UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

[X]             QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED:  MARCH 31, 2010

OR

[  ]             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:  1-33796

CHIMERA INVESTMENT CORPORATION
(Exact name of Registrant as specified in its Charter)
 
MARYLAND
26-0630461
(State or other jurisdiction of incorporation or organization)
(IRS Employer Identification No.)
 
1211 AVENUE OF THE AMERICAS, SUITE 2902
NEW YORK, NEW YORK
(Address of principal executive offices)

10036
 (Zip Code)

(646) 454-3759
(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all documents and 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 þ 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 (Section 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 o No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer þ Accelerated filer o Non-accelerated filer o Smaller reporting company o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No þ

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date:
 
Class
Outstanding at May 10, 2010
Common Stock, $.01 par value
768,122,737
 
 

 
CHIMERA INVESTMENT CORPORATION
FORM 10-Q
TABLE OF CONTENTS

Part I.     FINANCIAL INFORMATION
 
   
Item 1.  Consolidated Financial Statements:
 
   
1
   
2
   
3
   
4
   
5
   
27
   
52
   
57
   
   
Part II.     OTHER INFORMATION
 
   
58
   
58
   
59
   
60
   
CERTIFICATIONS
 
 
 
i

 
 
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
 
(dollars in thousands, except share and per share data)
 
(unaudited)
 
             
   
March 31,
2010
   
December 31,
2009 (1)
 
Assets:
           
Cash and cash equivalents
  $ 44,200     $ 24,279  
Non-Agency Mortgage-Backed Securities, at fair value
               
Senior
    1,429,530       2,022,406  
Subordinated
    947,963       376,459  
Senior, non-retained
    1,646,087       -  
Agency Mortgage-Backed Securities, at fair value
    1,558,795       1,690,029  
Securitized loans held for investment, net of allowance for loan losses of $4.6 million and
$4.6 million, respectively
    441,347       470,533  
Receivable for investments sold
    47,185       -  
Accrued interest receivable
    39,637       33,128  
Other assets
    1,451       1,494  
Total assets
  $ 6,156,195     $ 4,618,328  
                 
Liabilities:
               
Repurchase agreements
  $ 1,538,820     $ 1,716,398  
Repurchase agreements with affiliates
    147,417       259,004  
Securitized debt
    364,665       390,350  
Securitized debt, non-retained
    1,636,437       -  
Payable for investments purchased
    41,822       -  
Accrued interest payable
    9,691       3,235  
Dividends payable
    113,793       113,788  
Accounts payable and other liabilities
    489       472  
Investment management fees payable to affiliate
    8,114       8,519  
Total liabilities
  $ 3,861,248     $ 2,491,766  
                 
Commitments and Contingencies (Note 14)
    -       -  
                 
Stockholders' Equity:
               
Common stock: par value $0.01 per share; 1,000,000,000 shares authorized,  670,371,002 and 670,371,587
shares issued and outstanding, respectively
  $ 6,694     $ 6,693  
Additional paid-in-capital
    2,290,636       2,290,614  
Accumulated other comprehensive income
    144,978       (99,754 )
Accumulated deficit
    (147,361 )     (70,991 )
Total stockholders' equity
  $ 2,294,947     $ 2,126,562  
Total liabilities and stockholders' equity
  $ 6,156,195     $ 4,618,328  
 
(1) Derived from the audited consolidated financial statements at December 31, 2009.
See notes to consolidated financial statements.

 
1

 
 
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
 
(dollars in thousands, except share and per share data)
 
(unaudited)
 
             
   
For the quarters ended
 
   
March 31, 2010
   
March 31, 2009
 
Net Interest Income:
           
Interest income
  $ 128,984     $ 28,007  
Interest expense
    7,374       9,042  
                 
Interest income, non-retained
    50,861       -  
Interest expense, non-retained
    33,830       -  
Net interest income
    138,641       18,965  
Other-than-temporary impairments:
               
Total other-than-temporary impairment losses
    (22,687 )     -  
Non-credit portion of loss recognized in other comprehensive income
    20,143       -  
Net other-than-temporary credit impairment losses
    (2,544 )     -  
Other (losses) gains:
               
Realized gains on sales of investments, net
    342       3,627  
Realized losses on principal write-downs of non-Agency RMBS
    (949 )     -  
Total other (losses) gains
    (607 )     3,627  
Net investment income
    135,490       22,592  
Other expenses:
               
Management fee
    8,114       2,583  
Provision for loan losses
    606       234  
General and administrative expenses
    1,160       905  
Total other expenses
    9,880       3,722  
Income before income taxes
    125,610       18,870  
Income taxes
    -       1  
Net income
  $ 125,610     $ 18,869  
                 
Net income per share-basic and diluted
  $ 0.19     $ 0.11  
Weighted average number of shares outstanding-basic and diluted
    670,371,022       177,196,959  
Comprehensive income:
               
Net income
  $ 125,610     $ 18,869  
Other comprehensive income:
               
Unrealized gains on available-for-sale securities, net
    241,581       13,590  
Reclassification adjustment for net losses included in net income for other-than-temporary credit impairment losses
    2,544       -  
Reclassification adjustment for realized losses (gains) included in net income
    607       (3,627 )
Other comprehensive income:
    244,732       9,963  
Comprehensive income
  $ 370,342     $ 28,832  
                 
See notes to consolidated financial statements.
 

 
2

 
 
 
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
 
(dollars in thousands, except per share data)
 
(unaudited)
 
                               
   
Common Stock Par
Value
   
Additional Paid-in
Capital
   
Accumulated
Other
Comprehensive
Income
   
Accumulated
Deficit
   
Total
 
Balance, December 31, 2008
  $ 1,760     $ 831,966     $ (266,668 )   $ (152,603 )   $ 414,455  
Net income
    -       -       -       18,869       18,869  
Other comprehensive income
    -       -       9,963       -       9,963  
Proceeds from restricted stock grants
    1       104       -       -       105  
Common dividends declared, $0.06 per share
    -       -       -       (10,566 )     (10,566 )
Balance, March 31, 2009
  $ 1,761     $ 832,070     $ (256,705 )   $ (144,300 )   $ 432,826  
                                         
   
Common Stock Par
Value
   
Additional Paid-in
Capital
   
Accumulated
Other
Comprehensive
Income
   
Accumulated
Deficit
   
Total
 
Balance, December 31, 2009
  $ 6,693     $ 2,290,614     $ (99,754 )   $ (70,991 )   $ 2,126,562  
Net income
    -       -       -       125,610       125,610  
Cumulative effect of change in accounting principle
                            (88,187 )     (88,187 )
Other comprehensive income
    -       -       244,732       -       244,732  
Proceeds from common stock offerings
    -       (100     -       -       (100 )
Proceeds from restricted stock grants
    1       122       -       -       123  
Common dividends declared, $0.17 per share
    -        -        -       (113,793 )     (113,793 )
Balance, March 31, 2010
  $ 6,694     $ 2,290,636     $ 144,978     $ (147,361 )   $ 2,294,947  
                                         
See notes to consolidated financial statements.
 
 
 
3

 
 
 
CONSOLIDATED STATEMENTS OF CASH FLOW
 
(dollars in thousands)
 
             
   
For the Quarter
Ended March 31,
2010
   
For the Quarter
Ended March 31,
2009
 
Cash Flows From Operating Activites:
           
Net income
  $ 125,610     $ 18,869  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Accretion of investment discounts
    (53,842 )     (1,254 )
Realized gain on sale of investments
    (342 )     (3,627 )
Realized losses on principal write-downs of non-Agency RMBS
    949       -  
Net other-than-temporary credit impairment losses
    2,544       -  
Provision for loan losses
    606       234  
Restricted stock grants
    123       104  
Changes in operating assets:
               
   Increase in accrued interest receivable
    (6,509 )     (1,261 )
   Decrease in other assets
    43       309  
Changes in operating liabilities:
               
   Increase in accounts payable and other liabilities
    17       151  
   (Decrease) increase in investment management fees payable to affiliate
    (405 )     291  
   Increase in accrued interest payable
    6,456       4  
Net cash provided by operating activities
  $ 75,250     $ 13,820  
Cash Flows From Investing Activities:
               
Mortgage-Backed Securities portfolio:
               
   Purchases
  $ (442,919 )   $ (607,798 )
   Sales
    44,211       548,433  
   Principal payments
    184,831       38,557  
Mortgage-Backed Securities portfolio, non-retained:
               
   Principal payments
    145,421       -  
Securitized loans:
               
   Principal payments
    28,666       16,911  
Net cash used in investing activities
  $ (39,790 )   $ (3,897 )
Cash Flows From Financing Activities:
               
   Proceeds from repurchase agreements
  $ 6,776,126     $ 29,325,631  
   Payments on repurchase agreements
    (7,065,291 )     (29,327,824 )
   Net expenses from common stock offerings
    (100 )     -  
   Payments on securitized debt borrowings
    (26,572 )     (15,970 )
   Proceeds from securitized debt borrowings, non-retained
    498,720       -  
   Payments on securitized debt borrowings, non-retained
    (84,634 )     -  
   Common dividends paid
    (113,788 )     (7,040 )
Net cash used in financing activities
  $ (15,539 )   $ (25,203 )
Net increase (decrease) in cash and cash equivalents
  $ 19,921     $ (15,280 )
Cash and cash equivalents at beginning of period
    24,279       27,480  
Cash and cash equivalents at end of period
  $ 44,200     $ 12,200  
                 
                 
Supplemental disclosure of cash flow information:
               
   Interest paid
  $ 34,748     $ 9,039  
   Taxes paid
  $ -     $ -  
                 
Non cash investing activities:
               
   Payable for investments purchased
  $ 41,822     $ 193,973  
   Net change in unrealized gain on available-for sale securities
  $ 241,581     $ 13,590  
Non cash financing activities:
               
   Common dividends declared, not yet paid
  $ 113,793     $ 10,566  
                 
See notes to consolidated financial statements.
               
 
 
4

 
CHIMERA INVESTMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER ENDED MARCH 31, 2010
 (Unaudited)

 
1.   Organization

Chimera Investment Corporation (“Company”) was organized in Maryland on June 1, 2007.  The Company commenced operations on November 21, 2007 when it completed its initial public offering.  The Company has elected to be taxed as a real estate investment trust (“REIT”), under the Internal Revenue Code of 1986, as amended.  As long as the Company qualifies as a REIT, the Company will generally not be subject to U.S. federal or state corporate taxes on its income to the extent that the Company distributes at least 90% of its taxable net income to its stockholders.  In July 2008, the Company formed Chimera Securities Holdings, LLC, a wholly-owned subsidiary.  In June 2009, the Company formed Chimera Asset Holding LLC and Chimera Holding LLC, both wholly-owned subsidiaries.  In January 2010, the Company formed Chimera Special Holding, LLC which is a wholly-owned subsidiary of Chimera Asset Holding, LLC.  Chimera Securities Holdings LLC, Chimera Asset Holding LLC, Chimera Holding, LLC, and Chimera Special Holding, LLC are qualified REIT subsidiaries.  Annaly Capital Management, Inc. (“Annaly”) owns approximately 6.7% of the Company’s common shares.  The Company is managed by Fixed Income Discount Advisory Company (“FIDAC”), an investment advisor registered with the Securities and Exchange Commission (“SEC”).  FIDAC is a wholly-owned subsidiary of Annaly.

2.  Summary of the Significant Accounting Policies

(a) Basis of Presentation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Chimera Securities Holdings, LLC, Chimera Holding LLC, Chimera Asset Holding LLC and its wholly-owned subsidiary, Chimera Special Holding, LLC.  All intercompany balances and transactions have been eliminated.
 
(b) Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and cash deposited overnight in money market funds.

(c) Non-Agency and Agency Residential Mortgage-Backed Securities
The Company invests in residential mortgage-backed securities (“RMBS”) representing interests in obligations backed by pools of mortgage loans.   The Company classifies its investment securities as either “trading,” “available-for-sale,” or “held-to-maturity.”   In addition, the Company delineates between Agency, non-Agency, and non-Agency, non-retained securities.  Non-Agency, non-retained securities are further detailed in Note 8 to these consolidated financial statements.

The Company holds its RMBS as available-for-sale, records investments at estimated fair value as described in Note 5 of these consolidated financial statements, and includes unrealized gains and losses in other comprehensive income in the consolidated statements of operations and comprehensive income.  From time to time, as part of the overall management of its portfolio, the Company may sell any of its RMBS investments and recognize a realized gain or loss as a component of earnings in the consolidated statements of operations and comprehensive income utilizing the specific identification method.

Interest income on RMBS is computed on the remaining principal balance of the investment security.  Premium or discount amortization/accretion on RMBS that is guaranteed as to principal and/or interest repayment by agencies of the U.S. Government or federally chartered corporations such as Ginnie Mae, Freddie Mac or Fannie Mae (“Agency RMBS”) is recognized over the life of the investment using the effective interest method.  Premium or discount amortization/accretion on non-Agency RMBS is recognized in accordance with Accounting Standards Codification (“ASC”) 325, Investment-Other.  For non-Agency RMBS the Company estimates at the time of purchase expected future cash flows, prepayment speeds, credit losses, loss severity, and loss timing based on the Company’s observation of available market data, its experience, and the collective judgment of its management team to determine the effective interest rate on the RMBS.  Not less than quarterly, the Company reevaluates, and if necessary, makes adjustments to its analysis utilizing internal models, external market research and sources in conjunction with its view on performance in the non-Agency RMBS sector.  Changes to the Company’s assumptions subsequent to the purchase date may increase or decrease the amortization/accretion of premiums and discounts which affects interest income.  Changes to assumptions that decrease expected future cash flows may result in other-than-temporary impairment.
 
5

 
The Company fair values it RMBS.  Please see Note 5 to these consolidated financial statements for a discussion of the Company’s fair valuation methods.

(d) Securitized Loans Held for Investment
The Company’s securitized residential mortgage loans are comprised of fixed-rate and variable-rate loans.  The Company purchases pools of residential mortgage loans through a select group of originators.   Mortgage loans are designated as held for investment, recorded on trade date, and are carried at their principal balance outstanding, plus any premiums or discounts, less allowances for loan losses.  Interest income on loans held for investment is recognized over the life of the investment using the effective interest method.  Income recognition is suspended for loans when, in the opinion of management, a full recovery of income and principal becomes doubtful.  Income recognition is resumed when the loan becomes contractually current and performance is demonstrated to be resumed.  The Company estimates fair value of securitized loans as described in Note 5 of these consolidated financial statements.

(e) Allowance for Loan Losses
The Company has established an allowance for loan losses at a level that management believes is adequate based on an evaluation of known and inherent risks related to the Company’s loan portfolio.  The estimate is based on a variety of factors including current economic conditions, industry loss experience, the loan originator’s loss experience, credit quality trends, loan portfolio composition, delinquency trends, national and local economic trends, national unemployment data, changes in housing  appreciation or depreciation and whether specific geographic areas where the Company has significant loan concentrations are experiencing adverse economic conditions and events such as natural disasters that may affect the local economy or property values. Upon purchase of a pool of loans, the Company obtains written representations and warranties from the sellers that the Company could be reimbursed for the value of the loan if the loan fails to meet the agreed upon origination standards.  While the Company has little history of its own to establish loan trends, delinquency trends of the originators and the current market conditions aid in determining the allowance for loan losses.  The Company also performs due diligence procedures on a sample of loans that met its criteria during the purchase process.  The Company has created an unallocated provision for probable loan losses estimated as a percentage of the remaining unpaid principal balance on the loans.  Management’s estimate is based on historical experience of similarly underwritten pools.

When the Company determines it is probable that specific contractually due amounts are uncollectible, the amount is considered impaired.  Where impairment is indicated, a valuation write-off is measured based upon the excess of the recorded investment over the net fair value of the collateral, reduced by selling costs.  Any deficiency between the carrying amount of an asset and the net sales price of repossessed collateral is charged to the allowance for loan losses.

(f) Repurchase Agreements
The Company may finance the acquisition of its investment securities through the use of repurchase agreements. Repurchase agreements are treated as collateralized financing transactions and are carried at their contractual amounts, including accrued interest, as specified in the respective agreements.

(g) Securitized Debt and Securitized Debt-Non Retained
The Company has issued securitized debt to finance a portion of its residential mortgage loan portfolio and has re-securitized RMBS to finance its portfolio.  Certain transactions involving residential mortgage loans are accounted for as financings, and are recorded as an asset called “Securitized loans held for investment” and the corresponding debt as “Securitized debt” in the consolidated statements of financial condition.  These securitizations are collateralized by residential adjustable or fixed rate mortgage loans that have been placed in a trust and pay interest and principal payments to the debt holders of that securitization.  Re-securitization transactions classified as “Securitized debt, non-retained” reflect the transfer to a trust of fixed or adjustable rate RMBS which are classified as“Non-Agency Mortgage-Backed Securities Senior, non-retained” that pay interest and principal payments to the debt holders of that re-securitization.  Re-securitization transactions completed by the Company are accounted for as financings pursuant to the adoption of ASC 810. The debt holders of securitized debt and securitized debt, non-retained have no recourse to the Company.  The Company estimates fair value of securitized debt as described in Note 5 to these consolidated financial statements.
 
6

 
(h) Fair Value Disclosure
A complete discussion of the methodology utilized by the Company to fair value its financial instruments is included in Note 5 to these consolidated financial statements.

(i) Derivative Financial Instruments and Hedging Activity
The Company’s policies permit it to enter into derivative contracts, including interest rate swaps and interest rate caps, as a means of mitigating our interest rate risk. The Company intends to use interest rate derivative instruments to mitigate interest rate risk rather than to enhance returns. If the Company hedges using interest rate swaps these instruments are accounted for as either assets or liabilities in the consolidated statement of financial condition, and are measured at fair value with realized and unrealized gains and losses recognized in earnings.

The FASB issued additional guidance that attempts to improve the transparency of financial reporting by providing additional information about how derivative and hedging activities affect an entity’s financial position, financial performance and cash flows.  This guidance changed the disclosure requirements for derivative instruments and hedging activities by requiring enhanced disclosure about (1) how and why an entity uses derivative instruments, (2) how derivative instruments and related hedged items are accounted for, and (3) how derivative instruments and related hedged items affect the entity’s financial position, financial performance, and cash flows.
 
In the normal course of business, the Company may use a variety of derivative financial instruments to manage, or hedge, interest rate risk. These derivative financial instruments must be effective in reducing our interest rate risk exposure in order to qualify for hedge accounting. When the terms of an underlying transaction are modified, or when the underlying hedged item ceases to exist, all changes in the fair value of the instrument are included in net income for each period until the derivative instrument matures or is settled. Any derivative instrument used for risk management that does not meet the hedging criteria is carried at fair value with the changes in value included in net income.

The Company uses derivatives for economic hedging purposes rather than speculation and relies on quotations from third parties to determine fair values.  If the Company’s hedging activities do not achieve its desired results, the Company’s reported earnings may be adversely affected.

(j) Sales and Securitizations
The Company periodically enters into transactions in which it sells financial assets, such as RMBS, mortgage loans and other assets.  Gains and losses on sales of assets are computed on the specific identification method whereby the Company records a gain or loss on the difference between the carrying value of the asset and the proceeds from the sale.  In addition, the Company from time to time securitizes or re-securitizes assets and sells tranches in the newly securitized assets.  These transactions may be recorded as either a sale and the assets contributed to the securitization are removed from the consolidated statements of financial condition and a gain or loss is recognized, or as a financing whereby the assets contributed to the securitization are not derecognized but rather the liabilities issued by the securitization are recorded to reflect the term financing of the assets.  In these securitizations and re-securitizations the Company sometimes retains or acquires senior or subordinated interests in the securitized or re-securitized assets.
 
 (k) Income Taxes
The Company qualifies to be taxed as a REIT, and therefore it generally will not be subject to corporate, federal, or state income tax to the extent that qualifying distributions are made to stockholders and the REIT requirements, including certain asset, income, distribution and stock ownership tests are met.  If the Company failed to qualify as a REIT and did not qualify for certain statutory relief provisions, the Company would be subject to 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 REIT qualification was lost.

(l) Net Income per Share
The Company calculates basic net income per share by dividing net income for the period by the weighted-average shares of its common stock outstanding for that period.  Diluted net income per share takes into account the effect of dilutive instruments, such as stock options, but uses the average share price for the period in determining the number of incremental shares that are to be added to the weighted average number of shares outstanding.  The Company had no potentially dilutive securities outstanding during the periods presented.
 
7

 
(m) Stock-Based Compensation
The Company accounts for stock based compensation awards granted to the employees of FIDAC and its affiliates in accordance with GAAP guidance for compensation to non-employees.  GAAP requires the Company to measure the fair value of the equity instrument using the stock prices and other measurement assumptions as of the earlier of either the date at which a performance commitment by the counterparty is reached or the date at which the counterparty’s performance is complete.  Compensation expense related to the grants of stock and stock options is recognized over the vesting period of such grants based on the fair value of the stock on the vesting date.

 (n) Use of Estimates
The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and reporting period. The most significant estimates are related to the following: all assets classified as available-for-sale and are reported at their estimated fair value; all investment securities are amortized/accreted based on yields that incorporate management’s assumptions as to the expected performance of the investment over time; loan loss provisions reflect management estimates with regard to expected losses of the securitized loan portfolio.  Actual results could differ from those estimates.

(o) Recent Accounting Pronouncements

Generally Accepted Accounting Principles (ASC 105)

           In June 2009, the Financial Accounting Standards Board (FASB) issued The Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles “Codification” which revises the framework for selecting the accounting principles to be used in the preparation of financial statements that are presented in conformity with Generally Accepted Accounting Principles (GAAP).  The objective of the Codification is to establish the FASB ASC as the source of authoritative accounting principles recognized by the FASB.  Codification was effective for the Company as of September 30, 2009.   In adopting the Codification, all non-grandfathered, non-SEC accounting literature not included in the Codification was superseded and deemed non-authoritative.  Codification requires any references within the Company’s consolidated financial statements be modified from FASB issues to ASC.  However, as recommended in the FASB Accounting Standards Codification Notice to Constituents (v 2.0), the Company does not reference specific sections of the ASC but will use broad topic references.

           The Company’s recent accounting pronouncements section has been formatted to reflect the same organizational structure as the ASC.  Broad topic references will be updated with pending content as they are released.

Assets

Receivables (ASC 310)
In April 2010, the FASB issued ASU 2010-18, which addresses the effect of a loan modification when a loan is part of a pool accounted for as a single asset. This update clarifies the treatment of a troubled debt restructuring.  This guidance allows acquired assets, which have evidence of credit deterioration upon acquisition and common risk characteristics, to be accounted for in the aggregate as a pool.  Upon establishment of the pool, the pool becomes the unit of accounting.  Any purchase discount is not allocated to individual loans, thus all of the loans in the pool accrete at a single pool rate based on cash flow projections for the pool.  Likewise, impairment analysis is performed on the pool as a whole, not on individual loans.  Modifications to loans, even if those modifications are considered troubled debt restructuring, do not result in a loan being removed from the pool.  This treatment is consistent with the current accounting practices of the Company and therefore has no material effect on the Company’s consolidated financial statements.
 
8

 
Investments in Debt and Equity Securities (ASC 320)
New guidance was provided to make impairment guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments (OTTI) on debt and equity securities, as well as beneficial interests in securitized financial assets, in financial statements.  This guidance was the result of the Securities and Exchange Commission (SEC) mark-to-market study mandated under the Emergency Economic Stabilization Act of 2008 (EESA).  The SEC’s recommendation was to “evaluate the need for modifications (or the elimination) of current OTTI guidance to provide for a more uniform system of impairment testing standards for financial instruments.”  The guidance revises the OTTI evaluation methodology.  Previously the analytical focus was on whether the company had the “intent and ability to retain its investment in the debt security for a period of time sufficient to allow for any anticipated recovery in fair value.”   Now the focus is on whether the company (1) has the intent to sell the investment securities, (2) is more likely than not to be required to sell the investment securities before recovery, or (3) does not expect to recover the entire amortized cost basis of the investment securities.  Further, the security is analyzed for credit loss, (the difference between the present value of cash flows expected to be collected and the amortized cost basis).  The credit loss, if any, will then recognized in the statement of operations, while the balance of impairment related to other factors will be recognized in Other Comprehensive Income (OCI).  If the entity intends to sell the security, they will be required to sell the security before its anticipated recovery, or does not expect to recover the entire amortized cost basis of the security, the full OTTI will be recognized in the statement of operations.

OTTI has occurred if there has been an adverse change in future estimated cash flows and its impact is reflected in current earnings.  The determination cannot be overcome by management judgment of the probability of collecting all cash flows previously projected.   The objective of an OTTI analysis is to determine whether it is probable that the holder will realize some portion of the unrealized loss on an impaired security.  Factors to consider when assessing for OTTI includes information about past events, current conditions, reasonable and supportable forecasts, remaining payment terms, financial condition of the issuer, expected defaults, value of underlying collateral, industry analysis, sector credit rating, credit enhancement, and financial condition of guarantor.  The Company’s non-Agency RMBS and Agency RMBS investments fall under this guidance and as such, the Company assesses each security for OTTI based on estimated future cash flows.  This guidance became effective for the Company on June 30, 2009.

Broad Transactions

Consolidation (ASC 810)
On January 1, 2009, FASB amended the guidance concerning noncontrolling interests in consolidated financial statements.  This guidance requires classification of noncontrolling interests (previously referred to as “minority interest”) as part of consolidated net income and including the accumulated amount of noncontrolling interests as part of stockholders’ equity.  Further, this guidance requires distinction between equity amounts attributable to controlling interest and amounts attributable to the noncontrolling interests – previously classified as minority interest outside of stockholders’ equity.  In addition to these financial reporting changes, this guidance provided for significant changes in accounting related to noncontrolling interests; specifically, increases and decreases in controlling financial interests in consolidated subsidiaries are reported in equity similar to treasury stock transactions. If a change in ownership of a consolidated subsidiary results in loss of control and deconsolidation, any retained ownership interests are re-measured with the gain or loss reported in net earnings.   For the quarter ended March 31, 2010, the Company did not have any non-controlling interests.

Effective January 1, 2010, the consolidation standards have been amended by ASU 2009-17.  This amendment updates the existing standard and eliminates the exemption from consolidation of a Qualified Special Purpose Entity (QSPE).  The update requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a variable interest entity (VIE). The analysis identifies the primary beneficiary of a VIE as the enterprise that has both: a) the power to direct the activities that most significantly impact the entity’s economic performance and b) the obligation to absorb losses of the entity or the right to receive benefits from the entity which could potentially be significant to the VIE.  The update requires enhanced disclosures to provide users of financial statements with more transparent information about an enterprises involvement in a VIE.  The Company determined it is the primary beneficiary on a number of VIE’s formed through re-securitizations.  The Company was required to consolidate RMBS re-securitization transactions previously recorded during the year ended December 31, 2009 as sales for GAAP beginning with the effective date of this ASU.  Consolidation of these transactions altered the presentation of the consolidated financial statements by increasing its non-Agency portfolio and increasing the value of non-recourse liabilities for which it has no continuing obligation.   The consolidation has reversed previously recorded GAAP gains on sales of assets related to the re-securitizations undertaken in 2009.  The reversal of this gain will be accreted over the remaining life of the re-securitized assets.  The adoption of this guidance has resulted in material changes to the format and content of the Company’s consolidated financial statements, as well as enhanced disclosures.  Please refer to the discussion in Note 8.
 
9

 
Effective January 1, 2010,  FASB amended the consolidation standard with ASU 2010-10 which indefinitely defers the effective date of  ASU 2009-17 for a reporting enterprises interest in entities for which it is industry practice to issue financial statements in accordance with investment company standards (ASC 946).   This deferral is expected to most significantly affect reporting entities in the investment management industry.  This amendment has no effect on the Company’s consolidated financial statements.
 
Derivatives and Hedging (ASC 815)
Effective January 1, 2009 and adopted by the Company prospectively, the FASB issued additional guidance attempting  to improve the transparency of financial reporting by mandating the provision of additional information about how derivative and hedging activities affect an entity’s financial position, financial performance and cash flows.  This guidance changed the disclosure requirements for derivative instruments and hedging activities by requiring enhanced disclosure about (1) how and why an entity uses derivative instruments, (2) how derivative instruments and related hedged items are accounted for, and (3) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows.  To adhere to this guidance, qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts, gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements must be made.  This disclosure framework is intended to better convey the purpose of derivative use in terms of the risks that an entity is intending to manage.  The adoption of this ASC had no material impact on the Company’s consolidated financial statements.

The FASB issued ASU 2010-8 in February 2010.  ASU 2010-8 provided technical corrections to ASC 815.  This update provides a four step analysis to determine whether call or put options that can accelerate the settlement of debt instruments should be considered clearly and closely related to the debt host contract.  If it is determined that such option is closely related to the host contract, bifurcation of the host contract from the derivative instrument is not necessary.  If an existing hybrid instrument requires bifurcation under this update, a one-time election can be made to utilize the Fair Value Option for the entire contract.   This update is effective for the Company January 1, 2010 and has no effect on the consolidated financial statements.

ASU 2010-11 was issued in March 2010 and defined a scope exception for embedded derivative features which involve only the transfer of credit risk that is only in the form of subordination of one financial instrument to another.  Such instruments would not be subject to bifurcation under ASC 815.  This guidance is effective for the first quarter beginning after June 15, 2010, however early adoption for the first fiscal quarter is allowed.  The Company elected to adopt for the first quarter of 2010.  Adoption has no effect on the consolidated financial statements.

Fair Value Measurements and Disclosures (ASC 820)
In response to the deterioration of the credit markets, FASB issued guidance clarifying how fair value measurements should be applied when valuing securities in markets that are not active.  The guidance provides an illustrative example, utilizing management’s internal cash flow and discount rate assumptions when relevant observable data does not exist.  It further clarifies how observable market information and market quotes should be considered when measuring fair value in an inactive market.  It reaffirms the notion of fair value as an exit price as of the measurement date and that fair value analysis is a transactional process and should not be broadly applied to a group of assets.  The guidance was effective upon issuance including prior periods for which financial statements had not been issued.  The implementation of this guidance did not have a material impact on the fair value of the Company’s assets as the Company’s historical valuation methodologies complied with the new guidance.

In October 2008 EESA was signed into law.  Section 133 of the EESA mandated that the SEC conduct a study on mark-to-market accounting standards.  The SEC provided its study to the U.S. Congress on December 30, 2008.  Part of the recommendations within the study indicated that “fair value requirements should be improved through development of application and best practices guidance for determining fair value in illiquid or inactive markets.”  As a result of this study and the recommendations therein, on April 9, 2009, the FASB issued additional guidance for determining fair value when the volume and level of activity for the asset or liability have significantly decreased when compared with normal market activity for the asset or liability (or similar assets or liabilities).  The guidance gives specific factors to evaluate if there has been a decrease in normal market activity and if so, provides a methodology to analyze transactions or quoted prices and make necessary adjustments to fair value.  The objective is to determine the point within a range of fair value estimates that is most representative of fair value under current market conditions.  This guidance became effective for the Company’s June 30, 2009 reporting period.  The adoption did not have a material impact on the manner in which the Company estimates fair value, nor did it have any impact on the footnote disclosures.
 
10

 
In August 2009, FASB issued ASU 2009-05 regarding the fair value measurement of liabilities.  The guidance stated that a quoted price for the identical liability when traded as an asset in an active market is a Level 1 fair value measurement.  If the value must be adjusted for factors specific to the liability, then the adjustment to the quoted price of the asset renders the fair value measurement of the liability a lower level measurement.  This guidance had no material effect on the fair valuation of the Company’s liabilities as the Company does not fair value its liabilities.

In September 2009, FASB issued ASU 2009-12 on measuring the fair value of certain alternative investments.  This guidance offered investors a practical expedient for measuring the fair value of investments in certain entities that calculate net asset value (NAV) per share.  If an investment falls within the scope of the ASU, the reporting entity is permitted, but not required to use the investment’s NAV to estimate its fair value.  This guidance had no material effect on the fair valuation of the Company’s assets, as the Company does not hold any assets qualifying under this guidance.

In January 2010, FASB issued ASU 2010-06 which increases disclosures regarding the fair value of assets.  The key provisions of this guidance include the requirement to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 including a description of the reason for the transfers.  Previously this was only required of transfers between Level 2 and Level 3 assets.  Further, reporting entities are required to provide fair value measurement disclosures for each class of assets and liabilities; a class is potentially a subset of the assets or liabilities within a line item in the statement of financial position.  Additionally, disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements are required for either Level 2 or Level 3 assets.  This portion of the guidance is effective for the Company beginning January 1, 2010. The guidance also requires that the disclosure on any Level 3 assets presents separately information about purchases, sales, issuances and settlements.  In other words, Level 3 assets are presented on a gross basis rather than as one net number.  However, this last portion of the guidance is not effective for the Company until January 1, 2011.  Adoption of this guidance results in increased footnote disclosure in the Company’s consolidated financial statements.

Financial Instruments (ASC 825)
On April 9, 2009, the FASB issued guidance which requires disclosures about fair value of financial instruments for interim reporting periods as well as in annual financial statements.  This guidance became effective for the Company June 30, 2009.  The adoption increased footnote disclosure in the Company’s consolidated financial statements.
 
ASC 855 provides general standards governing accounting for and disclosure of events that occur after the balance sheet date through the date of issuance of the consolidated financial statements.  ASC 855 also provides guidance on the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements and the disclosures that an entity should make about events or transactions occurring after the balance sheet date. The Company adopted this ASC effective June 30, 2009, and adoption had no impact on the Company’s consolidated financial statements.

In February 2010, the FASB issued ASU 2010-09 as an amendment to ASC 855.  This update eliminated the requirement to provide a specific date through which subsequent events were evaluated.  The purpose of this update was to alleviate potential conflicts between ASC 855 and SEC reporting requirements.  The update was effective upon issuance.  The Company evaluated subsequent events through date of issuance of this Quarterly Report on Form 10Q.
 
11

 
Transfers and Servicing (ASC 860)
In February 2008, FASB issued guidance addressing whether transactions where assets purchased from a particular counterparty and financed through a repurchase agreement with the same counterparty can be considered and accounted for as separate transactions, or are required to be considered “linked” transactions and may be considered derivatives.  This guidance requires purchases and subsequent financing through repurchase agreements be considered linked transactions unless all of the following conditions apply: (1) the initial purchase and the use of repurchase agreements to finance the purchase are not contractually contingent upon each other; (2) the repurchase financing entered into between the parties provides full recourse to the transferee and the repurchase price is fixed; (3) the financial assets are readily obtainable in the market; and (4) the financial instrument and the repurchase agreement are not coterminous.  This guidance was effective for the Company on January 1, 2009 and the implementation did not have a material impact on the consolidated financial statements of the Company.

On June 12, 2009, the FASB issued ASU 2009-16, an amendment update to the accounting standards governing the transfer and servicing of financial assets.  This amendment updated the existing standard and eliminated the concept of a QSPE, clarified the surrendering of control to effect sale treatment and modified the financial components approach – limiting the circumstances in which a financial asset or portion thereof should be derecognized when the transferor maintains continuing involvement.  It defined the term “Participating Interest”.  Under this standard update, the transferor must recognize and initially measure at fair value all assets obtained and liabilities incurred as a result of a transfer, including any retained beneficial interest. Additionally, the amendment required enhanced disclosures regarding the transferors risk associated with continuing involvement in any transferred assets.   The amendment was effective beginning January 1, 2010.   The Company has determined the amendment has a material impact on the consolidated financial statements.  See discussion under Consolidation (ASC 810) above.

3.  Mortgage-Backed Securities

The following tables present the Company’s available-for-sale RMBS portfolio as of March 31, 2010 and December 31, 2009, at fair value.  The RMBS portfolio is composed of Agency and non-Agency RMBS collateralized by residential mortgage loans.  The Agency RMBS are mortgage pass-through certificates, collateralized mortgage obligations, or CMOs, and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans issued or guaranteed by the Federal National Mortgage Association, or Fannie Mae, the Federal Home Loan Mortgage Corporation, or Freddie Mac, and the Government National Mortgage Association, or Ginnie Mae.  The non-Agency RMBS portfolio is not issued or guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae and is therefore subject to risk as to the repayment of principal, or credit risk.  The Company classifies its non-Agency RMBS into senior and subordinated interests.  Senior interests in non-Agency RMBS are considered to be entitled to the first principal repayments in their pro-rata ownership interests.  Securities identified as Senior, non-retained have been consolidated pursuant to the adoption of ASC 810.  Please see Note 8 of these consolidated financial statements for a detailed discussion.

Following is a table presenting the principal value, unamortized premium, unamortized discount, gross unrealized gains, gross unrealized losses, and fair value of the Company’s RMBS portfolio by asset class.
 
March 31, 2010
 
(dollars in thousands)
 
                                     
   
Principal Value
   
Unamortized
Premium
   
Unamortized
Discount
   
Gross Unrealized
Gain
   
Gross Unrealized
Loss
   
Fair Value
 
Non-Agency RMBS
                                   
Senior
  $ 1,608,772     $ 102,268     $ (113,398 )   $ 33,007     $ (201,117 )   $ 1,429,532  
Subordinated
    2,648,170       2,528       (1,882,232 )     223,042       (43,545 )     947,963  
Senior, non-retained
    1,698,318       7,737       (168,340 )     108,535       (165 )     1,646,085  
Agency RMBS
    1,482,478       51,096       -       25,945       (724 )     1,558,795  
Total
  $ 7,437,738     $ 163,629     $ (2,163,970 )   $ 390,529     $ (245,551 )   $ 5,582,375  
 
 
12

 
 
December 31, 2009
 
(dollars in thousands)
 
                                     
   
Principal Value
   
Unamortized
Premium
   
Unamortized
Discount
   
Gross Unrealized
Gain
   
Gross Unrealized
Loss
   
Fair Value
 
Non-Agency RMBS
                                   
Senior
  $ 2,757,212     $ 1,536     $ (628,209 )   $ 83,946     $ (192,079 )   $ 2,022,406  
Subordinated
    1,616,031       10,346       (1,239,769 )     65,996       (76,145 )     376,459  
Agency RMBS
    1,616,450       55,081       (29 )     20,767       (2,240 )     1,690,029  
Total
  $ 5,989,693     $ 66,963     $ (1,868,007 )   $ 170,709     $ (270,464 )   $ 4,088,894  
 
The following tables present the gross unrealized losses and estimated fair value of the Company’s RMBS by length of time that such securities have been in a continuous unrealized loss position at March 31, 2010 and December 31, 2009.  The securities in an unrealized loss position have been evaluated by the Company for OTTI as discussed in the paragraphs following these tables.  All of the unrealized loss related to the non-Agency senior RMBS securities that have been in a continuous unrealized loss position greater than twelve months is related to seven securities held in the portfolio since prior to March 31, 2008.  These seven securities are performing in line with the Company’s expectations at the time of their purchase, have expected future cash flows in excess of their amortized cost, but have suffered significant market value declines consistent with similar asset classes as a result of the credit crisis.
 
March 31, 2010
 
(dollars in thousands)
 
                                     
   
Unrealized Loss Position For:
       
   
Less than 12 Months
   
12 Months or More
   
Total
 
RMBS
 
Estimated Fair
Value
   
Unrealized
Losses
   
Estimated Fair
Value
   
Unrealized
Losses
   
Estimated Fair
Value
   
Unrealized
Losses
 
Non-Agency RMBS
                                   
Senior
  $ 520,521     $ (49,778 )   $ 419,057     $ (151,339 )   $ 939,578     $ (201,117 )
Subordinated
    143,241       (19,700 )     20,238       (23,845 )     163,479       (43,545 )
Senior, non-retained
    9,601       (165 )     -       -       9,601       (165 )
Agency
    165,635       (724 )     -       -       165,635       (724 )
Total
  $ 838,998     $ (70,367 )   $ 439,295     $ (175,184 )   $ 1,278,293     $ (245,551 )
                                                 
December 31, 2009
 
(dollars in thousands)
 
                                                 
   
Unrealized Loss Position For:
       
   
Less than 12 Months
   
12 Months or More
   
Total
 
RMBS
 
Estimated Fair
Value
   
Unrealized
Losses
   
Estimated Fair
Value
   
Unrealized
Losses
   
Estimated Fair
Value
   
Unrealized
Losses
 
Non-Agency RMBS
                                               
Senior
  $ 539,579     $ (38,466 )   $ 489,670     $ (153,613 )   $ 1,029,249     $ (192,079 )
Subordinated
    179,226       (72,438 )     5,862       (3,707 )     185,088       (76,145 )
Agency
    682,681       (2,240 )     -       -       682,681       (2,240 )
Total
  $ 1,401,486     $ (113,144 )   $ 495,532     $ (157,320 )   $ 1,897,018     $ (270,464 )
 
 
13

 
 
The Company recorded a $2.5 million other-than-temporary credit impairment during the quarter ending March 31, 2010 on investments where the expected future cash flows of certain non-Agency RMBS were less than their amortized cost basis.  The Company evaluates each investment in its RMBS portfolio for OTTI quarterly or more often if market conditions warrant.  The amortized cost of each investment in an unrealized loss position is compared to the present value of expected future cash flows of the position.  In estimating future cash flows, the Company evaluated the non-Agency RMBS for other-than-temporary impairment by considering delinquencies, credit losses, loss severities, prepayment speeds, geographic data, borrower characteristics, loan to value ratios, seasoning and credit support in conjunction with broader macroeconomic expectations such as home price depreciation, expectations of future delinquencies and loss severities and the ability of the borrow to refinance or modify their loans.  If after determining the expected future cash flows of the position, the amortized cost of the security is less than the present value of its expected future cash flows, an other-than-temporary credit impairment has occurred.  If the Company does not intend to sell nor are more likely than not required to sell the debt security prior to its anticipated recovery, the credit loss, if any, is recognized in the statement of operations, while the balance of impairment related to other factors is recognized in Other Comprehensive Income (“OCI”).  If the Company intends to sell the debt security, or will be more likely than not required to sell the security before its anticipated recovery, the full OTTI is recognized in the statement of operations.  The determination cannot be overcome by management judgment of the probability of collecting all cash flows previously projected.  A summary of the OTTI included in earnings for the quarter ending March 31, 2010 and March 31, 2009 is presented below:
 
   
For the Quarter Ending
 
   
March 31, 2010
   
March 31, 2009
 
   
(dollars in thousands)
 
Cumulative credit loss beginning balance
  $ 9,996     $ -  
Additions:
               
Other-than-temporary impairments not previously recognized
    2,462       -  
Increases related to other-than-temporary impairments on securities with
previously recognized other-than-temporary impairments
    82       -  
Cumulative credit loss ending balance
  $ 12,540     $ -  


The impairment recorded during the quarter ending March 31, 2010 was related to seven securities.  Five of the seven securities are subordinated securitized or re-securitized IOs with underlying collateral that had increasing prepayment speeds which eroded the expected future cash flows.  One security recorded a significant increase in the severity of losses recorded in the current period and as such the Company increased severity expectations over the life of the security.  The seventh security is nearing final payment of the principal balance and the Company expects final settlement of the security to have increased losses.  In the quarter ending March 31, 2010, these securities recorded loss severities ranging from 38% to 82% Constant Default Rate, three month prepayments speeds between 7 and 19 CPR, 60+ day delinquencies between 18% and 45% of the pool balance, despite having weighted average FICO scores on the pools between 692 and 735.  There was no impairment recorded for the quarter ending March 31, 2009.

The Company’s investment guidelines place no restrictions on the credit rating of the assets the Company is able to hold in its portfolio.  The portfolio is most heavily weighted to contain RMBS with credit risk.  The Company chooses assets for the portfolio after carefully evaluating each investment’s risk profile.
 
   
March 31, 2010
   
December 31, 2009
 
AAA
    40.85 %     39.41 %
AA
    0.72 %     0.75 %
A
    0.00 %     0.55 %
BBB
    0.17 %     1.07 %
BB
    1.00 %     1.77 %
B
    1.05 %     2.18 %
Below B or not rated
    56.21 %     54.27 %
Total
    100.00 %     100.00 %

The AAA rated assets in the RMBS portfolio are predominantly Agency RMBS.  As the Company securitizes or re-securitizes assets, it expects the Below B or not rated percentages in the portfolio to increase as the Company typically retains the subordinated tranches of these types of transactions.

Actual maturities of mortgage-backed securities are generally shorter than stated contractual maturities.  Actual maturities of the Company’s RMBS are affected by the contractual lives of the underlying mortgages, periodic payments of principal and prepayments of principal.  The following tables summarize the Company’s RMBS at March 31, 2010 and December 31, 2009 according to their estimated weighted-average life classifications.  The weighted-average lives of the mortgage-backed securities at March 31, 2010 and December 31, 2009 in the tables below are based on data provided through dealer quotes, assuming constant prepayment rates to the balloon or reset date for each security.  The prepayment model considers current yield, forward yield, steepness of the curve, current mortgage rates, mortgage rates of the outstanding loan, loan age, margin and volatility.
 
14

 
March 31, 2010
 
(dollars in thousands)
 
                         
   
Weighted Average Life
             
   
Less than one
year
   
Greater than one
year and less
than five years
   
Greater than five
years
   
Total
 
Fair value
                       
Non-Agency RMBS
                       
Senior
  $ 128,499     $ 576,586     $ 724,447     $ 1,429,532  
Subordinated
    1,410       40,825       905,728       947,963  
Senior, non-retained
    153,632       1,492,453       -       1,646,085  
Agency RMBS
    -       1,181,114       377,681       1,558,795  
Total fair value
  $ 283,541     $ 3,290,978     $ 2,007,856     $ 5,582,375  
Amortized cost
                               
Non-Agency RMBS
                               
Senior
  $ 133,408     $ 570,855     $ 893,379     $ 1,597,642  
Subordinated
    1,588       41,422       725,456       768,466  
Senior, non-retained
    149,774       1,387,941       -       1,537,715  
Agency RMBS
    -       1,162,171       371,403       1,533,574  
Total amortized cost
  $ 284,770     $ 3,162,389     $ 1,990,238     $ 5,437,397  
                                 
December 31, 2009
 
(dollars in thousands)
 
                                 
   
Weighted Average Life
                 
   
Less than one
year
   
Greater than one
year and less
than five years
   
Greater than five
years
   
Total
 
Fair value
                               
Non-Agency RMBS
                               
Senior
  $ 20,533     $ 1,520,809     $ 481,065     $ 2,022,407  
Subordinated
    137       204,481       171,840       376,458  
Agency RMBS
    -       1,690,029       -       1,690,029  
Total fair value
  $ 20,670     $ 3,415,319     $ 652,905     $ 4,088,894  
Amortized cost
                               
Non-Agency RMBS
                               
Senior
  $ 20,549     $ 1,631,461     $ 478,530     $ 2,130,540  
Subordinated
    76       244,937       141,594       386,607  
Agency RMBS
    -       1,671,502       -       1,671,502  
Total amortized cost
  $ 20,625     $ 3,547,900     $ 620,124     $ 4,188,649  
 
The non-Agency RMBS portfolio is subject to credit risk.  The Company seeks to mitigate credit risk through its asset selection process.  The non-Agency RMBS portfolio is collateralized by what the Company classifies as Alt-A first lien mortgages.  The Company categorizes collateral as Alt-A regardless of whether the loans were originally described as “prime” if the behavior of the collateral when we purchase the security more typically resembles Alt-A.  The Company defines Alt-A collateral characteristics to be when the 60+ day delinquency bucket of the pool is greater than 5% and weighted average FICO scores are greater than 650 at origination.  At March 31, 2010, 98% of the non-Agency RMBS are Alt-A collateral.  At December 31, 2009, 89% of the non-Agency RMBS were Alt-A collateral.  The investment securities contained in this portion of the portfolio have the following collateral characteristics at March 31, 2010 and December 31, 2009.
 
The table below presents origination year for the Company's portfolio of non-Agency RMBS at March 31, 2010:
 
Origination Year as a Percentage of
Outstanding Principal Balance
 
March 31, 2010
 
2005
    8.3 %
2006
    36.8 %
2007
    52.1 %
2008
    1.6 %
2009
    1.2 %
Total
    100.0 %
 
15

 
 
March 31, 2010
December 31, 2009
Number of securities in portfolio
 
346
 
209
Weighted average maturity (years)
 
28.2
 
28.5
Weighted average amortized loan to value
 
73.7%
 
73.8%
Weighted average FICO
 
716.2
 
715.7
Weighted average loan balance (in thousands)
 
425.8
 
415.9
Weighted average percentage owner occupied
 
83.4%
 
82.8%
Weighted average percentage single family residence
 
60.7%
 
59.9%
Weighted average current credit enhancement
 
21.6%
 
12.2%
Weighted average geographic concentration
CA
57.4%
CA
44.8%
 
FL
13.8%
FL
17.3%
 
NY
6.7%
NY
7.5%
 
NJ
3.9%
MD
4.9%
 
MD
3.5%
NJ
4.4%
 
On January 29, 2010, the Company transferred $1.7 billion in principal value of its RMBS to the CSMC 2010-1R Trust in a re-securitization transaction.  This transaction was recorded as a “secured borrowing” pursuant to ASC Topics 860 and 810.  In this transaction, the Company financed through the transaction $271.6 million of AAA-rated fixed rate bonds to third party investors for net proceeds of $268.1 million.  The Company has retained $391.9 million of AAA-rated bonds, $1.0 billion in subordinated bonds and the owner trust certificate, and interest only bonds with a notional value of $1.6 billion.  The subordinated bonds and the owner trust certificate provide credit support to the AAA-rated bonds.  The bonds issued by the trust are collateralized by RMBS that were transferred to the CSMC 2010-1R Trust.  The assets classified as non-agency MBS under the subheading “Senior, non-retained” in the Company's consolidated financial statements were financed by selling AAA-rated bonds to third parties.  The liability related to the financing is reflected in the Company's consolidated financial statements as “Securitized debt, non-retained.”  Secured borrowings under GAAP do not reflect a gain or loss on the sale of the bonds over their cost basis but rather amortize or accrete the gains over the life of the bonds.  The Company has no continuing involvement with the transferred assets except for its right to receive principal and interest cash flows from the bonds it has retained.
 
During the quarter ended March 31, 2010, the Company sold RMBS with a carrying value of $89.6 million for net realized gains of $342 thousand.  Of the four securities sold during the quarter, two of the securities had realized losses on the sale amounting to $1.8 million.  These sales were effected for opportunistic repositioning of the portfolio into higher yielding assets.  During the quarter ended December 31, 2009, the Company sold RMBS with a carrying value of $213.0 million for realized gains of approximately $16.2 million.
 
4.  Securitized Loans Held for Investment

The following table represents the Company’s securitized residential mortgage loans classified as held for investment at March 31, 2010 and December 31, 2009.  At March 31, 2010, approximately 56% of the Company’s securitized loans are adjustable rate mortgage loans and 44% are fixed rate mortgage loans.  All of the adjustable rate loans held for investment are hybrid adjustable rate mortgages (“ARMs”).  Hybrid ARMs are mortgages that have interest rates that are fixed for an initial period (typically three, five, seven or ten years) and thereafter reset at regular intervals subject to interest rate caps.  The periodic cap on all hybrid ARMs in the securitized loan portfolio range from 0.00% to 3.00% for the quarters ended March 31, 2010 and December 31, 2009.  The securitized loans held for investment are carried at their principal balance outstanding, plus premiums or discounts, less an allowance for loan losses:
 
   
March 31, 2010
   
December 31, 2009
 
   
(dollars in thousands)
 
             
Securitized loans, at principal balance
  $ 445,901     $ 475,084  
Less: allowance for loan losses
    4,554       4,551  
Securitized loans held for investment
  $ 441,347     $ 470,533  

 
16

 
 
The securitized loan portfolio is collateralized by prime, jumbo, first lien residential mortgages of which 54% were originated during 2008 and 44% were originated during 2007.  A summary of key characteristics of these loans follows:
 
 
March 31, 2010
December 31, 2009
Number of loans
 
636
 
681
Weighted average maturity (years)
 
27
 
27
Weighted average amortized loan to value
 
73.5%
 
73.0%
Weighted average FICO
 
757
 
756
Weighted average loan balance (in thousands)
 
692.9
 
690.1
Weighted average percentage owner occupied
 
90.5%
 
90.9%
Weighted average percentage single family residence
 
59.5%
 
60.0%
Weighted average geographic concentration
CA
33.4%
CA
33.8%
 
FL
6.7%
FL
6.4%
 
IL
6.0%
NJ
6.3%
 
NJ
6.0%
IL
6.0%
 
VA
4.9%
VA
4.8%

The following table summarizes the changes in the allowance for loan losses for the securitized mortgage loan portfolio during the quarters ended March 31, 2010 and December 31, 2009:
 
   
March 31, 2010
   
December 31, 2009
 
   
(dollars in thousands)
 
Balance, beginning of period
  $ 4,551     $ 1,621  
Provision for loan losses
    606       3,101  
Charge-offs
    (603 )     (171 )
Balance, end of period
  $ 4,554     $ 4,551  

On a quarterly basis, the Company evaluates the adequacy of its allowance for loan losses.  The Company’s allowance for loan losses at March 31, 2010 was $4.6 million, representing 104 basis points of the principal balance of the Company’s securitized mortgage loan portfolio.  The Company’s allowance for loan losses was $4.6 million at December 31, 2009, representing 101 basis points of the principal balance of the Company’s securitized loan portfolio.  At March 31, 2010, 2.4% of the securitized loans held for investment were greater than 60 days delinquent and 1.0% were in some stage of foreclosure.  At December 31, 2009, 1.82% of the securitized loans held for investment were greater than 60 days delinquent and 0.89% were in some stage of foreclosure.

5.  Fair Value Measurements

GAAP defines fair value, establishes a framework for measuring fair value, establishes a three-level valuation hierarchy for disclosure of fair value measurement and enhances disclosure requirements for fair value measurements.  The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date.  The three levels are defined as follows:
 
Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets and liabilities in active markets.
 
Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
 
Level 3 – inputs to the valuation methodology are unobservable and significant to fair value.
 
The following discussion describes the methodologies utilized by the Company to fair value its financial instruments by instrument class.
 
Short-term Instruments
The carrying value of cash and cash equivalents, accrued interest receivable, dividends payable, accounts payable, and accrued interest payable generally approximates estimated fair value due to the short term nature of these financial instruments.
 
17

 
Non-Agency and Agency RMBS
The Company determines the fair value of its investment securities utilizing a pricing model that incorporates such factors as coupon, prepayment speeds, weighted average life, collateral composition, borrower characteristics, expected interest rates, life caps, periodic caps, reset dates, collateral seasoning, expected losses, expected default severity, credit enhancement, and other pertinent factors.  Management reviews the fair values generated by the model to determine whether prices are reflective of the current market.  Management performs a validation of the fair value calculated by the pricing model by comparing its results to independent prices provided by dealers in the securities and/or third party pricing services.  The Company believes the observable inputs used in its model in conjunction with dealer and/or third party pricing services meets the criteria for classification as Level 2.
 
Any changes to the valuation methodology are reviewed by management 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 to produce a fair value calculation may not be indicative of net realizable value or reflective of future fair values. Furthermore, while the Company believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments could 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.

Non-Agency Non-Retained RMBS
The non-Agency, non-retained securities reflected in the consolidated financial statements are securities consolidated pursuant to the Company’s adoption of ASC 860 and ASC 810 on January 1, 2010.  These assets have been financed with third parties without recourse to the Company the normal course of the Company’s portfolio optimization strategy.  The Company classifies these assets as Level 3 as the fair valuation of these securities is not based on observable inputs.  The Company fair values these assets at the actual sale price obtained in the financing of the debt to the third party as any current or future appreciation or depreciation of the assets in not realizable by the Company.  Please see Note 8 to these consolidated financial statements for a detailed discussion of these securities.

During times of market dislocation, as has been experienced for some time, the observability of prices and inputs can be reduced for certain instruments.  If dealers or independent pricing services are unable to provide a price for an asset, or if the price provided by them is deemed unreliable by the Company, then the asset will be valued at its fair value as determined in good faith by the Company.  In addition, validating third party pricing for the Company’s investments may be more subjective as fewer participants may be willing to provide this service to the Company.  Illiquid investments typically experience greater price volatility as a ready market does not exist.  As fair value is not an entity specific measure and is a market based approach which considers the value of an asset or liability from the perspective of a market participant, observability of prices and inputs can vary significantly from period to period.  A condition such as this can cause instruments to be reclassified from Level 1 to Level 2 or Level 2 to Level 3 when the Company is unable to obtain third party pricing verification.

If at the valuation date, the fair value of an investment security is less than its amortized cost at the date of the consolidated statement of financial condition, the Company analyzes the investment security for OTTI.  Management evaluates the Company’s RMBS for OTTI at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.  Consideration is given to (1) the length of time and the extent to which the fair value has been lower than carrying value, (2) the intent of the Company to sell the investment prior to recovery in fair value (3) whether the Company will be more likely than not be required to sell the investment before the expected recovery, and (4) the expected future cash flows of the investment in relation to its amortized cost.  Unrealized losses on assets that are considered OTTI due to credit are recognized in earnings and the cost basis of the assets are adjusted.
 
18

 
At March 31, 2010 and December 31, 2009, the Company has classified a portion of its assets as “Level 2” and a portion as “Level 3.”  The Company’s financial assets carried at fair value on a recurring basis are valued at March 31, 2010 and December 31, 2009 as follows:
 
March 31, 2010
 
   
Level 1
   
Level 2
   
Level 3
 
   
(dollars in thousands)
       
Assets:
                 
Non-Agency RMBS
                 
Senior
  $ -     $ 1,429,530     $ -  
Subordinated
    -       947,963       -  
Senior, non-retained
    -       -       1,646,087  
Agency mortgage-backed securities
    -       1,558,795       -  
                         
December 31, 2009
 
   
Level 1
   
Level 2
   
Level 3
 
   
(dollars in thousands)
         
Assets:
                       
Non-Agency RMBS
                       
Senior
  $ -     $ 2,022,406     $ -  
Subordinated
    -       376,459       -  
Senior, non-retained
    -       -       -  
Agency mortgage-backed securities
    -       1,690,029       -  
 
The table below presents a reconciliation of changes in assets classified as Level 3 in the Company’s consolidated financial statements.  All of the assets classified as Level 3 as of the period ended March 31, 2010 have been added to this classification with the adoption of ASC 860 and ASC 810 as of January 1, 2010.  A discussion of the method of fair valuing these assets is included above in Non-Agency Non-Retained RMBS.  Unrealized gains on the assets are included in other comprehensive income.
 
Fair Value Reconciliation, Level 3
 
(dollars in thousands)
 
       
   
March 31, 2010
 
Non-Agency RMBS
     
Senior, non-retained
     
Beginning balance Level 3 assets
  $ -  
Transfers in to Level 3
    1,537,715  
Total unrealized gains included in OCI
    108,370  
Ending balance Level 3 assets
  $ 1,646,085  

As of the quarters ended March 31, 2010 and December 31, 2009, the Company was able to obtain third party pricing verification for all assets classified as Level 2.  In the aggregate, the Company’s fair valuation of RMBS investments were 0.76% higher than the aggregated dealer marks for the quarter ended March 31, 2010 and 1.05% lower than the aggregated dealer marks for the quarter ended December 31, 2009.

Securitized Loans Held for Investment
The Company records securitized loans held for investment when it securitizes loan and records the transaction as a “financing.”  The Company carries securitized loans held for investment at principal value, plus premiums or discounts paid, less an allowance for loan losses.  The Company fair values its securitized loans held for investment by estimating future cash flows of the underlying assets.  The Company models each underlying asset by considering, among other items, the structure of the underlying security, coupon, servicer, actual and expected defaults, actual and expected default severities, reset indices, and prepayment speeds in conjunction with market research for similar collateral performance and management’s expectations of general economic conditions in the sector and greater economy.

Repurchase Agreements
The Company records repurchase agreements at their contractual amounts including accrued interest payable.  Repurchase agreements are collateralized financing transactions utilized by the Company to acquire investment securities.  Due to the short term nature of these financial instruments, the Company estimated the fair value of these repurchase agreements to be the contractual obligation plus accrued interest payable at maturity.
 
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Securitized Debt
The Company records securitized debt for certificates or notes financed without recourse to the Company in securitization or re-securitization transactions treated as “financings” pursuant to ASC 860.  The Company carries securitized debt at the principal balance outstanding on non-retained notes associated with its securitized loans held for investment plus premiums or discounts recorded with the sale of the notes to third parties.  The premiums or discounts associated with the sale of the notes or certificates are amortized over the life of the instrument.  The Company estimates the fair value of securitized debt by estimating the future cash flows associated with underlying assets collateralizing the secured debt outstanding.  The Company models each underlying asset by considering, among other items, the structure of the underlying security, coupon, servicer, actual and expected defaults, actual and expected default severities, reset indices, and prepayment speeds in conjunction with market research for similar collateral performance and management’s expectations of general economic conditions in the sector and greater economy.

The following table presents the carrying value and estimated fair value, as described above, of the Company’s financial instruments at March 31, 2010 and December 31, 2009:
 
   
March 31, 2010
   
December 31, 2009
 
   
Carrying
Amount
   
Estimated Fair
Value
   
Carrying
Amount
   
Estimated Fair
Value
 
   
(dollars in thousands)
 
Non-Agency RMBS
  $ 4,023,580     $ 4,023,580     $ 2,398,865     $ 2,398,865  
Agency RMBS
    1,558,795       1,558,795       1,690,029       1,690,029  
Securitized loans held for investment
    441,347       419,791       470,533       453,388  
Repurchase agreements
    1,686,237       1,876,393       1,975,402       1,977,664  
Securitized debt
    364,665       381,832       390,350       408,404  
Securitized debt, non-retained
    1,636,437       1,638,374       -       -  

6.  Repurchase Agreements

The Company had outstanding $1.7 billion and $2.0 billion of repurchase agreements with weighted average borrowing rates of 0.49% and 0.60% and weighted average remaining maturities of 28 and 26 days as of March 31, 2010 and December 31, 2009, respectively.  At March 31, 2010 and December 31, 2009, RMBS pledged as collateral under these repurchase agreements had an estimated fair value of $1.9 billion and $2.0 billion, respectively.   The interest rates of these repurchase agreements are generally indexed to the one-month LIBOR rate and re-price accordingly.

At March 31, 2010 and December 31, 2009, the repurchase agreements collateralized by RMBS had the following remaining maturities:
 
   
March 31, 2010
   
December 31, 2009
 
   
(dollars in thousands)
 
Overnight
  $ 203,616     $ -  
1-30 days (1)
    1,278,672       1,772,662  
30 to 59 days
    140,497       62,243  
60 to 89 days
    -       -  
90 to 119 days
    -       -  
Greater than or equal to 120 days
    63,452       140,497  
Total
  $ 1,686,237     $ 1,975,402  
(1) Repurchase agreements with affiliates totalled $147.4 million and $259.0 million for the quarters ended March 31, 2010 and December 31, 2009, respectively.
 

At March 31, 2010 and December 31, 2009, the Company did not have an amount at risk greater than 10% of its equity with any counterparty.

7.  Securitized Debt

All of the Company’s securitized debt is collateralized by residential mortgage loans or residential mortgage-backed securities.  For financial reporting purposes, the Company’s securitized debt is accounted for as a financing.  Thus, the residential mortgage loans or RMBS held as collateral are recorded in the assets of the Company as securitized loans held for investment or RMBS and the securitized debt is recorded as a liability in the statements of financial condition.
 
20

 
At March 31, 2010, the Company’s securitized debt collateralized by residential mortgage loans had a principal balance of $381.8 million.  The debt matures between the years 2015 and 2038.  At March 31, 2010, the debt carried a weighted average cost of financing equal to 5.56%, that is secured by residential mortgage loans of which approximately 44% of the remaining principal balance pays a fixed rate of 6.33% and 56% of the remaining principal balance pays a variable rate of 5.60%.  At December 31, 2009, the Company’s securitized debt collateralized by residential mortgage loans had a principal balance of $390.4 million.  At December 31, 2009, the debt carried a weighted average cost of financing equal to 5.50%, that is secured by residential mortgage loans of which approximately 43% of the remaining principal balance pays a fixed rate of 6.33% and 57% of the remaining principal balance pays a variable rate of 5.63%.

At March 31, 2010, the Company’s securitized debt collateralized by RMBS has a principal balance of $1.7 billion.  The debt matures between the years 2035and 2047.  At March 31, 2010, the debt carried a weighted average cost of financing equal to 5.92%.  At December 31, 2009 the Company did not have securitized debt collateralized by RMBS.

The following table presents the estimated principal repayment schedule of the securitized debt held by the Company outstanding at March 31, 2010 and December 31, 2009, based on expected cash flows of the loans collateralizing the debt:
 
   
March 31, 2010
   
December 31, 2009
 
   
(dollars in thousands)
 
Within One Year
  $ 858,127     $ 37,192  
One to Three Years
    1,255,603       70,885  
Three to Five Years
    514,613       59,382  
Greater Than or Equal to Five Years
    1,540,066       240,945  
Total
  $ 4,168,409     $ 408,404  

The significant debt reflected above reflects the Company’s adoption of ASC 810 on January 1, 2010.  Please see Note 8 for a more detailed discussion.

Maturities of the Company’s securitized debt are dependent upon cash flows received from the underlying loans. The estimate of their repayment is based on scheduled principal payments on the underlying loans. This estimate will differ from actual amounts to the extent prepayments and/or loan losses are experienced.  Please see Note 4 for a more detailed discussion of the loans collateralizing the securitized debt.

8.  Consolidation

In June 2009, the FASB issued two new accounting standards that amended guidance applicable to the accounting for transfers of financial assets and the consolidation of VIE’s (ASC 860 and ASC 810, respectively).  The primary affect of these standards was to eliminate the concept of a QPSE when transferring assets and to remove the exemption of a QSPE when applying the consolidation standard.  The Company adopted these new accounting standards as of January 1, 2010.

The Company uses securitization trusts or variable interest entities in our securities issuance process.  Prior to January 1, 2010, these variable interest entities met the definition of QSPE’s and as such, were not subject to consolidation.  Effective January 1, 2010, all such variable interest entities must be considered for consolidation based on the criteria in ASC 810.

Per ASC 810, an entity shall consolidate a VIE when that entity has a variable interest that provides the reporting entity with a controlling financial interest.  The assessment of the characteristics of the reporting entity’s VIE shall consider the VIE’s purpose and design.  A controlling financial interest is defined as (a) the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance and (b) the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.
 
21

 
Since the Company’s inception, there have been seven securitization trust VIE’s commenced for the purpose of securitizing whole mortgage loans or re-securitizing MBS and obtaining term financing. The Company evaluated its interest in each securitization trust VIE to determine our primary beneficiary status.  The Company found that five trusts, one of which had been consolidated since its inception, met the requirements of consolidation.  The Company found that in five of the seven securitizations, based on holding all of the subordinate interests, it maintains the obligation to absorb losses and/or the right to receive benefits that could be significant to the VIE.  In addition, the Company had the power to direct activities of the trust or was determined to have the ability to control the trust due to our contribution in the purpose and design of the structure.  The remaining two trusts evaluated did not meet the requirements to consolidate due to the inability to control one of the trusts and the lack of obligation to absorb losses on the remaining trust.
 
VIE’s for which we are the Primary Beneficiary
Based on our consolidation evaluation, the Company has consolidated three VIE’s as of January 1, 2010 that were not previously consolidated.  Our retained beneficial interest is, minimally, the subordinate tranche of these re-securitizations. In some cases we hold interests in additional tranches.  As of January 1, 2010, we have consolidated these trusts and recognized the assets and liabilities at their carrying value.  The effect in the current quarter is the inclusion of assets of $1.6 billion of non-Agency mortgage-backed securities at fair value no longer retained by the Company, the inclusion in our liabilities of $1.6 billion of non-recourse securitized debt associated with these mortgage-backed securities and the de-recognition of gains on sales of bonds during 2009 associated with re-securitizations. These accounting changes had no economic effect on us.

On an ongoing basis, our retained beneficial interests will be fair valued as Level 2 assets.  The consolidated third-party owned interests will be fair valued as Level 3 assets using the sale price as fair value.  This is due to the fact that we have no control over the third-party interests and will not receive any future value from them.  Line items pertaining to the third-party owned interests are separately stated within our consolidated financial statements and labeled as “Non-Retained”.

The trusts are structured as pass through entities that receive principal and interest on the underlying collateral and distribute those payments to the certificate holders. The assets and other instruments held by the securitization entities are restricted and can only be used to fulfill the obligations of the securitization entity.  Additionally, the obligations of the securitization entities do not have any recourse to the general credit of any other consolidated subsidiaries, nor to Chimera as the primary beneficiary.  The Company’s risks associated with its involvement with these VIE’s is limited to its risks and rights as a certificate holder of the bonds it has retained.

The securitization entities newly consolidated by the Company are similar in nature to the portfolio as a whole.  The securitization entities are all composed of RMBS of the quality and characteristics of assets reflected in the RMBS classifications found in the Company’s consolidated financial statements.  Please see Note 3 for a discussion of the securities characteristics of the portfolio.
 
22

 
The table below presents the assets and liabilities of consolidated entities as of January 1, 2010:
 
   
Carrying Value (1)
 
   
(dollars in thousands)
 
Assets
     
Non-Agency RMBS
     
Senior, non-retained
  $ 1,114,034  
Liabilities
       
Securitized debt, non-retained
    1,202,221  
Net assets and liabilities of newly consolidated entities
    (88,187 )
Cumulative effect adjustment to retained earnings upon adoption
  $ (88,187 )
         
(1) Carrying value represents the amount the assets would have been recorded at in the consolidated financial statements at January 1, 2010 had they been recorded in the consolidated financial statements on the date the Company first met the conditions for consolidation.
 

The cumulative effect of adopting ASC 810 on January 1, 2010 on a based on the shares outstanding on that date was to reduce the beginning book value of the Company by $0.13 per share.

The table below reflects the assets and liabilities recorded in the consolidated statements of financial condition related to the newly consolidated securitization entities for the period ended March 31, 2010.
 
   
March 31, 2010
 
   
(dollars in thousands)
 
Assets
     
Non-Agency RMBS
     
Senior, non-retained
  $ 1,646,087  
Liabilities
       
Securitized debt, non-retained
  $ 1,636,437  

The consolidation of these securitization entities increases both the recorded assets and liabilities of the Company.  The assets of the trust associated with each securitization entity can only be used to settle the obligations of each respective trust.  In addition, the securitization entities consolidated have no recourse to the credit of the Company.  Please see Note 5 for a discussion of the fair value measurement of the assets and liabilities.

The consolidation of these securitization entities increases both the income and expense recorded in the consolidated statement of operations for the Company as detailed in the table below.
 
   
For the Quarter Ended
March 31, 2010
 
   
(dollars in thousands)
 
Interest income, non-retained
  $ 50,861  
Interest expense, non-retained
    33,830  
Net interest income, non-retained
  $ 17,031  

A discussion of the significant accounting policies of the Company to record income and expense is included in Note 2 to these consolidated financial statements.  The effect of adopting ASC 810 based on the weighted average shares outstanding was to increase the net interest income of the Company by approximately $0.03 per share in the quarter ending March 31, 2010.

The consolidation of these securitization entities increases the cash flows recorded with respect to the companies financing activities as detailed in the table below.
 
23

 
   
For the Quarter Ended
March 31, 2010
 
   
(dollars in thousands)
 
Proceeds from securitized debt borrowings, non-retained
  $ 498,720  
Payments on securitized debt borrowings, non-retained
    (84,634 )
Increase in accrued interest receivable
    (7,841 )
Increase in accrued interest payable
    8,142  
Net cash flows, non-retained
  $ 414,387  
 
VIE’s for which we are not the Primary Beneficiary
The table below represents the carrying amounts and classification of assets recorded on our consolidated financial statements related to our variable interests in non-consolidated VIE’s, as well as our maximum exposure to loss as a result of our involvement with these VIE’s.
 
   
March 31, 2010
   
December 31, 2009
 
   
Amortized Cost
   
Fair Value
   
Amortized Cost
   
Fair Value
 
   
(dollars in thousands)
 
Assets
                       
Non-Agency RMBS
                       
Senior
  $ -     $ -     $ 47,998     $ 46,047  
Subordinated
    9,505       8,572       9,701       7,081  
Agency RMBS
    4,295       4,978       4,730       4,720  
Total
  $ 13,800     $ 13,550     $ 62,429     $ 57,848  

Our involvement with VIE’s for which we are not the primary beneficiary generally are in the form of purchasing an investment in these entities.  Our maximum exposure to loss in these entities is represented by the fair value of these assets.  This amount does not include OTTI or other write-downs that we previously recognized through earnings.

9.  Common Stock

On September 24, 2009, the Company implemented a dividend reinvestment and share purchase plan (“DRSPP”).  The DRSPP provides holders of record of our common stock an opportunity to automatically reinvest all or a portion of their cash distributions received on common stock in additional shares of our common stock as well as to make optional cash payments to purchase shares of our common stock. Persons who are not already stockholders may also purchase our common stock under the plan through optional cash payments.   The DRSPP is administered by the Administrator, The Bank of New York Mellon.  To date, no shares have been issued under the DRSPP.

On March 31, 2010 the Company announced the sale of 85,000,000 shares of common stock at $3.61 per share for estimated proceeds, less the underwriters’ discount and offering expenses, of $306.7 million.  In addition, on April 1, 2010, the underwriters exercised the option to purchase up to an additional 12,750,000 shares of common stock to cover over-allotments for proceeds, less the underwriters’ discount, of approximately $46.0 million. This sale was completed on April 7, 2010.  In all, the Company raised net proceeds of approximately $352.7 million in these offerings.

There was no preferred stock issued or outstanding as of March 31, 2010 and December 31, 2009.

During the quarter ended March 31, 2010, the Company declared dividends to common shareholders totaling $113.8 million or $0.17 per share.  During the quarter ended December 31, 2009, the Company declared dividends to common shareholders totaling $113.8 million or $0.17 per share.
 
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10.  Long Term Incentive Plan

The Company has adopted a long term stock incentive plan to provide incentives to its independent directors and employees of FIDAC and its affiliates, to stimulate their efforts towards the Company’s continued success, long-term growth and profitability and to attract, reward and retain personnel and other service providers.  The incentive plan authorizes the Compensation Committee of the board of directors to grant awards, including incentive stock options, non-qualified stock options, restricted shares and other types of incentive awards.  The specific award granted to an individual is based upon, in part, the individual’s position within FIDAC, the individual’s position within the Company, his or her contribution to the Company’s performance, market practices, as well as the recommendations of FIDAC.  The incentive plan authorizes the granting of options or other awards for an aggregate of the greater of 8.0% of the outstanding shares of the Company’s common stock up to a ceiling of 40,000,000 shares.

On January 2, 2008, the Company granted restricted stock awards in the amount of 1,301,000 shares to FIDAC’s employees and the Company’s independent directors.  The awards to the independent directors vested on the date of grant and the awards to FIDAC’s employees vest quarterly over a period of 10 years.  Of these shares, as of March 31, 2010, 302,025 shares have vested and 22,540 shares were forfeited or cancelled.

On December 22, 2009, the Compensation Committee awarded each independent director $45,000 in common stock which vested on December 31, 2009.
 
As of March 31, 2010, there was $17.7 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the long term incentive plan, based on closing price of the shares on the grant date. That cost is expected to be recognized over a weighted-average period of 7.8 years. The total fair value of shares vested during the quarter ended March 31, 2010 was $125,033, based on the closing price of the stock on the vesting date.
 
11.  Income Taxes

As a REIT, the Company is not subject to Federal income tax to the extent that it makes qualifying distributions to its stockholders, and provided it satisfies on a continuing basis, through actual investment and operating results, the REIT requirements including certain asset, income, distribution and stock ownership tests.  Most states recognize REIT status as well.  During the quarter ended March 31, 2010, the Company recorded no income tax expense related to state and federal tax liabilities on undistributed income.  During the quarter ended December 31, 2009, the Company recorded no income tax expense related to state and federal tax liabilities on undistributed income.

In general, common stock cash dividends declared by the Company will be considered ordinary income to stockholders for income tax purposes.  From time to time, a portion of the Company’s dividends may be characterized as capital gains or return of capital.  For the quarters ended March 31, 2010 and December 31, 2009 the Company estimates that all income distributed in the form of dividends will be characterized as ordinary income.

12.  Credit Risk and Interest Rate Risk

The Company’s primary components of market risk are credit risk and interest rate risk.  The Company is subject to credit risk and interest rate risk in connection with its investments in non-Agency residential mortgage loans and credit sensitive mortgage-backed securities.  When the Company assumes credit risk, it attempts to minimize interest rate risk through asset selection, hedging and matching the income earned on mortgage assets with the cost of related liabilities.  The Company is subject to interest rate risk, primarily in connection with its investments in fixed-rate and adjustable-rate mortgage-backed securities, residential mortgage loans, and borrowings under repurchase agreements.  The Company attempts to minimize credit risk through due diligence and asset selection by purchasing loans underwritten to agreed-upon specifications of selected originators.  The Company has established a whole loan target market including prime borrowers with FICO scores generally greater than 650, Alt-A documentation, geographic diversification, owner-occupied property, and moderate loan to value ratio.  These factors are considered to be important indicators of credit risk

13.  Management Agreement and Related Party Transactions

The Company has entered into a management agreement with FIDAC, which provides for an initial term through December 31, 2010 with an automatic one-year extension option and subject to certain termination rights.  The Company pays FIDAC a quarterly management fee equal to 1.50% per annum of the gross Stockholders’ Equity (as defined in the management agreement) of the Company.
 
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Management fees accrued and paid to FIDAC for the quarters ended March 31, 2010 and 2009 were $8.1 million and $2.6 million, respectively.

The Company is obligated to reimburse FIDAC for its costs incurred under the management agreement.  In addition, the management agreement permits FIDAC to require the Company to pay for its pro rata portion of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses that FIDAC incurred in the operation of the Company.  These expenses are allocated between FIDAC and the Company based on the ratio of the Company’s proportion of gross assets compared to all remaining gross assets managed by FIDAC as calculated at each quarter end.   FIDAC and the Company will modify this allocation methodology, subject to the Company’s board of directors’ approval if the allocation becomes inequitable (i.e., if the Company becomes very highly leveraged compared to FIDAC’s other funds and accounts).  FIDAC has waived its right to request reimbursement from the Company of these expenses until such time as it determines to rescind that waiver.  The amount waived by FIDAC is not material to the consolidated financial statements.

During the quarters ended March 31, 2010 and December 31, 2009, 32,225 and 32,225 shares of restricted stock issued by the Company to FIDAC’s employees vested, as discussed in Note 10.

In April 2009, the Company entered into a Securities Industry and Financial Markets Association standard preprinted form Master Repurchase Agreement with RCAP Securities, Inc., an affiliate.  This standard agreement does not contain any sort of liquidity, net worth or other similar types of positive or negative covenants.  Rather, the agreement contains covenants that require the buyer and seller of securities to deliver collateral or securities, and similar covenants which are customary in the form Master Repurchase Agreement.  As of March 31, 2010, the Company was financing $147.4 million under this agreement at a weighted average rate of 1.22%. The Company has been in compliance with all covenants of this agreement since it entered into this agreement.

In March 2008, the Company entered into a Securities Industry and Financial Markets Association standard preprinted form Master Repurchase Agreement with Annaly.  This standard agreement does not contain any sort of liquidity, net worth or other similar types of positive or negative covenants.  Rather, the agreement contains covenants that require the buyer and seller of securities to deliver collateral or securities, and similar covenants which are customary in the form Master Repurchase Agreement.  At March 31, 2010, the Company had no financing under this agreement.  At December 31, 2009, the Company financed $259.0 million under this agreement at a weighted average rate of 1.72%.  The Company has been in compliance with all covenants of this agreement since it entered into this agreement.

14.  Commitments and 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 reported or unreported contingencies at March 31, 2010.

15.  Subsequent Events

On April 30, the Company transferred $566.6 million in principal value of its RMBS to the CSMC 2010-11R Trust in a re-securitization transaction.  In this transaction, the Company term financed $138.8 million of AAA-rated fixed rate bonds financing without recourse to the Company with third party investors for net proceeds of $137.4 million.  The Company retained $427.8 million in subordinated non-rated bonds and the owner trust certificate, and inverse interest only bonds with a notional value of $566.8 million.  The subordinated bonds and the owner trust certificate provide credit support to the AAA-rated bonds.  The bonds issued by the trust are collateralized by RMBS that were transferred to the CSMC 2010-11R Trust.  This re-securitization will be consolidated pursuant to ASC 810.

On March 31, 2010 the Company announced the sale of 85,000,000 shares of common stock at $3.61 per share for estimated proceeds, less the underwriters’ discount and offering expenses, of $306.7 million.  In addition, on April 1, 2010, the underwriters exercised the option to purchase up to an additional 12,750,000 shares of common stock to cover over-allotments for proceeds, less the underwriters’ discount, of approximately $46.0 million. This sale was completed on April 7, 2010.  In all, the Company raised net proceeds of approximately $352.7 million in these offerings.
 
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Special Note Regarding Forward-Looking Statements

We make forward-looking statements in this report that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our business, financial condition, liquidity, results of operations, plans and objectives. When we use the words ‘‘believe,’’ ‘‘expect,’’ ‘‘anticipate,’’ ‘‘estimate,’’ ‘‘plan,’’ ‘‘continue,’’ ‘‘intend,’’ ‘‘should,’’ ‘‘may,’’ ‘‘would,’’ ‘‘will’’ or similar expressions, we intend to identify forward-looking statements.  Statements regarding the following subjects, among others, are forward-looking by their nature:
 
 
·
our business and investment strategy;
 
 
·
our projected financial and operating results;
 
 
·
our ability to maintain existing financing arrangements, obtain future financing arrangements and the terms of such arrangements;
 
 
·
general volatility of the securities markets in which we invest;
 
 
·
the implementation, timing and impact of, and changes to, various government programs, including the US Department of the Treasury’s plan to buy Agency residential mortgage-backed securities, the Term Asset-Backed Securities Loan Facility and the Public-Private Investment Program;
 
 
·
our expected investments;
 
 
·
changes in the value of our investments;
 
 
·
interest rate mismatches between our mortgage-backed securities and our borrowings used to fund such purchases;
 
 
·
changes in interest rates and mortgage prepayment rates;
 
 
·
effects of interest rate caps on our adjustable-rate mortgage-backed securities;
 
 
·
rates of default or decreased recovery rates on our investments;
 
 
·
prepayments of the mortgage and other loans underlying our mortgage-backed or other asset-backed securities;
 
 
·
the degree to which our hedging strategies may or may not protect us from interest rate volatility;
 
 
·
impact of and changes in governmental regulations, tax law and rates, accounting guidance, and similar matters;
 
 
·
availability of investment opportunities in real estate-related and other securities;
 
 
·
availability of qualified personnel;
 
 
·
estimates relating to our ability to make distributions to our stockholders in the future;
 
 
·
our understanding of our competition; and
 
 
·
market trends in our industry, interest rates, the debt securities markets or the general economy.
 
The forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us. You should not place undue reliance on these forward-looking statements. These beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to us. Some of these factors are described under the caption ‘‘Risk Factors’’ in our most recent Annual Report on Form 10-K and any subsequent Quarterly Reports on Form 10-Q.  If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. Any forward-looking statement speaks only as of the date on which it is made. New risks and uncertainties arise from time to time, and it is impossible for us to predict those events or how they may affect us.  Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
 
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Executive Summary

We are a specialty finance company that invests, either directly or indirectly through our subsidiaries, in residential mortgage-backed securities, or RMBS, residential mortgage loans, real estate related securities and various other asset classes.  We are externally managed by Fixed Income Discount Advisory Company, which we refer to as FIDAC or our Manager.  FIDAC is a fixed-income investment management company that is registered as an investment adviser with the Securities and Exchange Commission, or SEC.  FIDAC is a wholly owned subsidiary of Annaly Capital Management, Inc., or Annaly.  FIDAC has a broad range of experience in managing investments in Agency RMBS, which are mortgage pass-through collateralized mortgage obligations, or CMOs, and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans issued or guaranteed by the Federal National Mortgage Association, or Fannie Mae, the Federal Home Loan Mortgage Corporation, or Freddie Mac, and the Government National Mortgage Association, or Ginnie Mae, non-Agency RMBS, debt obligations, or CDOs, and other real estate related investments, including managing CreXus Investment Corp., a publicly traded REIT.

We have elected and intend to qualify to be taxed as a real estate investment trust, or REIT, for federal income tax purposes commencing with our taxable year ending on December 31, 2007.  Our targeted asset classes and the principal investments we expect to make in each are as follows:

·
RMBS, consisting of:

 
o
Non-Agency RMBS, including investment-grade and non-investment grade classes, including the BB-rated, B-rated and non-rated classes
 
 
o
Agency RMBS
 
·
Whole mortgage loans, consisting of:

 
o
Prime mortgage loans
 
 
o
Jumbo prime mortgage loans
 
 
o
Alt-A mortgage loans
 
·
Asset Backed Securities, or ABS, consisting of:

 
o
Commercial mortgage-backed securities, or CMBS
 
 
o
Debt and equity tranches of collateralized debt obligations, or CDOs
 
 
o
Consumer and non-consumer ABS, including investment-grade and non-investment grade classes, including the BB-rated, B-rated and non-rated classes
 
We completed our initial public offering on November 21, 2007.  In that offering and in a concurrent private offering we raised net proceeds of approximately $533.6 million.  We completed a second public offering and second private offering on October 29, 2008.  In these offerings we raised net proceeds of approximately $301.0 million.  During the second quarter 2009, we completed a third public offering and third private offering on April 21, 2009, and a fourth public offering and fourth private offering June 2, 2009.  In these offerings, we raised net proceeds of approximately $850.9 million and $612.4 million.  We completed a fifth public offering April 7, 2010.  In this offering we raised net proceeds of approximately $352.7 million.

Our objective is to provide attractive risk-adjusted returns to our investors over the long-term, primarily through dividends and secondarily through capital appreciation.  We intend to achieve this objective by investing in a broad class of financial assets to construct an investment portfolio that is designed to achieve attractive risk-adjusted returns and that is structured to comply with the various federal income tax requirements for REIT status and to maintain our exemption from the Investment Company Act of 1940, or the 1940 Act.
 
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Since we commenced operations in November 2007, we have focused our investment activities on acquiring non-Agency RMBS and on purchasing residential mortgage loans that have been originated by select high-quality originators, including the retail lending operations of leading commercial banks.  Our investment portfolio is weighted toward non-Agency RMBS.  At March 31, 2010, approximately 76% of our investment portfolio was non-Agency RMBS, 15% of our investment portfolio was Agency RMBS, and 9% of our investment portfolio was secured residential mortgage loans.  At December 31, 2009, approximately 68% of our investment portfolio was non-Agency RMBS, 25% of our investment portfolio was Agency RMBS, and 7% of our investment portfolio was secured residential mortgage loans.  We expect that over the near term our investment portfolio will continue to be weighted toward RMBS, subject to maintaining our REIT qualification and our 1940 Act exemption.  In addition, we have engaged in and depending on market conditions, anticipate continuing to engage in transactions with residential mortgage lending operations of leading commercial banks and other high-quality originators in which we identify and re-underwrite residential mortgage loans owned by such entities, and rather than purchasing and securitizing such residential mortgage loans ourselves, we and the originator would structure the securitization and we would purchase the resulting mezzanine and subordinate non-Agency RMBS.  We may also engage in similar transactions with non-Agency RMBS in which we would acquire non-Agency RMBS and re-securitize those securities.  We would sell some or all of the resulting AAA-rated RMBS and may retain some of the AAA-rated RMBS and other subordinate bonds and interests.

Our investment strategy is intended to take advantage of opportunities in the current interest rate and credit environment.  We will adjust our strategy to changing market conditions by shifting our asset allocations across these various asset classes as interest rate and credit cycles change over time.  We believe that our strategy, combined with FIDAC’s experience, will enable us to pay dividends and achieve capital appreciation throughout changing market cycles.  We expect to take a long-term view of assets and liabilities, and our reported earnings and mark-to-market valuations at the end of a financial reporting period will not significantly impact our objective of providing attractive risk-adjusted returns to our stockholders over the long-term.

We use leverage to seek to increase our potential returns and to fund the acquisition of our assets.  Our income is generated primarily by the difference, or net spread, between the income we earn on our assets and the cost of our borrowings.  We expect to finance our investments using a variety of financing sources including, when available, repurchase agreements, warehouse facilities, securitizations, commercial paper and term financing CDOs.  We may manage our debt by utilizing interest rate hedges, such as interest rate swaps, to reduce the effect of interest rate fluctuations related to our debt.

Recent Developments

We commenced operations in November 2007 in the midst of challenging market conditions which affected the cost and availability of financing from the facilities with which we expected to finance our investments.  These instruments included repurchase agreements, warehouse facilities, securitizations, asset-backed commercial paper, or ABCP, and term CDOs.  The liquidity crisis which commenced in August 2007 affected each of these sources—and their individual providers—to different degrees; some sources generally became unavailable, some remained available but at a high cost, and some were largely unaffected.  For example, in the repurchase agreement market, non-Agency RMBS became harder to finance, depending on the type of assets collateralizing the RMBS.  The amount, term and margin requirements associated with these types of financings were also impacted.  At that time, warehouse facilities to finance whole loan prime residential mortgages were generally available from major banks, but at significantly higher cost and had greater margin requirements than previously offered.  It was also extremely difficult to term finance whole loans through securitization or bonds issued by a CDO structure.  Financing using ABCP froze as issuers became unable to place (or roll) their securities, which resulted, in some instances, in forced sales of mortgage-backed securities, or MBS, and other securities which further negatively impacted the market value of these assets.
 
 
Although the credit markets had been undergoing much turbulence, as we started ramping up our portfolio in late 2007, we noted a slight easing.  We entered into a number of repurchase agreements we could use to finance RMBS.  In January 2008, we entered into two whole mortgage loan repurchase agreements.  As we began to see the availability of financing, we were also seeing better underwriting standards used to originate new mortgages.  We commenced buying and financing RMBS and also entered into agreements to purchase whole mortgage loans.  We purchased high credit quality assets which we believed we would be readily able to finance.

Beginning in mid-February 2008, credit markets experienced a dramatic and sudden adverse change.  The severity of the limitation on liquidity was largely unanticipated by the markets.   Credit once again froze, and in the mortgage market, valuations of non-Agency RMBS and whole mortgage loans came under severe pressure.  This credit crisis began in early February 2008, when a heavily leveraged investor announced that it had to de-lever and liquidate a portfolio of approximately $30 billion of non-Agency RMBS.  Prices of these types of securities dropped dramatically, and lenders started lowering the prices on non-Agency RMBS that they held as collateral to secure the loans they had extended.  The subsequent failure in March 2008 of Bear Stearns & Co. worsened the crisis.  As the year progressed, deterioration in the fair value of our assets continued, we received and met margin calls under our repurchase agreements, which resulted in our obtaining additional funding from third parties, including from Annaly Capital Management, Inc. (“Annaly”), an affiliate, and taking other steps to increase our liquidity.
 
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The challenges of the first half of 2008 have continued through the first quarter of 2010, as financing difficulties have severely pressured liquidity and asset values.  In September 2008, Lehman Brothers Holdings, Inc., a major investment bank, experienced a major liquidity crisis and failed.  Securities trading remains limited and mortgage securities financing markets remain challenging as the industry continues to report negative news.  This dislocation in the non-Agency mortgage sector has made it difficult for us to obtain short-term financing on favorable terms.   As a result, we have completed loan securitizations in order to obtain long-term financing and terminated our un-utilized whole loan repurchase agreements in order to avoid paying non-usage fees under those agreements.  In addition, we have continued to seek funding from Annaly and/or RCAP Securities, Inc.  Under these circumstances, we expect to take actions intended to protect our liquidity, which may include reducing borrowings and disposing of assets as well as raising capital.

During this period of market dislocation, fiscal and monetary policymakers have established new liquidity facilities for primary dealers and commercial banks, reduced short-term interest rates, and passed legislation that is intended to address the challenges of mortgage borrowers and lenders. This legislation, the Housing and Economic Recovery Act of 2008, seeks to forestall home foreclosures for distressed borrowers and assist communities with foreclosure problems.

Subsequent to June 30, 2008, there were increased market concerns about Freddie Mac and Fannie Mae’s ability to withstand future credit losses associated with securities held in their investment portfolios, and on which they provide guarantees, without the direct support of the federal government.  In September 2008 Fannie Mae and Freddie Mac were placed into the conservatorship of the Federal Housing Finance Agency, or FHFA, their federal regulator, pursuant to its powers under The Federal Housing Finance Regulatory Reform Act of 2008, a part of the Housing and Economic Recovery Act of 2008.  As the conservator of Fannie Mae and Freddie Mac, the FHFA controls and directs the operations of Fannie Mae and Freddie Mac and may (1) take over the assets of and operate Fannie Mae and Freddie Mac with all the powers of the shareholders, the directors, and the officers of Fannie Mae and Freddie Mac and conduct all business of Fannie Mae and Freddie Mac; (2) collect all obligations and money due to Fannie Mae and Freddie Mac; (3) perform all functions of Fannie Mae and Freddie Mac which are consistent with the conservator’s appointment; (4) preserve and conserve the assets and property of Fannie Mae and Freddie Mac; and (5) contract for assistance in fulfilling any function, activity, action or duty of the conservator.   A primary focus of this new legislation is to increase the availability of mortgage financing by allowing Fannie Mae and Freddie Mac to continue to grow their guarantee business without limit, while limiting net purchases of mortgage-backed securities to a modest amount through the end of 2009.

In addition to FHFA becoming the conservator of Fannie Mae and Freddie Mac, (i) the U.S. Department of Treasury and FHFA have entered into preferred stock purchase agreements between the U.S. Department of Treasury, or the Treasury, and Fannie Mae and Freddie Mac pursuant to which the Treasury will ensure that each of Fannie Mae and Freddie Mac maintains a positive net worth; (ii) the Treasury has established a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, which is intended to serve as a liquidity backstop, which was available through December 2009; and (iii) the Treasury has initiated a temporary program to purchase RMBS issued by Fannie Mae and Freddie Mac.  Although the Treasury has committed capital to Fannie Mae and Freddie Mac, there can be no assurance that these actions will be adequate for their needs. If these actions are inadequate, Fannie Mae and Freddie Mac could continue to suffer losses and could fail to honor their guarantees and other obligations. The future roles of Fannie Mae and Freddie Mac could be significantly reduced and the nature of their guarantees could be considerably diminished. Any changes to the nature of the guarantees provided by Fannie Mae and Freddie Mac could redefine what constitutes Mortgage-Backed Securities and could have broad adverse market implications.

Given the highly fluid and evolving nature of these events, it is unclear how our business will be impacted.  Based upon the further activity of the U.S. government or market response to developments at Fannie Mae or Freddie Mac, our business could be adversely impacted.
 
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The Emergency Economic Stabilization Act of 2008, or EESA, was enacted in October 2008.  The EESA provides the U.S. Secretary of the Treasury with the authority to establish a Troubled Asset Relief Program, or TARP, to purchase from financial institutions up to $700 billion of equity or preferred securities, residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, as well as any other financial instrument that the U.S. Secretary of the Treasury, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, upon transmittal of such determination, in writing, to the appropriate committees of the U.S. Congress.  The EESA also provides for a program that would allow companies to insure their troubled assets.

The U.S. Government, Federal Reserve and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis.  The Term Asset-Backed Securities Loan Facility, or TALF, was first announced by the Treasury on November 25, 2008, and has been expanded in size and scope since its initial announcement.   Under the TALF, the Federal Reserve Bank of New York, or the FRBNY, provides non-recourse loans to borrowers to fund their purchase of eligible assets.  The FRBNY has stopped accepting applications for credit under the TALF program for all collateral except for newly issued commercial mortgage-backed securities, for which it has extended the time period of accepting applications to June 30, 2010.

In addition, on March 23, 2009, the U.S. Treasury, in conjunction with the Federal Deposit Insurance Corporation, or FDIC, and the Federal Reserve, announced the establishment of the Public-Private Investment Program, or PPIP. The PPIP is designed to encourage the transfer of certain illiquid legacy real estate-related assets off of the balance sheets of financial institutions, restarting the market for these assets and supporting the flow of credit and other capital into the broader economy.

Although these aggressive steps are intended to protect and support the US housing and mortgage market, we continue to operate under very difficult market conditions.  As a result, there can be no assurance that the EESA, the TARP, the TALF, PPIP or other policy initiatives will have a beneficial impact on the financial markets, including current extreme levels of volatility.  We cannot predict whether or when such actions may occur or what impact, if any, such actions could have on our business, results of operations and financial condition.

Trends
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 assets, and the supply of and demand for such assets.  Our net interest income, which reflects the amortization of purchase premiums and accretion of discounts, varies primarily as a result of changes in interest rates, borrowing costs, and prepayment speeds, which is a measurement of how quickly borrowers pay down the unpaid principal balance on their mortgage loans.
 
Prepayment Speeds. Prepayment speeds, as reflected by the Constant Prepayment Rate, or CPR, vary according to interest rates, the type of investment, conditions in financial markets, competition and other factors, none of which can be predicted with any certainty.  In general, when interest rates rise, it is relatively less attractive for borrowers to refinance their mortgage loans, and as a result, prepayment speeds tend to decrease.  When interest rates fall, prepayment speeds tend to increase. For mortgage loan and RMBS investments purchased at a premium, as prepayment speeds increase, the amount of income we earn decreases because the purchase premium we paid for the bonds amortizes faster than expected.  Conversely, decreases in prepayment speeds result in increased income and can extend the period over which we amortize the purchase premium. For mortgage loan and RMBS investments purchased at a discount, as prepayment speeds increase, the amount of income we earn increases because of the acceleration of the accretion of the discount into interest income. Conversely, decreases in prepayment speeds result in decreased income and can extend the period over which we accrete the purchase discount into interest income.

Rising Interest Rate Environment. As indicated above, as interest rates rise, prepayment speeds generally decrease.  Rising interest rates, however, increase our financing costs which may result in a net negative impact on our net interest income.  In addition, if we acquire Agency and non-Agency RMBS collateralized by monthly reset adjustable-rate mortgages, or ARMs, and three- and five-year hybrid ARMs, such interest rate increases could result in decreases in our net investment income, as there could be a timing mismatch between the interest rate reset dates on our RMBS portfolio and the financing costs of these investments.  We expect, however, that our fixed-rate assets would decline in value in a rising interest rate environment and that our net interest spreads on fixed rate assets could decline in a rising interest rate environment to the extent such assets are financed with floating rate debt.
 
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Falling Interest Rate Environment. As interest rates fall, prepayment speeds generally increase.  Falling interest rates, however, decrease our financing costs which may result in a net positive impact on our net interest income.  In addition, if we acquire Agency and non-Agency RMBS collateralized by monthly reset adjustable-rate mortgages, or ARMs, and three- and five-year hybrid ARMs, such interest rate decreases could result in increases in our net investment income, as there could be a timing mismatch between the interest rate reset dates on our RMBS portfolio and the financing costs of these investments.  We expect, however, that our fixed-rate assets would increase in value in a falling interest rate environment and that our net interest spreads on fixed rate assets could increase in a falling interest rate environment to the extent such assets are financed with floating rate debt.

Credit Risk.  One of our strategic focuses is acquiring assets which we believe to be of high credit quality. We believe this strategy will generally keep our credit losses and financing costs low.  We retain the risk of potential credit losses on all of the residential mortgage loans we hold in our portfolio.  Additionally, some of our investments in RMBS may be qualifying interests for purposes of maintaining our exemption from the 1940 Act because we retain a 100% ownership interest in the underlying loans.  If we purchase all classes of these securitizations, we have the credit exposure on the underlying loans.  Prior to the purchase of these securities, we conduct a due diligence process that allows us to remove loans that do not meet our credit standards based on loan-to-value ratios, borrowers’ credit scores, income and asset documentation and other criteria that we believe to be important indications of credit risk.

Size of Investment Portfolio.  The size of our investment portfolio, as measured by the aggregate unpaid principal balance of our mortgage loans and aggregate principal balance of our mortgage related securities and the other assets we own is also a key revenue driver.  Generally, as the size of our investment portfolio grows, the amount of interest income we receive increases.  The larger investment portfolio, however, drives increased expenses as we incur additional interest expense to finance the purchase of our assets.

Since changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our ability to effectively manage interest rate risks and prepayment risks while maintaining our status as a REIT.

Current Environment.  The current weakness in the broader mortgage markets could adversely affect one or more of our potential lenders or any of our lenders and could cause one or more of our potential lenders or any of our lenders to be unwilling or unable to provide us with financing or require us to post additional collateral.  In general, this could potentially increase our financing costs and reduce our liquidity or require us to sell assets at an inopportune time.  We expect to use a number of sources to finance our investments, including repurchase agreements, warehouse facilities, securitizations, asset-backed commercial paper and term CDOs.  Current market conditions have affected the cost and availability of financing from each of these sources and their individual providers to different degrees; some sources generally are unavailable, some are available but at a high cost, and some are largely unaffected.  For example, in the repurchase agreement market, borrowers have been affected differently depending on the type of security they are financing.  Non-Agency RMBS have been harder to finance, depending on the type of assets collateralizing the RMBS.  The amount, term and margin requirements associated with these types of financings have been negatively impacted.

Currently, warehouse facilities to finance whole loan prime residential mortgages are generally available from major banks, but at significantly higher cost and have greater margin requirements than previously offered. Many major banks that offer warehouse facilities have also reduced the amount of capital available to new entrants and consequently the size of those facilities offered now are smaller than those previously available.

It is currently a challenging market to term finance whole loans through securitization or bonds issued by a CDO structure. The highly rated senior bonds in these securitizations and CDO structures currently have liquidity, but at much wider spreads than issues priced in recent history. The junior subordinate tranches of these structures currently have few buyers and current market conditions have forced issuers to retain these lower rated bonds rather than sell them.

Certain issuers of ABCP have been unable to place (or roll) their securities, which has resulted, in some instances, in forced sales of MBS and other securities which has further negatively impacted the market value of these assets.  These market conditions are fluid and likely to change over time.   As a result, the execution of our investment strategy may be dictated by the cost and availability of financing from these different sources.
 
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If one or more major market participants fails or otherwise experiences a major liquidity crisis, as was the case for Bear Stearns & Co. in March 2008, and Lehman Brothers Holdings Inc. in September 2008, it could negatively impact the marketability of all fixed income securities and this could negatively impact the value of the securities we acquire, thus reducing our net book value.  Furthermore, if many of our potential lenders or any of our lenders are unwilling or unable to provide us with financing, we could be forced to sell our securities or residential mortgage loans at an inopportune time when prices are depressed.

As described above, there has been significant government action in the capital markets.  However, there can be no assurance that the government’s actions with respect to Freddie Mac and Fannie Mae, the EESA, the TARP, the TALF, the PPIP or other policy initiatives will have a beneficial impact on the financial markets.  To the extent the market does not respond favorably to these actions, or these actions do not function as intended, our business may not receive the anticipated positive impact from them.  In addition, the U.S. Government, Federal Reserve and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis. We cannot predict whether or when such actions may occur or what impact, if any, such actions could have on our business, results of operations and financial condition.

In the current market, it may be difficult or impossible to obtain third party pricing on the investments we purchase.  In addition, validating third party pricing for our investments may be more subjective as fewer participants may be willing to provide this service to us.  Moreover, the current market is more illiquid than in recent history for some of the investments we purchase.  Illiquid investments typically experience greater price volatility as a ready market does not exist.    As volatility increases or liquidity decreases we may have greater difficulty financing our investments which may negatively impact our earnings and the execution of our investment strategy.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP.  These accounting principles may require us to make some complex and subjective decisions and assessments.  Our most critical accounting policies will involve decisions and assessments that could affect our reported assets and liabilities, as well as our reported revenues and expenses.  We believe that all of the decisions and assessments upon which our consolidated financial statements are based will be reasonable at the time made and based upon information available to us at that time.  At each quarter end, we calculate estimated fair value of the investment portfolio using a pricing model.  We validate our pricing model by obtaining independent pricing on all of our assets and performing a verification of those sources to our own internal estimate of fair value.  The following are our most critical accounting policies:

Sales and Securitizations

We periodically enter into transactions in which we sell financial assets, such as RMBS, mortgage loans and other assets.  Gains and losses on sales of assets are computed on the specific identification method whereby we record a gain or loss on the difference between the carrying value of the asset and the proceeds from the sale.  In addition, we may from time to time securitize or re-securitize assets and sell tranches in the newly securitized assets.  These transactions may be recorded as either a sale and the assets contributed to the securitization are removed from the consolidated statements of financial condition and a gain or loss is recognized, or as a financing whereby the assets contributed to the securitization are not derecognized but rather the liabilities issued by the securitization are recorded to reflect the term financing of the assets.  In these securitizations and re-securitizations we sometimes retain or acquire senior or subordinated interests in the securitized or re-securitized assets.
 
 
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Valuation of Investments
 ASC 820, Fair Value Measurements and Disclosures, establishes a framework for measuring fair value, and establishes a three-level valuation hierarchy for disclosure of fair value measurement and enhances disclosure requirements for fair value measurements.  The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date.  The three levels are defined as follows:
 
Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets and liabilities in active markets.
 
Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
 
Level 3 – inputs to the valuation methodology are unobservable and significant to overall fair value.
 
Non-Agency and Agency Mortgage-Backed Securities are valued using a pricing model.  The MBS pricing model incorporates such factors as coupons, prepayment speeds, spread to the Treasury and swap curves, convexity, duration, periodic and life caps, and credit enhancement.  Management reviews the fair values determined by the pricing model and compares its results to dealer quotes received on each investment to validate the reasonableness of the valuations indicated by the pricing models.  The dealer quotes incorporate common market pricing methods, including a spread measurement to the Treasury curve or interest rate swap curve as well as underlying characteristics of the particular security including coupon, periodic and life caps, rate reset period, issuer, additional credit support and expected life of the security.

Although we utilize a pricing model to compute the fair value of the securities in our portfolio, we validate our fair values by seeking indications of fair value from third-party dealers and/or pricing services. The variability of fair value among dealers and pricing services can be wide at this time as full liquidity for the non-Agency market has yet to return.  In addition, there are fewer participants in the RMBS sector available to fair value investments.     In the aggregate, our internal valuations of the securities on which we received dealer marks were 0.05% lower than the aggregated dealer marks.

Any changes to the valuation methodology are reviewed by management to ensure the changes are appropriate. As markets and products develop and the pricing for certain products becomes more transparent, we continue to refine our valuation methodologies. The methods used by us may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while we believe our valuation methods are appropriate and consistent with other market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.  We use inputs that are current as of the measurement date, which may include periods of market dislocation, during which price transparency may be reduced.  This condition could cause our financial instruments to be reclassified from Level 2 to Level 3.

Other-than-Temporary Impairments
FASB issued new guidance to improve the presentation and disclosure of other-than-temporary impairments, or OTTI, on debt and equity securities.  We analyze our non-Agency RMBS portfolio as these investments fall under this new guidance.  The security is analyzed for credit loss (the difference between the present value of cash flows expected to be collected and the amortized cost basis).  If we do not intend to sell nor are required to sell the debt security prior to its anticipated recovery, the credit loss, if any, is recognized in the statement of earnings, while the balance of impairment related to other factors is recognized in Other Comprehensive Income, or OCI.  If we intend to sell the debt security, or will be required to sell the security before its anticipated recovery, the full OTTI is recognized in the statement of earnings.  Other-than-temporary impairment has occurred if there has been an adverse change in future estimated cash flow and its impact reflected in current earnings.  The determination cannot be overcome by management judgment of the probability of collecting all cash flows previously projected.
 
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Securitized Loans Held for Investment
Our securitized residential mortgage loans are comprised of fixed-rate and variable-rate loans.  We purchase pools of residential mortgage loans through a select group of originators.  Mortgage loans are designated as held for investment, recorded on trade date, and are carried at their principal balance outstanding, plus any premiums or discounts which are amortized or accreted over the estimated life of the loan, less allowances for loan losses.

Non-Agency and Agency Residential Mortgage-Backed Securities
We invest in RMBS representing interests in obligations backed by pools of mortgage loans and carry those securities at fair value estimated using a pricing model.  Management reviews the fair values generated by the model to determine whether prices are reflective of the current market.  Management performs a validation of the fair value calculated by the pricing model by comparing its results to independent prices provided by dealers in the securities and/or third party pricing services.  If dealers or independent pricing services are unable to provide a price for an asset, or if the price provided by them is deemed unreliable by FIDAC, then the asset will be valued at its fair value as determined in good faith by FIDAC.  In the current market, it may be difficult or impossible to obtain third party pricing on certain of our investments.   In addition, validating third party pricing for our investments may be more subjective as fewer participants may be willing to provide this service to us.  Moreover, the current market is more illiquid than in recent history for some of the investments we own.  Illiquid investments typically experience greater price volatility as a ready market does not exist.  As volatility increases or liquidity decreases, we may have greater difficulty financing its investments which may negatively impact its earnings and the execution of its investment strategy.

Our investment securities are classified as either trading investments, available-for-sale investments or held-to-maturity investments. We intend to hold our RMBS as available-for-sale and as such may sell any of our RMBS as part of our overall management of our portfolio.  All assets classified as available-for-sale are reported at estimated fair value, with unrealized gains and losses included in other comprehensive income.

When the fair value of an available-for-sale security is less than its amortized cost for an extended period or there is a significant decline in value, we consider whether there is OTTI in the value of the security.  If, based on our analysis, a credit portion of OTTI exists, the cost basis of the security is written down to the then-current fair value, and the unrealized loss is transferred from accumulated other comprehensive loss as an immediate reduction of current earnings (as if the loss had been realized in the period of OTTI).  The determination of OTTI is a subjective process, and different judgments and assumptions could affect the timing of loss realization.

We consider the following factors when determining OTTI for a security:

 
·
the length of time and the extent to which the market value has been less than the amortized cost;
 
 
·
the financial condition and near-term prospects of the issuer;
 
 
·
the credit quality and cash flow performance of the security; and
 
 
·
whether we will be more likely than not required to sell the investment before the expected recovery.
 
The determination of OTTI is made at least quarterly.  If we determine an impairment to be other than temporary we will realize a loss which will negatively impact current income.

RMBS transactions are recorded on the trade date.  Realized gains and losses from sales of RMBS are determined based on the specific identification method and recorded as a gain (loss) on sale of investments in the statement of operations.  Accretion of discounts or amortization of premiums on available-for-sale securities and mortgage loans is computed using the effective interest yield method and is included as a component of interest income in the statement of operations.

Interest Income
Interest income on RMBS and loans held for investment is recognized over the life of the investment using the effective interest method.  Income recognition is suspended for loans when, in the opinion of management, a full recovery of income and principal becomes doubtful.  Income recognition is resumed when the loan becomes contractually current and performance is demonstrated to be resumed.
 
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Accounting For Derivative Financial Instruments and Hedging Activities
Our policies permit us to enter into derivative contracts, including interest rate swaps and interest rate caps, as a means of mitigating our interest rate risk. We intend to use interest rate derivative instruments to mitigate interest rate risk rather than to enhance returns. If we hedge using interest rate swaps we account for these instruments as free-standing derivatives.  Accordingly, they are carried at fair value with realized and unrealized gains and losses recognized in earnings.

We recognize all derivatives as either assets or liabilities in the statement of financial condition and measure those instruments at fair value. Additionally, the fair value adjustments will affect either other comprehensive income in stockholders’ equity until the hedged item is recognized in earnings or net income depending on whether the derivative instrument qualifies as a hedge for accounting purposes and, if so, the nature of the hedging activity.

The FASB issued additional guidance that attempts to improve the transparency of financial reporting by providing additional information about how derivative and hedging activities affect an entity’s financial position, financial performance and cash flows.  This guidance requires the disclosure requirements for derivative instruments and hedging activities by requiring enhanced disclosure about (1) how and why an entity uses derivative instruments, (2) how derivative instruments and related hedged items are accounted for, and (3) how derivative instruments and related hedged items affect the entity’s financial position, financial performance, and cash flows.

 In the normal course of business, we may use a variety of derivative financial instruments to economically manage, or hedge, interest rate risk. These derivative financial instruments must be effective in reducing our interest rate risk exposure in order to qualify for hedge accounting. When the terms of an underlying transaction are modified, or when the underlying hedged item ceases to exist, all changes in the fair value of the instrument are included in net income for each period until the derivative instrument matures or is settled. Any derivative instrument used for risk management that does not meet the hedging criteria is carried at fair value with the changes in value included in net income.

Derivatives will be used for economic hedging purposes rather than speculation. We will rely on quotations from third parties to determine fair values.  If our hedging activities do not achieve our desired results, our reported earnings may be adversely affected.

Allowance for Probable Credit Losses
We have established an allowance for loan losses at a level that management believes is adequate based on an evaluation of known and inherent probable losses related to our loan portfolio.  The estimate is based on a variety of factors including current economic conditions, industry loss experience, the loan originator’s loss experience, credit quality trends, loan portfolio composition, delinquency trends, national and local economic trends, national unemployment data, changes in housing  appreciation or depreciation and whether specific geographic areas where we have significant loan concentrations are experiencing adverse economic conditions and events such as natural disasters that may affect the local economy or property values. Upon purchase of the pools of loans, we obtained written representations and warranties from the sellers that we could be reimbursed for the value of the loan if the loan fails to meet the agreed upon origination standards.  While we have little history of its own to establish loan trends, delinquency trends of the originators and the current market conditions aid in determining the allowance for loan losses.  We also performed due diligence procedures on a sample of loans that met its criteria during the purchase process.  We have created an unallocated provision for probable loan losses estimated as a percentage of the remaining principal on the loans.  Management’s estimate is based on historical experience of similarly underwritten pools.

When we determine it is probable that specific contractually due amounts are uncollectible, the amount is considered impaired.  Where impairment is indicated, a valuation write-off is measured based upon the excess of the recorded investment over the net fair value of the collateral, reduced by selling costs.  Any deficiency between the carrying amount of an asset and the net sales price of repossessed collateral is charged to the allowance for loan losses.
 
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Income Taxes
We have elected and intend to qualify to be taxed as a REIT.  Therefore we will generally not be subject to corporate federal or state income tax to the extent that we make qualifying distributions to our stockholders, and provided we satisfy on a continuing basis, through actual investment and operating results, the REIT requirements including certain asset, income, distribution and stock ownership tests.

If we fail to qualify as a REIT, and do not qualify for certain statutory relief provisions, we will be subject to 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 we lost our REIT qualification.  Accordingly, our failure to qualify as a REIT could have a material adverse impact on our results of operations and amounts available for distribution to our stockholders.

The dividends paid deduction of a REIT for qualifying dividends to its stockholders is computed using our taxable income as opposed to net income reported on the consolidated financial statements.  Taxable income, generally, will differ from net income reported on the consolidated financial statements because the determination of taxable income is based on tax provisions and not financial accounting principles.
 
Recent Accounting Pronouncements

General Principles

Generally Accepted Accounting Principles (ASC 105)

In June 2009, the Financial Accounting Standards Board or FASB issued The Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles, or Codification which revises the framework for selecting the accounting principles to be used in the preparation of financial statements that are presented in conformity with Generally Accepted Accounting Principles or GAAP.  The objective of the Codification is to establish the FASB Accounting Standards Codification, or ASC as the source of authoritative accounting principles recognized by the FASB.  Codification was effective for us as of September 30, 2009.  In adopting the Codification, all non-grandfathered, non-SEC accounting literature not included in the Codification was superseded and deemed non-authoritative.  Codification requires any references within our consolidated financial statements be modified from FASB issues to ASC.  However, in accordance with the FASB Accounting Standards Codification Notice to Constituents (v 2.0), we do not reference specific sections of the ASC but will use broad topic references.

           Our recent accounting pronouncements section has been formatted to reflect the same organizational structure as the ASC.  Broad topic references will be updated with pending content as they are released.

Assets

Receivables (ASC 310)
In April, 2010, the FASB issued ASU 2010-18, which addresses the effect of a loan modification when a loan is part of a pool accounted for as a single asset. This update clarifies the treatment of a troubled debt restructuring.  This guidance allows acquired assets, which have evidence of credit deterioration upon acquisition and common risk characteristics, to be accounted for in the aggregate as a pool.  Upon establishment of the pool, the pool becomes the unit of accounting.  Any purchase discount is not allocated to individual loans, thus all of the loans in the pool accrete at a single pool rate based on cash flow projections for the pool.  Likewise, impairment analysis is performed on the pool as a whole, not on individual loans.  Modifications to loans, even if those modifications are considered troubled debt restructuring, do not result in a loan being removed from the pool.  This treatment is consistent with our current accounting practices and therefore has no material effect on our consolidated financial statements.
 
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Investments in Debt and Equity Securities (ASC 320)
New guidance was provided to make impairment guidance more operational and to improve the presentation and disclosure of OTTI on debt and equity securities, as well as beneficial interests in securitized financial assets, in financial statements.  This guidance was the result of the Securities and Exchange Commission, or SEC mark-to-market study mandated under the EESA.  The SEC’s recommendation was to “evaluate the need for modifications (or the elimination) of current OTTI guidance to provide for a more uniform system of impairment testing standards for financial instruments.”  The guidance revises the OTTI evaluation methodology.  Previously the analytical focus was on whether the company had the “intent and ability to retain its investment in the debt security for a period of time sufficient to allow for any anticipated recovery in fair value.”   Now the focus is on whether the company (1) has the intent to sell the investment securities, (2) is more likely than not  to be required to sell the investment securities before recovery, or (3) does not expect to recover the entire amortized cost basis of the investment securities.  Further, the security is analyzed for credit loss, (the difference between the present value of cash flows expected to be collected and the amortized cost basis).  The credit loss, if any, is then recognized in the statement of operations, while the balance of impairment related to other factors will be recognized in OCI.  If the entity intends to sell the security, they will be required to sell the security before its anticipated recovery, or does not expect to recover the entire amortized cost basis of the security, the full OTTI will be recognized in the statement of operations.

OTTI has occurred if there has been an adverse change in future estimated cash flows and its impact reflected in current earnings.  The determination cannot be overcome by management judgment of the probability of collecting all cash flows previously projected.   The objective of an OTTI analysis is to determine whether it is probable that the holder will realize some portion of the unrealized loss on an impaired security.  Factors to consider when assessing for OTTI includes information about past events, current conditions, reasonable and supportable forecasts, remaining payment terms, financial condition of the issuer, expected defaults, value of underlying collateral, industry analysis, sector credit rating, credit enhancement, and financial condition of guarantor.  Our non-Agency RMBS and Agency RMBS investments fall under this guidance and as such, we will assess each security for OTTI based on estimated future cash flows.  This guidance became effective for us on June 30, 2009.

Broad Transactions

Consolidation (ASC 810)
On January 1, 2009, FASB amended the guidance concerning non-controlling interests in consolidated financial statements.  This guidance requires classification of non-controlling interests (previously referred to as “minority interest”) as part of consolidated net income and to include the accumulated amount of non-controlling interests as part of stockholders’ equity.  Further, this guidance requires distinction between equity amounts attributable to controlling interest and amounts attributable to the noncontrolling interests – previously classified as minority interest outside of stockholders’ equity.  In addition to these financial reporting changes, this guidance provided for significant changes in accounting related to non-controlling interests; specifically, increases and decreases in controlling financial interests in consolidated subsidiaries are reported in equity similar to treasury stock transactions. If a change in ownership of consolidated subsidiary results in a loss of control and deconsolidation, any retained ownership interests are re-measured with the gain or loss reported in net earnings. For the quarter ended March 31, 2010, we did not have any non-controlling interests.

Effective January 1, 2010, the consolidation standards have been amended by ASU 2009-17.  This amendment updates the existing standard and eliminates the exemption from consolidation of a Qualified Special Purpose Entity or QSPE.  The update requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a variable interest entity, or VIE. The analysis identifies the primary beneficiary of a VIE as the enterprise that has both: a) the power to direct the activities that most significantly impact the entity’s economic performance and b) the obligation to absorb losses of the entity or the right to receive benefits from the entity which could potentially be significant to the VIE.  The update requires enhanced disclosures to provide users of financial statements with more transparent information about an enterprises involvement in a VIE.  We have determined we are the primary beneficiary on a number of VIE’s formed through re-securitizations.  We were required to consolidate RMBS re-securitization transactions previously recorded during the year ended December 31, 2009 as sales for GAAP beginning with the effective date of this ASU.  Consolidation of these transactions altered the presentation of the consolidated financial statements by increasing our non-Agency portfolio and increasing the value of non-recourse liabilities for which we have no continuing obligation.   The consolidation has reversed previously recorded GAAP gains on sales of assets related to the re-securitizations undertaken in 2009.  The reversal of this gain will be accreted over the remaining life of the re-securitized assets.  The adoption of this guidance has resulted in material changes to the format and content of our consolidated financial statements, as well as enhanced disclosures.  Please refer to the discussion in Note 8 to the consolidated financial statements.
 
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Effective January 1, 2010,  FASB amended the consolidation standard with ASU 2010-10 which indefinitely defers the effective date of  ASU 2009-17 for a reporting enterprises interest in entities for which it is industry practice to issue financial statements in accordance with investment company standards (ASC 946).   This deferral is expected to most significantly affect reporting entities in the investment management industry.  This amendment has no effect on our consolidated financial statements.

Derivatives and Hedging (ASC 815)
Effective January 1, 2009 and adopted prospectively, the FASB issued additional guidance attempting to improve the transparency of financial reporting by mandating the provision of additional information about how derivative and hedging activities affect an entity’s financial position, financial performance and cash flows.  This guidance changed the disclosure requirements for derivative instruments and hedging activities by requiring enhanced disclosure about (1) how and why an entity uses derivative instruments, (2) how derivative instruments and related hedged items are accounted for, and (3) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows.  To adhere to this guidance, qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts, gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements must be made.  This disclosure framework is intended to better convey the purpose of derivative use in terms of the risks that an entity is intending to manage.  The adoption of this ASC had no effect on our consolidated financial statements.

The FASB issued ASU 2010-8 in February 2010.  ASU 2010-8 provided technical corrections to ASC 815.  This update provides a four step analysis to determine whether call or put options that can accelerate the settlement of debt instruments should be considered clearly and closely related to the debt host contract.  If it is determined that such option is closely related to the host contract, bifurcation of the host contract from the derivative instrument is not necessary.  If an existing hybrid instrument requires bifurcation under this update, a one-time election can be made to utilize the Fair Value Option for the entire contract.   This update is effective for us January 1, 2010 and has no material effect on our consolidated financial statements.

 ASU 2010-11 was issued in March 2010 and defined a scope exception for embedded derivative features which involve only the transfer of credit risk that is only in the form of subordination of one financial instrument to another.  Such instruments would not be subject to bifurcation under ASC 815.  This guidance is effective for the first quarter beginning after June 15, 2010, however early adoption for the first fiscal quarter is allowed.  We elected to adopt for the first quarter of 2010.  Adoption has no effect on our consolidated financial statements.

Fair Value Measurements and Disclosures (ASC 820)
In response to the deterioration of the credit markets, FASB issued guidance clarifying how fair value measurements should be applied when valuing securities in markets that are not active.  The guidance provides an illustrative example, utilizing management’s internal cash flow and discount rate assumptions when relevant observable data does not exist.  It further clarifies how observable market information and market quotes should be considered when measuring fair value in an inactive market.  It reaffirms the notion of fair value as an exit price as of the measurement date and that fair value analysis is a transactional process and should not be broadly applied to a group of assets.  The guidance was effective upon issuance including prior periods for which financial statements had not been issued.  The implementation of this guidance did not have a material effect on the fair value of our assets as our historical valuation methodologies complied with the new guidance.

In October 2008 the EESA was signed into law.  Section 133 of the EESA mandated that the SEC conduct a study on mark-to-market accounting standards.  The SEC provided its study to the U.S. Congress on December 30, 2008.  Part of the recommendations within the study indicated that “fair value requirements should be improved through development of application and best practices guidance for determining fair value in illiquid or inactive markets.”  As a result of this study and the recommendations therein, on April 9, 2009, the FASB issued additional guidance for determining fair value when the volume and level of activity for the asset or liability have significantly decreased when compared with normal market activity for the asset or liability (or similar assets or liabilities).  The guidance gives specific factors to evaluate if there has been a decrease in normal market activity and if so, provides a methodology to analyze transactions or quoted prices and make necessary adjustments to fair value.  The objective is to determine the point within a range of fair value estimates that is most representative of fair value under current market conditions.  This guidance became effective for the June 30, 2009 reporting period.  The adoption did not have a material impact on the manner in which we estimate fair value, nor did it have any impact on our footnote disclosures.
 
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In August 2009, FASB issued ASU 2009-05 regarding the fair value measurement of liabilities.  The guidance states that a quoted price for the identical liability when traded as an asset in an active market is a Level 1 fair value measurement.  If the value must be adjusted for factors specific to the liability, then the adjustment to the quoted price of the asset shall render the fair value measurement of the liability a lower level measurement.  This guidance had no material effect on the fair valuation of our liabilities as we do not fair value our liabilities.

In September 2009, FASB issued ASU 2009-12 on measuring the fair value of certain alternative investments.  This guidance offers investors a practical expedient for measuring the fair value of investments in certain entities that calculate net asset value or NAV per share.  If an investment falls within the scope of the ASU, the reporting entity is permitted, but not required to use the investment’s NAV to estimate its fair value.  This guidance had no material effect on the fair valuation of our assets, as we do not hold any assets qualifying under this guidance.

In January 2010, FASB issued ASU 2010-06, which increases disclosure regarding the fair value of assets.  The key provisions of this guidance include the requirement to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 including a description of the reason for the transfers.  Previously this was only required of transfers between Level 2 and Level 3 assets.  Further, reporting entities are required to provide fair value measurement disclosures for each class of assets and liabilities; a class is potentially a subset of the assets or liabilities within a line item in the statement of financial position.  Additionally, disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements are required for either Level 2 or Level 3 assets.  This portion of the guidance is effective for all interim and annual reporting periods after December 15, 2009. The guidance also requires that the disclosure on any Level 3 assets is presented separately information for purchases, sales, issuances and settlements.  In other words, Level 3 assets are presented on a gross basis rather than as one net number.  However, this last portion of the guidance becomes effective for all interim and annual reporting periods beginning after December 15, 2010.  Adoption of this guidance results in increased footnote disclosure in our consolidated financial statements.

Financial Instruments (ASC 825)
On April 9, 2009, the FASB issued guidance which requires disclosures about fair value of financial instruments for interim reporting periods as well as in annual financial statements.  This guidance became effective June 30, 2009.  The adoption increase footnote disclosure in the consolidated financial statements.

Subsequent Events (ASC 855)
ASC 855 provides general standards governing accounting for and disclosures of events that occur after the balance sheet date through the date of issuance of the consolidated financial statements but before the financial statements are issued or are available to be issued.  ASC 855 also provides guidance on the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements and the disclosures that an entity should make about events or transactions occurring after the balance sheet date. We adopted this ASC effective June 30, 2009, and adoption had no impact on our consolidated financial statements.

In February 2010, the FASB issued ASU 2010-09 as an amendment to ASC 855.  This update eliminated the requirement to provide a specific date through which subsequent events were evaluated.  The purpose of this update was to alleviate potential conflicts between ASC 855 and SEC reporting requirements.  The update was effective upon issuance.  We have evaluated subsequent events through date of issuance of this Quarterly Report on Form 10Q.
 
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Transfers and Servicing (ASC 860)
In February 2008, FASB issued guidance addressing whether transactions where assets purchased from a particular counterparty and financed through a repurchase agreement with the same counterparty can be considered and accounted for as separate transactions, or are required to be considered “linked” transactions and may be considered derivatives.  This guidance requires purchases and subsequent financing through repurchase agreements be considered linked transactions unless all of the following conditions apply: (1) the initial purchase and the use of repurchase agreements to finance the purchase are not contractually contingent upon each other; (2) the repurchase financing entered into between the parties provides full recourse to the transferee and the repurchase price is fixed; (3) the financial assets are readily obtainable in the market; and (4) the financial instrument and the repurchase agreement are not coterminous.  This guidance was effective on January 1, 2009 and the implementation did not have a material effect on our consolidated financial statements.

On June 12, 2009, the FASB issued ASU 2009-16 an amendment update to the accounting standards governing the transfer and servicing of financial assets. This amendment updates the existing standard and eliminated the concept of a QSPE, clarifies the surrendering of control to effect sale treatment, and modifies the financial components approach – limiting the circumstances in which a financial asset or portion thereof should be derecognized when the transferor maintains continuing involvement.  It defines the term “Participating Interest”.  Under this standard update, the transferor must recognize and initially measure at fair value all assets obtained and liabilities incurred as a result of a transfer, including any retained beneficial interest. Additionally, the amendment requires enhanced disclosures regarding the transferors risk associated with continuing involvement in any transferred assets.   The amendment was effective beginning January 1, 2010 and had a material impact on our consolidated financial statements.   See discussion under Consolidation (ASC 810) above.

 
Financial Condition

At March 31, 2010, our portfolio consisted of $4.0 billion of non-Agency RMBS, $1.6 billion of Agency RMBS and $441.3 million of securitized mortgage loans.

The following table summarizes certain characteristics of our portfolio at the quarters ended March 31, 2010 and 2009 and quarter ended December 31, 2009.
 
   
March 31, 2010
   
March 31, 2009
   
December 31, 2009