators.

In a statement issued at the conclusion of its August 1, 2012 meeting, the U.S. Federal Reserve Board acknowledged that despite some signs of improvement, the U.S. housing sector remains depressed. Based on the deceleration in economic and employment growth as well as the expectation for continued low inflation, the U.S. Federal Reserve Board announced that it would continue its highly accommodative fiscal policy and extend through the end of the year its program to extend the average maturity of its holdings of securities by continuing to reinvest principal payments received on its holdings of Agency debt and Agency mortgage-backed securities in additional Agency mortgage-backed securities. This program dubbed “Operation Twist” was originally announced in September 2011. By extending the average maturity of securities held by the U.S. Federal Reserve Board in its portfolio, the expectation is that such action will continue to create downward pressure on longer-term interest rates, which, in turn, will ease financial conditions in the U.S. and provide additional stimulus to support the economic recovery. On May 1, 2013, the U.S. Federal Reserve affirmed its intention to extend what is commonly referred to as “QE3” by continuing to reinvest principal payments received on its Agency mortgage-backed bond portfolio in new Agency mortgage-backed securities and by purchasing an incremental $40 billion of Agency mortgage-backed securities and $45 billion of longer-term Treasury securities each month. The U.S. Federal Reserve Board also announced that it is prepared to increase or decrease the pace of these purchases in order to maintain the appropriate policy accommodation as the outlook for the labor market or inflation changes. In this regard, the U.S. Federal Reserve Board also stated that it expects to continue an accommodative monetary policy after the asset purchase program ends, maintaining the target range for the federal funds rate at 0.00% to 0.25% as long as the U.S. unemployment rate remains above 6.5% and inflation does not exceed 2.5%.

Our Investment Strategy

Our Manager’s investment philosophy, which developed from a singular focus in fixed-income asset management over a variety of credit cycles and conditions, is to provide clients with diversified, tightly controlled, long-term value-oriented portfolios. Through rigorous analysis of all sectors of the fixed-income market, our Manager seeks to identify assets with the greatest risk-adjusted total value potential. In making investment decisions on our behalf, our Manager incorporates its views on the economic environment and the outlook for the mortgage markets, including relative valuation, supply and demand trends, the level of interest rates, the shape of the yield curve, prepayment rates, financing and liquidity, commercial and residential real estate prices, delinquencies, default rates, recovery of various segments of the economy and vintage of collateral, subject to maintaining our REIT qualification and our exemption from registration under the 1940 Act. We benefit from the breadth and depth of our Manager’s overall investment philosophy, which focuses on a macroeconomic analysis as well as an in-depth analysis of individual assets and their relative value.

We rely on our Manager’s expertise in asset allocation and identifying attractive assets within our investment strategy. Although our core investment strategy is currently focused primarily on Agency RMBS, our Manager’s expertise in related investment disciplines such as Non-Agency RMBS, CMBS, and ABS provides our Manager with both: (i) valuable investment insights to our Agency RMBS investment selection and strategy; and (ii) flexibility to invest in assets other than Agency RMBS opportunistically as market conditions warrant.

We currently purchase and sell Agency RMBS and have invested in a limited amount of Non-Agency RMBS. In the future, we may expand our purchase of Non-Agency RMBS as well as purchase and sell our other Additional Target Assets. Our Manager has not and does not expect to purchase securities on our behalf with a view to selling them shortly after purchase. However, in order to maximize returns and manage portfolio risk while remaining opportunistic, we may dispose of securities earlier than anticipated or hold securities longer than anticipated depending upon prevailing market conditions, credit performance, availability of leverage or other factors regarding a particular security or our capital position.

Table of Contents

Our Target Assets

We have invested the proceeds of our IPO, concurrent private placements and follow-on public offering and expect to continue to focus on investing in the following types of securities:

Agency RMBS - Agency RMBS, which are RMBS for which the principal and interest payments are guaranteed by a U.S. Government agency, such as Government National Mortgage Association (“GNMA”), or a U.S. Government-sponsored entity, such as Federal National Mortgage Association (“FNMA”) or Federal Home Loan Mortgage Corporation (“FHLMC”). The Agency RMBS we acquire can be secured by fixed-rate mortgages, adjustable-rate mortgages or hybrid adjustable-rate mortgages. Fixed-rate mortgages have interest rates that are fixed for the term of the loan and do not adjust. The interest rates on adjustable-rate mortgages generally adjust annually (although some may adjust more frequently) to an increment over a specified interest rate index. Hybrid adjustable-rate mortgages have interest rates that are fixed for a specified period of time (typically three, five, seven or ten years) and, thereafter, adjust to an increment over a specified interest rate index. Adjustable-rate mortgages and hybrid adjustable-rate mortgages generally have periodic and lifetime constraints on the amount by which the loan interest rate can change on any predetermined interest rate reset date. As of March 31, 2013, all of our Agency RMBS are secured by fixed-rate mortgages.

Mortgage pass-through certificates. - Mortgage pass-through certificates are securities representing interests in “pools” of mortgage loans secured by residential real property where payments of both interest and scheduled principal, plus pre-paid principal, on the securities are made monthly to holders of the securities, in effect “passing through” monthly payments made by the individual borrowers on the mortgage loans that underlie the securities, net of fees paid to the issuer/guarantor of the securities and servicers of the underlying mortgages.

Agency Derivatives:

Agency Interest-Only Strips or IOs. - This type of security only entitles the holder to interest payments. The yield to maturity of Agency Interest-Only Strips is extremely sensitive to the rate of principal payments (particularly prepayments) on the underlying pool of mortgages. We invest in these types of securities primarily to take advantage of particularly attractive prepayment-related or structural opportunities in the Agency RMBS markets, as well as to help manage the duration of our overall portfolio.

Agency Inverse Interest-Only Strips or IIOs. - This type of security has a coupon with an inverse relationship to its index and is subject to caps and floors. Agency Inverse Interest-Only RMBS entitles the holder to interest only payments based on a notional principal balance, which is typically equal to a fixed rate of interest on the notional principal balance less a floating rate of interest on the notional principal balance that adjusts according to an index subject to set minimum and maximum rates. The value of Agency Inverse Interest-Only RMBS will generally decrease when its related index rate increases and increase when its related index rate decreases.

Collateralized Mortgage Obligations or CMOs. - CMOs are securities that are structured from residential pass-through certificates, which receive monthly payments of principal and interest. CMOs divide the cash flows which come from the underlying mortgage pass-through certificates into different classes of securities that may have different maturities and different weighted average lives than the underlying pass-through certificates.

CMOs involve Agency collateral and include Agency stripped securities, which are mortgage-backed securities structured with two or more classes that receive different distributions of principal or interest on a pool of Agency RMBS. Stripped securities include interest only Agency RMBS and inverse interest only Agency RMBS, each of which we may invest in subject to maintaining our qualification as a REIT.

TBAs. - We may utilize “to-be-announced” forward contracts, or TBAs, in order to invest in Agency RMBS. Pursuant to these TBAs, we would agree to purchase (or deliver), for future settlement, Agency RMBS with certain principal and interest terms and certain types of underlying collateral, but the particular Agency RMBS to be delivered would not be identified until shortly before the TBA settlement date. Our ability to purchase Agency RMBS through TBAs may be limited by the 75% income and asset tests applicable to REITs.

Our Additional Target Assets

Although our core investment strategy is focused on Agency RMBS, we have opportunistically supplemented our portfolio with Non-Agency RMBS and may do so with the other types of assets, which we define as part of our Additional Target Assets, described below.

Non-Agency RMBS. - RMBS that are not guaranteed by a U.S. Government agency or U.S. Government-sponsored entity, with an emphasis on securities that when originally issued were rated in the highest rating category by one or more of the nationally recognized statistical rating organizations.

The mortgage loan collateral for Non-Agency RMBS consists of residential mortgage loans that do not generally conform to underwriting guidelines issued by a U.S. Government agency or U.S. Government-sponsored entity due to certain factors, including mortgage balances in excess of agency underwriting guidelines, borrower characteristics, loan characteristics and level of documentation, and therefore are not issued or guaranteed by a U.S. Government agency or U.S. Government-sponsored entity. The mortgage loan collateral may be classified as subprime, Alternative-A or prime depending on the borrower’s credit rating and the underlying level of documentation. The Non-Agency RMBS we may acquire could be secured by fixed-rate mortgages, adjustable-rate mortgages or hybrid adjustable-rate mortgages.

Table of Contents

CMBS. - Fixed and floating rate CMBS, with an emphasis on securities that when originally issued were rated in the highest rating category by one or more of the nationally recognized statistical rating organizations. We have not established a minimum current rating requirement.

ABS. - Debt and/or equity tranches of securitizations backed by various asset classes including, but not limited to, small balance commercial mortgages, aircrafts, automobiles, credit cards, equipment, manufactured housing, franchises, recreational vehicles and student loans with an emphasis on securities that when originally issued were rated in the highest rating category by one or more of the nationally recognized statistical rating organizations. Investments in ABS generally are not qualifying assets for purposes of the 75% asset test applicable to REITs and generally do not generate qualifying income for purposes of the 75% income test applicable to REITs. As a result, we may be limited in our ability to invest in such assets.

Other Agency MBS. - We may also invest in mortgage-backed securities, or MBS, for which the principal and interest payments are guaranteed by a U.S. Government agency or U.S. Government-sponsored entity, but for which the underlying mortgage loans are secured by real property other than single family residences. These may include, but are not limited to Fannie Mae DUS (Delegated Underwriting and Servicing) MBS, Freddie Mac Multifamily Mortgage Participation Certificates and Ginnie Mae project loan pools, and/or CMOs structured from such collateral.

As of March 31, 2013, the fair value of our investment portfolio was comprised of approximately 96.6% of Agency RMBS and 3.4% of Non-Agency RMBS, excluding linked transactions. As of March 31, 2013, the fair value of our investment portfolio was comprised of approximately 95.1% of Agency RMBS and 4.9% of Non-Agency RMBS, including linked transactions.

Our Financing Strategy

The leverage that we employ is specific to each asset class and is determined based on several factors, including potential asset price volatility, margin requirements, the current cycle for interest rates, the shape of the yield curve, the outlook for interest rates and our ability to use and the effectiveness of interest rate hedg