XNYS:AI Arlington Asset Investment Corp. Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-Q


(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2012

OR

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                    to

Commission File Number: 000-50230
 

ARLINGTON ASSET INVESTMENT CORP.
(Exact name of Registrant as specified in its charter)
 


Virginia
 
54-1873198
(State or Other Jurisdiction of Incorporation or Organization)
 
(I.R.S. Employer Identification No.)
     
1001 Nineteenth Street North
Arlington, VA
 
22209
(Address of Principal Executive Offices)
 
(Zip Code)

(703) 373-0200
(Registrant’s Telephone Number, Including Area Code)
 


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Sec.232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

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

Large accelerated filer o
Accelerated filer x
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 x

Number of shares outstanding of each of the registrant’s classes of common stock, as of April 20, 2012:

Title
 
Outstanding
Class A Common Stock
 
9,115,671 shares
Class B Common Stock
 
566,112 shares



 
 

 
 
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2012
INDEX

       
Page
PART I—FINANCIAL INFORMATION
   
         
Item 1.
   
1
         
     
1
         
     
2
         
     
3
         
     
4
         
     
5
         
Item 2.
   
17
         
Item 3.
   
27
         
Item 4.
   
30
         
PART II—OTHER INFORMATION
   
         
Item 1.
   
32
         
Item 1A.
   
32
         
Item 2.
   
32
         
Item 4.
   
32
         
Item 6.
   
33
         
     
34

 
 


PART I
FINANCIAL INFORMATION

Consolidated Financial Statements and Notes—(unaudited)

ARLINGTON ASSET INVESTMENT CORP.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
(Unaudited)

   
March 31,
2012
   
December 31,
2011
 
ASSETS
           
Cash and cash equivalents
  $ 25,388     $ 20,018  
Receivables
               
Interest
    2,535       2,366  
Sold securities receivable
    21,609       41,321  
Other
    15       11  
Mortgage-backed securities, at fair value
               
Available-for-sale
    175,655       179,566  
Trading
    774,843       636,872  
Other investments
    2,882       2,946  
Derivative assets, at fair value
    299       504  
Deposits
    69,337       71,079  
Prepaid expenses and other assets
    81       377  
Total assets
  $ 1,072,644     $ 955,060  
                 
LIABILITIES AND EQUITY
               
Liabilities:
               
Repurchase agreements
  $ 668,618     $ 647,977  
Interest payable
    342       504  
Accrued compensation and benefits
    1,314       6,177  
Dividend payable
    8,322       6,785  
Derivative liabilities, at fair value
    63,592       63,024  
Purchased securities payable
    77,431       15,820  
Accounts payable, accrued expenses and other liabilities
    16,906       16,401  
Long-term debt
    15,000       15,000  
Total liabilities
    851,525       771,688  
                 
Commitments and contingencies (Note 7)
           
Equity:
               
Preferred stock, $0.01 par value, 25,000,000 shares authorized, none issued and outstanding
           
Class A common stock, $0.01 par value, 450,000,000 shares authorized, 8,852,421 and 7,099,336 shares issued and outstanding, respectively
    88       71  
Class B common stock, $0.01 par value, 100,000,000 shares authorized, 566,112 shares issued and outstanding
    6       6  
Additional paid-in capital
    1,548,903       1,508,713  
Accumulated other comprehensive income, net of taxes
    33,464       38,367  
Accumulated deficit
    (1,361,342 )     (1,363,785 )
Total equity
    221,119       183,372  
Total liabilities and equity
  $ 1,072,644     $ 955,060  

See notes to consolidated financial statements.

 
1


CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in thousands, except per share data)
(Unaudited)

   
Three Months Ended
March 31,
 
   
2012
   
2011
 
Interest income
  $ 13,363     $ 12,495  
                 
Interest expense
               
Interest on short-term debt
    692       317  
Interest on long-term debt
    125       115  
Total interest expense
    817       432  
Net interest income
    12,546       12,063  
Other income, net
               
Investment gain, net
    2,808       11,224  
Other loss
    (4 )     (3 )
Total other income, net
    2,804       11,221  
Operating income before other expenses
    15,350       23,284  
Other expenses
               
Compensation and benefits
    1,960       2,436  
Professional services
    1,584       123  
Business development
    17       32  
Occupancy and equipment
    95       96  
Communications
    52       46  
Other operating expenses
    438       295  
Total other expenses
    4,146       3,028  
Income before income taxes
    11,204       20,256  
Income tax provision
    442       471  
Net income
  $ 10,762     $ 19,785  
                 
Basic earnings per share
  $ 1.37     $ 2.58  
Diluted earnings per share
  $ 1.37     $ 2.58  
Dividends declared per share
  $ 0.875     $ 0.75  
Weighted-average shares outstanding (in thousands)
               
Basic
    7,865       7,661  
Diluted
    7,873       7,681  
                 
Other comprehensive income, net of taxes
               
Unrealized (losses) gains for the period on available-for-sale securities (net of taxes of $-0-)
  $ (4,903 )   $ 2,606  
Reclassification adjustment for gains included in net income on available for sale securities (net of taxes of $-0-)
          (12,850 )
Comprehensive income
  $ 5,859     $ 9,541  
                 

See notes to consolidated financial statements.

 
2


ARLINGTON ASSET INVESTMENT CORP.
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
(Dollars in thousands)
(Unaudited)

   
Class A
Common
Stock (#)
   
Class A
Amount
($)
   
Class B
Common
Stock (#)
   
Class B
Amount
($)
   
Additional
Paid-In
Capital
   
Accumulated
Other
Comprehensive
Income
   
Accumulated
Deficit
   
Total
 
                                                 
Balances, December 31, 2010
    7,106,330     $ 71       566,112     $ 6     $ 1,505,971     $ 63,495     $ (1,352,799 )   $ 216,744  
Net income
                                        15,173       15,173  
Issuance of Class A common stock
    29,147                         545                   545  
Repurchase of Class A common stock
    (8,910 )                       (229 )                 (229 )
Forfeitures of Class A common stock
    (27,231 )                       (770 )                 (770 )
Amortization of Class A common shares issued as stock-based awards
                            601                   601  
Reclassification of restricted stock units issued as stock based awards
                            2,595                   2,595  
Other comprehensive income
                                                               
Net change in unrealized gain on available-for-sale investment securities, (net of taxes of $-0-)
                                  (25,128 )           (25,128 )
Dividends declared
                                        (26,159 )     (26,159 )
Balances, December 31, 2011
    7,099,336       71       566,112       6       1,508,713       38,367       (1,363,785 )     183,372  
Net income
                                        10,762       10,762  
Issuance of Class A common stock
    1,755,000       17                   40,075                   40,092  
Forfeitures of Class A common stock
    (1,915 )                       (45 )                 (45 )
Amortization of Class A common shares issued as stock-based awards
                            160                   160  
Other comprehensive income
                                                               
Net change in unrealized gain on available-for-sale investment securities, (net of taxes of $-0-)
                                  (4,903 )           (4,903 )
Dividends declared
                                        (8,319 )     (8,319 )
Balances, March 31, 2012
    8,852,421     $ 88       566,112     $ 6     $ 1,548,903     $ 33,464     $ (1,361,342 )   $ 221,119  

See notes to consolidated financial statements.

 
3


ARLINGTON ASSET INVESTMENT CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)

   
Three Months Ended
March 31,
 
   
2012
   
2011
 
Cash flows from operating activities:
           
Net income
  $ 10,762     $ 19,785  
Adjustments to reconcile net income to net cash provided by (used in) operating activities
               
Net investment gain
    (2,808 )     (11,224 )
Net (discount)/premium (accretion)/amortization on mortgage-backed securities
    (2,633 )     (4,061 )
Depreciation and amortization
    12       12  
Other
    161       391  
Changes in operating assets
               
Interest receivable
    (169 )     (1,143 )
Other receivables
    (4 )     (337 )
Prepaid expenses and other assets
    1,470       (8,937 )
Changes in operating liabilities
               
Accounts payable and accrued expenses
    302       (431 )
Accrued compensation and benefits
    (4,863 )     (2,892 )
Net cash provided by (used in) operating activities
    2,230       (8,837 )
                 
Cash flows from investing activities:
               
Purchases of available-for-sale mortgage-backed securities
          (10,978 )
Purchases of trading mortgage-backed securities
    (170,224 )     (495,974 )
Proceeds from sales of available-for-sale mortgage-backed securities
          62,030  
Proceeds from sales of trading mortgage-backed securities
    21,548       105,603  
Receipt of principal payments on available-for-sale mortgage-backed securities
    3,516       5,733  
Receipt of principal payments on trading mortgage-backed securities
    13,771       6,862  
Changes in purchased securities payable
    61,611       (2,555 )
Changes in sold securities receivable
    19,712        
Proceeds from derivatives and deposits, net
    926       4,120  
Other
    (1,740 )     (71 )
Net cash used in investing activities
    (50,880 )     (325,230 )
                 
Cash flows from financing activities:
               
Proceeds from repurchase agreements, net
    20,641       347,828  
Proceeds from stock issuance
    40,164        
Dividends paid
    (6,785 )     (4,655 )
Repayments of short-term debt
          (970 )
Repurchase of common stock
          (229 )
Net cash provided by financing activities
    54,020       341,974  
                 
Net increase in cash and cash equivalents
    5,370       7,907  
Cash and cash equivalents, beginning of period
    20,018       12,412  
Cash and cash equivalents, end of period
  $ 25,388     $ 20,319  
                 
Supplemental cash flow information
               
Cash payments for interest
  $ 979     $ 378  
Cash payments for taxes
  $     $ 115  

See notes to consolidated financial statements.

 
4


ARLINGTON ASSET INVESTMENT CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

1.
Basis of Presentation:

The consolidated financial statements of Arlington Asset Investment Corp. (Arlington Asset) and its subsidiaries (unless the context otherwise provides, collectively, the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to Form 10-Q. Therefore, they do not include all information required by GAAP for complete financial statements. The interim financial statements reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair statement of the results for the periods presented. All significant intercompany accounts and transactions have been eliminated in consolidation. The results of operations for the three months ended March 31, 2012 are not necessarily indicative of the operating results for the entire year or any other subsequent interim period. The Company’s unaudited condensed consolidated financial statements and notes thereto should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

The preparation of the Company’s financial statements in conformity with GAAP requires the Company to make estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Although the Company based the estimates and assumptions on historical experience, when available, market information, and on various other factors that the Company believes to be reasonable under the circumstances, management exercises significant judgment in the final determination of the estimates. Actual results may differ from these estimates.

Certain amounts in the consolidated financial statements and notes for prior periods have been reclassified to conform to the current period presentation. These reclassifications had no effect on the results of operations of the Company.

2.
Financial Instruments:
 
  Fair Value of Financial Instruments

The accounting principles related to fair value measurements define fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, not adjusted for transaction costs. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures (ASC 820), establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels giving the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3) as described below:

 
Level 1 Inputs—
Unadjusted quoted prices in active markets for identical assets or liabilities that are accessible by the Company;

 
Level 2 Inputs—
Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly; and

 
Level 3 Inputs—
Unobservable inputs for the asset or liability, including significant assumptions of the Company and other market participants.

The Company determines fair values for the following assets and liabilities:

Mortgage-backed securities (MBS), at fair value

Agency-backed MBS - The Company’s agency-backed MBS, the principal and interest payments on which are guaranteed by the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac), are generally classified within Level 2 of the fair value hierarchy as they are valued after considering quoted market prices provided by a broker or dealer, or alternative pricing sources with reasonable levels of price transparency. The Company reviews broker or pricing service quotes to determine whether the quotes are relevant, for example, whether an active market exists to provide price transparency or whether the quote is an indicative price or a binding offer. The independent brokers and dealers providing market prices are those who make markets in these financial instruments.

 
5


Private-label MBS - The Company classifies private-label MBS within Level 3 of the fair value hierarchy because they trade infrequently and, therefore, have little or no price transparency. The Company utilizes present value techniques based on estimated cash flows of the instrument taking into consideration various assumptions derived by management and other assumptions used by other market participants. These assumptions are corroborated by evidence such as historical data, risk characteristics, transactions in similar instruments, and completed or pending transactions, when available. The significant inputs in the Company’s valuation process include default rate, loss severity, prepayment rate and discount rate. In general, significant increases (decreases) in default rate, loss severity or discount rate, in isolation, would result in a significantly lower (higher) fair value measurement.  However, significant increases (decreases) in prepayment rate may result in a significantly higher (lower) fair value measurement. It is difficult to generalize the interrelationships between these significant inputs as the actual results could differ considerably on an individual security basis.  For example, an increase in the default rate may not increase the loss severity rate if actual losses are lower than the average.  Also, changes in discount rates may be greatly influenced by market expectation at any given point based upon many variables not directly related to the MBS market.  Therefore, each significant input is closely analyzed to ascertain the reasonableness for the Company’s valuation purposes.

Establishing fair value is inherently subjective given the volatile and sometimes illiquid markets for these private-label MBS and requires management to make a number of assumptions, including assumptions about the future of interest rates, prepayment rates, discount rates, credit loss rates, and the timing of cash flows and credit losses. The assumptions the Company applies are specific to each security. Although the Company relies on the internal calculations to compute the fair value of these private-label MBS, the Company requests and considers indications of value (mark) from third-party dealers to assist in the valuation process.

Other investments—The Company’s other investments consist of investments in equity securities, investment funds, interest-only MBS, and other MBS-related securities. Interest-only MBS and residual interest in a securitization of which the Company is not considered the primary beneficiary are classified within Level 3 of the fair value hierarchy.

Derivative instruments—In the normal course of the Company’s operations, the Company is a party to various financial instruments that are accounted for as derivatives in accordance with ASC 815, Derivatives and Hedging (ASC 815). The derivative instruments that trade in active markets or exchanges are classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices. Other derivative instruments are generally classified within Level 2 of the fair value hierarchy because they are valued using broker or dealer quotations, which are model-based calculations based on market-based inputs, including, but not limited to, contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs.
 
Other—Cash and cash equivalents, interest receivable, deposits, repurchase agreements, accounts payable, accrued expenses and other liabilities are reflected in the consolidated balance sheets at their amortized cost, which approximates fair value because of the short term nature of these instruments.

The estimated fair values of the Company’s financial instruments are as follows:

   
March 31, 2012
   
December 31, 2011
 
   
Carrying
Amount
   
Estimated
Fair Value
   
Carrying
Amount
   
Estimated
Fair Value
 
Financial assets
                       
Cash and cash equivalents
  $ 25,388     $ 25,388     $ 20,018     $ 20,018  
Interest receivable
    2,535       2,535       2,366       2,366  
Sold securities receivable
    21,609       21,609       41,321       41,321  
Non-interest bearing receivables
    15       15       11       11  
MBS
                               
Agency-backed MBS
    774,959       774,959       637,011       637,011  
Private-label MBS
                               
Senior securities
    8,647       8,647       9,311       9,311  
Re-REMIC securities
    166,892       166,892       170,116       170,116  
Derivative assets
    299       299       504       504  
Other investments
    2,882       2,882       2,946       2,946  
Deposits
    69,337       69,337       71,079       71,079  
                                 
Financial liabilities
                               
Repurchase agreements
    668,618       668,618       647,977       647,977  
Purchased securities payable
    77,431       77,431       15,820       15,820  
Interest payable
    342       342       504       504  
Long-term debt
    15,000       15,000       15,000       15,000  
Derivative liabilities
    63,592       63,592       63,024       63,024  

 
6

 
  Fair Value Hierarchy

The following tables set forth financial instruments accounted for under ASC 820 by level within the fair value hierarchy as of March 31, 2012 and December 31, 2011. As required by ASC 820, assets and liabilities that are measured at fair value are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Financial Instruments Measured at Fair Value on a Recurring Basis

 
 
March 31, 2012
 
 
 
Total
 
 
Level 1
 
 
Level 2
 
 
Level 3
 
MBS, at fair value
 
 
 
 
 
 
 
 
 
 
 
 
Trading                        
Agency-backed MBS
 
$
774,843
 
 
$
 
 
$
774,843
 
 
$
 
Available-for-sale
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency-backed MBS
 
 
116
 
 
 
 
 
 
116
 
 
 
 
Private-label MBS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior securities
 
 
8,647
 
 
 
 
 
 
 
 
 
8,647
 
Re-REMIC securities
 
 
166,892
 
 
 
 
 
 
 
 
 
166,892
 
Total available-for-sale
 
 
175,655
 
 
 
 
 
 
116
 
 
 
175,539
 
Total MBS
 
 
950,498
 
 
 
 
 
 
774,959
 
 
 
175,539
 
Derivative assets, at fair value
 
 
299
 
 
 
 
 
 
299
 
 
 
 
Derivative liabilities, at fair value
 
 
(63,592
)
 
 
(63,592
)
 
 
 
 
 
 
Interest-only MBS, at fair value
 
 
1,011
 
 
 
 
 
 
 
 
 
1,011
 
Total
 
$
888,216
 
 
$
(63,592
)
 
$
775,258
 
 
$
176,550
 

 
 
December 31, 2011
 
 
 
Total
 
 
Level 1
 
 
Level 2
 
 
Level 3
 
MBS, at fair value
 
 
 
 
 
 
 
 
 
 
 
 
Trading
 
 
 
 
 
 
 
 
 
 
 
 
Agency-backed MBS
 
$
636,872
 
 
$
 
 
$
636,872
 
 
$
 
Available-for-sale
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency-backed MBS
 
 
139
 
 
 
 
 
 
139
 
 
 
 
Private-label MBS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior securities
 
 
9,311
 
 
 
 
 
 
 
 
 
9,311
 
Re-REMIC securities
 
 
170,116
 
 
 
 
 
 
 
 
 
170,116
 
Total available-for-sale
 
 
179,566
 
 
 
 
 
 
139
 
 
 
179,427
 
Total MBS
 
 
816,438
 
 
 
 
 
 
637,011
 
 
 
179,427
 
Derivative assets, at fair value
 
 
504
 
 
 
 
 
 
504
 
 
 
 
Derivative liabilities, at fair value
 
 
(63,024
)
 
 
(63,024
)
 
 
 
 
 
 
Interest-only MBS, at fair value
 
 
1,060
 
 
 
 
 
 
 
 
 
1,060
 
Total
 
$
754,978
 
 
$
(63,024
)
 
$
637,515
 
 
$
180,487
 

 
7


The total financial assets measured and reported at fair value on a recurring basis and classified within Level 3 were $176,550, or 16.46%, and $180,487, or 18.90%, of the Company’s total assets as of March 31, 2012 and December 31, 2011, respectively.

There were no significant transfers of securities in or out of Levels 1, 2 or 3 during the quarter ended March 31, 2012 or the year ended December 31, 2011.

Level 3 Financial Assets and Liabilities

Financial Instruments Measured at Fair Value on a Recurring Basis

As of March 31, 2012, the fair value of the Company’s Level 3, available-for-sale, private-label MBS was $176,550. These securities are primarily senior and re-REMIC tranches in securitization trusts issued between 2005 and 2010. The senior securities represent interests in securitizations that have the first right to cash flows and absorb losses last. The re-REMIC securities represent interests in re-securitizations of senior MBS and pro-rata mezzanine securities. For re-REMIC securities, the cash flows from, and any credit losses absorbed by, the underlying MBS are allocated among the re-REMIC securities issued in the re-securitization transactions based on the re-REMIC structure. For example, prime and non-prime residential senior securities have been resecuritized to create a two-tranche structure with a re-REMIC senior security and a re-REMIC subordinated security. In these re-REMIC securities, all principal payments from the underlying securities are directed to the re-REMIC senior security until the face value is fully paid off. Thereafter, all principal payments are directed to the re-REMIC subordinated security. For pro-rata mezzanine securities, principal payments from the underlying MBS are typically allocated concurrently and proportionally to the mezzanine securities along with senior securities. The re-REMIC subordinated and mezzanine securities absorb credit losses, if any, first; however, these credit losses occur only when credit losses exceed the credit protection provided to the underlying securities. Senior, re-REMIC and mezzanine securities receive interest while any face value is outstanding.
 
As of March 31, 2012, the Company’s senior securities and re-REMIC securities were collateralized by residential Prime and Alt-A mortgage loans and had a weighted-average original loan-to-value of 71%, weighted-average original FICO score of 729, weighted-average three-month prepayment rate of 15% and weighted-average three-month loss severities of 50%. These underlying collateral loans had a weighted-average coupon rate of 5.28%. These securities are currently rated below investment grade. The significant inputs for the valuation model include the following weighted-averages:

   
March 31, 2012
   
December 31, 2011
 
   
Senior
Securities
   
Re-REMIC
Securities
   
Senior
Securities
   
Re-REMIC
Securities
 
Discount rate
    6.90 %     8.67 %     7.00 %     8.75 %
Default rate
    10.45 %     5.60 %     10.30 %     5.55 %
Loss severity rate
    60.00 %     43.60 %     60.00 %     43.06 %
Prepayment rate
    17.45 %     15.28 %     17.30 %     15.20 %

The ranges of the significant inputs for the valuation model were as follows as of the dates indicated:

   
March 31, 2012
   
December 31, 2011
 
   
Senior
Securities
   
Re-REMIC
Securities
   
Senior
Securities
   
Re-REMIC
Securities
 
Discount rate
    6.90 – 6.90 %     7.15 – 13.73 %     7.00 – 7.00 %     7.45 – 13.73 %
Default rate
    10.45 – 10.45 %     2.05 – 13.10 %     10.30 – 10.30 %     2.10 – 13.00 %
Loss severity rate
    60.00 – 60.00 %     27.79 – 57.50 %     60.00 – 60.00 %     28.18 – 57.50 %
Prepayment rate
    17.45 – 17.45 %     9.60 – 21.05 %     17.30 – 17.30 %     9.60 – 21.00 %

 
8


The tables below set forth a summary of changes in the fair value and gains and losses of the Company’s Level 3 financial assets and liabilities that are measured at fair value on a recurring basis for the three months ended March 31, 2012 and 2011.

   
Three Months Ended March 31, 2012
 
   
Senior
Securities
   
Re-REMIC
Securities
   
Total
 
Beginning balance, January 1, 2012
  $ 9,311     $ 170,116     $ 179,427  
Total net gains (losses)
                       
Included in earnings
                 
Included in other comprehensive income
    (607 )     (4,276 )     (4,883 )
Purchases
                 
Sales
                 
Principal payoffs
    (256 )     (3,260 )     (3,516 )
Net accretion of discount
    199       4,312       4,511  
Ending balance, March 31, 2012
  $ 8,647     $ 166,892     $ 175,539  
                         
The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date
  $     $     $  

   
Three Months Ended March 31, 2011
 
   
Senior
Securities
   
Re-REMIC
Securities
   
Total
 
Beginning balance, January 1, 2011
  $ 51,038     $ 201,697     $ 252,735  
Total net gains (losses)
                       
Included in earnings
    3,472       7,209       10,681  
Included in other comprehensive income
    (5,226 )     (4,144 )     (9,370 )
Purchases
    330       10,648       10,978  
Sales
    (32,935 )     (29,095 )     (62,030 )
Principal payoffs
    (1,452 )     (4,281 )     (5,733 )
Net accretion of discount
    638       3,423       4,061  
Ending balance, March 31, 2011
  $ 15,865     $ 185,457     $ 201,322  
                         
The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date
  $     $     $  
 
Gains and losses included in earnings for the three months ended March 31, 2012 and 2011 are reported in the following statement of comprehensive income line descriptions:

   
Other Income, Investment Gain, net
 
   
Three Months Ended March 31,
 
   
2012
   
2011
 
Total gains included in earnings for the period
  $     $ 10,681  
                 
Change in unrealized gains relating to assets still held at reporting date
  $     $  
 
Level 3 Financial Instruments Measured at Fair Value on a Non-Recurring Basis

The Company also measures certain financial assets at fair value on a non-recurring basis. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets due to impairments. Due to the nature of these financial assets, enterprise values are primarily used to value these financial assets. In determining the enterprise value, the Company analyzes various financial, performance and market factors to estimate fair value, including where applicable, market trading activity. As a result, these financial assets are classified within Level 3 of the fair value hierarchy. As of March 31, 2012, these financial assets are classified within the other investments category and represent the Company’s interest in non-public equity securities and investment funds. For the three months ended March 31, 2011, the Company recorded a loss of $85 in the carrying value of these financial assets. For the three months ended March 31, 2012, there were no changes to the carrying value of these financial assets.

 
9


MBS, at Fair Value

MBS, at fair value(1) (2), consisted of the following as of the dates indicated:
 
   
March 31, 2012
   
December 31, 2011
   
Fair
Value
   
Net
Unamortized
Premium
(Discount)
   
Percent
of
Total
Fair
Value
   
Weighted
Average
Life
   
Weighted
Average
Rating(3)
   
Fair
Value
   
Net
Unamortized
Premium
(Discount)
   
Percent
of
Total
Fair
Value
   
Weighted
Average
Life
 
Weighted
Average
Rating(3)
Trading
                                                       
Fannie Mae
  $ 519,120     $       54.62 %     7.2    
AAA
    $ 432,039     $       52.92 %     5.7  
AAA
Freddie Mac
    255,723             26.90 %     7.7    
AAA
      204,833             25.09 %     6.0  
AAA
Available-for-sale:
                                                                       
Agency-backed
                                                                       
Fannie Mae
    116             0.01 %     5.0    
AAA
      139             0.01 %     5.2  
AAA
Private-label
                                                                       
Senior securities
    8,647       (4,997 )     0.91 %     6.1       C       9,311       (5,196 )     1.14 %     5.0  
CC+
Re-REMIC securities
    166,892       (127,228 )     17.56 %     9.4    
NR
      170,116       (131,541 )     20.84 %     9.1  
NR
    $ 950,498     $ (132,225 )     100.00 %                   $ 816,438     $ (136,737 )     100.00 %          
________________________
(1)
The Company’s MBS portfolio was primarily comprised of fixed-rate MBS at March 31, 2012 and December 31, 2011. The weighted-average coupon of the MBS portfolio at March 31, 2012 and December 31, 2011 was 4.72% and 4.85%, respectively.
(2)
As of March 31, 2012 and December 31, 2011, the Company’s MBS investments with a fair value of $750,932 and $731,432, respectively, were pledged as collateral for repurchase agreements.
(3)
The securities issued by Fannie Mae and Freddie Mac are not rated by any rating agency; however, they are commonly thought of as having an implied rating of “AAA.” There is no assurance, particularly given the downgrade of the U.S.’s credit rating to “AA” by Standard & Poors during the quarter ended September 30, 2011, that these securities would receive such a rating if they were ever rated by a rating agency. The weighted-average rating of the Company’s private-label senior securities is calculated based on face value of the securities.

The Company has generally purchased private-label MBS at a discount. The Company, at least on a quarterly basis, estimates the future expected cash flows based on the Company’s observation of current information and events and applying a number of assumptions related to prepayment rates, interest rates, default rates, and the timing and amount of cash flows and credit losses. These assumptions are difficult to predict as they are subject to uncertainties and contingencies related to future events that may impact the Company’s estimates and its interest income.

Interest income on the private-label MBS that were purchased at a discount to face value is recognized based on the security’s expected effective interest rate. At acquisition, the accretable yield is calculated as the difference between the undiscounted expected cash flows and the purchase price which is expected to be accreted into interest income over the remaining life of the security on a level-yield basis. The difference between the contractually required payments and the undiscounted expected cash flows represents the non-accretable difference. Based on actual payment activities and changes in estimates of undiscounted expected future cash flows, the accretable yield and the non-accretable difference can change over time. Significant increases in the amount or timing of undiscounted expected future cash flows are recognized prospectively as an adjustment to the accretable yield.
 
The following table presents the changes in the accretable yield on available-for-sale, private-label MBS for the three months ended March 31, 2012 and 2011.

 
 
Three Months Ended March 31,
 
 
 
2012
 
 
2011
 
Beginning balance
 
$
194,619
 
 
$
316,029
 
Accretion of discount
 
 
(6,292
)
 
 
(8,027
)
Reclassifications, net
 
 
(5,460
)
 
 
(12,097
)
Acquisitions
 
 
 
 
 
15,106
 
Sales
 
 
 
 
 
(52,994
)
Ending balance
 
$
182,867
 
 
$
258,017
 

 
10


The Company purchased no available for sale, private-label MBS during the three months ended March 31, 2012.  For the available-for-sale, private-label MBS acquired during the three months ended March 31, 2011, the contractually required payments receivable, the cash flow expected to be collected, and the fair value at the acquisition date were as follows:

Contractually required payments receivable
 
$
31,958
 
Cash flows expected to be collected
 
 
28,639
 
Basis in acquired securities
 
 
13,533
 
 
The Company’s available-for-sale MBS are carried at fair value in accordance with ASC 320, Debt and Equity Securities (ASC 320), the securities with resulting unrealized gains and losses reflected as other comprehensive income or loss. Gross unrealized gains and losses on these securities were the following as of the dates indicated:

 
 
March 31, 2012
 
 
 
Amortized
 
 
 
 
 
 
 
 
 
 
 
 
Cost/
 
 
Unrealized
 
 
 
 
 
 
Cost Basis(1)
 
 
Gains
 
 
Losses
 
 
Fair Value
 
Agency-backed MBS
 
$
107
 
 
$
9
 
 
$
 
 
$
116
 
Private-label MBS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior securities
 
 
8,340
 
 
 
307
 
 
 
 
 
 
8,647
 
Re-REMIC securities
 
 
133,712
 
 
 
33,180
 
 
 
 
 
 
166,892
 
Total
 
$
142,159
 
 
$
33,496
 
 
$
 
 
$
175,655
 
________________________
(1)
The amortized cost of MBS includes unamortized net discounts of $132,225 at March 31, 2012.
 
 
 
December 31, 2011
 
 
 
Amortized
 
 
 
 
 
 
 
 
 
 
 
 
Cost/
 
 
Unrealized
 
 
 
 
 
 
Cost Basis(1)
 
 
Gains
 
 
Losses
 
 
Fair Value
 
Agency-backed MBS
 
$
128
 
 
$
11
 
 
$
 
 
$
139
 
Private-label MBS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior securities
 
 
8,397
 
 
 
914
 
 
 
 
 
 
9,311
 
Re-REMIC securities
 
 
132,661
 
 
 
37,455
 
 
 
 
 
 
170,116
 
Total
 
$
141,186
 
 
$
38,380
 
 
$
 
 
$
179,566
 
________________________
(1)
The amortized cost of MBS includes unamortized net discounts of $136,737 at December 31, 2011.
 
The Company recorded no other-than-temporary impairment charges on MBS during the three months ended March 31, 2012 and 2011.
 
The following table presents the results of sales of MBS for the periods indicated:

 
 
Three Months Ended
March 31, 2012
 
 
Three Months Ended
March 31, 2011
 
 
 
Agency-
Backed MBS
 
 
Private-Label MBS
 
 
Agency-
Backed MBS
 
 
Private-Label MBS
 
Proceeds from sales
 
$
21,609
 
 
$
 
 
$
105,603
 
 
$
62,029
 
Gross gains
 
 
 
 
 
 
 
 
320
 
 
 
10,681
 
Gross losses
 
 
120
 
 
 
 
 
 
128
 
 
 
 

 
11


  Other Investments
 
The Company’s other investments consisted of the following as of the dates indicated:
 
 
 
March 31, 2012
 
 
December 31, 2011
 
Interest-only MBS
 
$
1,011
 
 
$
1,060
 
Non-public equity securities
 
 
975
 
 
 
975
 
Investment funds
 
 
896
 
 
 
911
 
Total other investments
 
$
2,882
 
 
$
2,946
 

3.
Borrowings:

  Repurchase Agreements

The Company has entered into repurchase agreements to fund its investments in MBS. As of March 31, 2012, the amount at risk related to $203,576 of repurchase agreements with Credit Suisse Securities USA LLC was $46,460, or 21.01% of the Company’s equity, with a weighted-average maturity of 15 days. As of December 31, 2011, the amount at risk related to $177,402 and $219,737 of repurchase agreements with Credit Suisse Securities USA LLC and Barclays Capital Inc., respectively, was $46,848 and $19,995, respectively, or 25.55% and 10.90%  of the Company’s equity, respectively, with a weighted-average maturity of 16 and 12 days, respectively. The following tables provide information regarding the Company’s outstanding repurchase agreement borrowings as of the dates and for the periods indicated:

 
March 31, 2012
 
December 31, 2011
 
Outstanding balance
  $ 668,618     $ 647,977  
Value of assets pledged as collateral
               
Agency-backed MBS
    674,379       653,322  
Private-label MBS
    76,553       78,110  
Weighted-average rate
    0.45 %     0.49 %
Weighted-average term to maturity
 
13.0 days
   
13.1 days
 
                 
 
March 31, 2012
 
March 31, 2011
 
Weighted-average outstanding balance during the three months ended
  $ 645,469     $ 321,850  
Weighted-average rate during the three months ended
    0.42 %     0.39 %

  Long-Term Debt

As of March 31, 2012 and December 31, 2011, the Company had $15,000 of outstanding long-term debentures. The long-term debentures accrue and require payments of interest quarterly at an annual rate of three-month LIBOR plus 2.25% to 3.00%. The weighted-average interest rate on these long-term debentures was 3.32% and 3.15% as of March 31, 2012 and December 31, 2011, respectively. All of these borrowings mature between 2033 and 2035.

4.
Derivative Financial Instruments and Hedging Activities:

In the normal course of its operations, the Company is a party to financial instruments that are accounted for as derivative financial instruments in accordance with ASC 815. These instruments may include interest rate swaps, Eurodollar and U.S. Treasury futures contracts, put options and certain commitments to purchase and sell MBS.
 
During the three months ended March 31, 2012, the Company entered into various financial contracts to hedge certain MBS and related borrowings and other long-term debt. These financial contracts are not designated as hedges under ASC 815. The changes in fair value on these derivatives are recorded to net investment gain or loss in the statement of comprehensive income. For the three months ended March 31, 2012 and 2011, the Company recorded net losses of $385 and $2,547, respectively, on these derivatives. The Company held the following derivative instruments as of the dates indicated:

 
12

 
 
 
March 31, 2012
 
 
December 31, 2011
 
 
 
Notional Amount
 
 
Fair Value
 
 
Notional Amount
 
 
Fair Value
 
No hedge designation
 
 
 
 
 
 
 
 
 
 
 
 
Eurodollar futures (1)
 
$
12,307,000
 
 
$
(63,510
)
 
$
12,157,000
 
 
$
(62,556
)
10-year U.S. Treasury note futures
 
 
 
 
 
 
 
 
39,700
 
 
 
(468
)
Commitment to purchase MBS(2)
 
 
75,000
 
 
 
86
 
 
 
75,000
 
 
 
504
 
Commitment to sell MBS(3)
 
 
75,000
 
 
 
150
 
 
 
 
 
 
 
Stock sales option(4)
 
 
 
 
 
(19
)
 
 
 
 
 
 
 ____________________
(1)
The $12,307,000 total notional amount of Eurodollar futures contracts as of March 31, 2012 represents the accumulation of Eurodollar futures contracts that mature on a quarterly basis between 2012 and 2017 and have a lifetime weighted-average rate of 3.41% as compared to a lifetime weighted-average market rate of 1.35%. As of March 31, 2012, the Company maintained $69,337 as a deposit and margin against the open Eurodollar futures contracts.
(2)
The $75,000 total notional amount of commitment to purchase MBS as of March 31, 2012 represents forward commitments to purchase fixed-rate MBS securities with settlement dates in April 2012.
(3)
The $75,000 total notional amount of commitment to sell MBS as of March 31, 2012 represents forward commitments to sell fixed-rate MBS securities with settlement dates in April 2012.
(4)
Represents the over-allotment option granted to the underwriters in the Company’s March 2012 public offering of Class A common stock to purchase up to an additional 263,250 shares at a public offering price of $23.90 per share less the $0.875 per share dividend declared on March 16, 2012 pursuant to the Underwriting Agreement dated March 22, 2012.

5.
Income Taxes:

The total income tax provision for the three months ended March 31, 2012 and 2011 was $442 and $471, respectively. The Company generated pre-tax book income of $11,204 and $20,256 for the three months ended March 31, 2012 and 2011, respectively.

The Company’s effective tax rate for the three months ended March 31, 2012 and 2011 was 3.9% and 2.3%, respectively. The effective tax rate during these periods was lower than the highest marginal tax rates due to the realization of deferred tax assets that were previously recorded. The net deferred tax assets, which are offset by a full valuation allowance, include net operating losses (NOLs), which are available to offset the current and future taxable income. The Company recorded an expected tax liability for these periods due to the expected alternative minimum taxes. Limitations prevent the Company from using its NOLs to fully offset its taxable income for alternative minimum tax purposes. The Company expects to realize an additional portion of the tax benefits of NOLs in 2012, which are reflected in the Company’s projected effective tax rate for the year, along with a corresponding release of the valuation allowance previously recorded against these losses. The Company will continue to provide a valuation allowance against the other deferred tax assets to the extent the Company believes that it is more likely than not that the benefits will not be realized in the future. The Company will continue to assess the need for a valuation allowance at each reporting date.

The Company is subject to examination by the U.S. Internal Revenue Service (IRS), and other taxing authorities in jurisdictions where the Company has significant business operations, such as Virginia. During the three months ended March 31, 2012, the Company received a notification from the IRS related to the commencement of an IRS examination of the Company’s tax years 2009 and 2010.

6.
Earnings Per Share:

Basic earnings per share includes no dilution and is computed by dividing net income or loss available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share includes the impact of dilutive securities such as stock options and unvested shares of restricted stock. The following tables present the computations of basic and diluted earnings per share for the periods indicated:

 
13

 
   
Three Months Ended March 31,
 
(Shares in thousands)
 
2012
   
2011
 
   
Basic
   
Diluted
   
Basic
   
Diluted
 
Weighted-average shares outstanding
                       
Common stock
    7,865       7,865       7,661       7,661  
Stock options and unvested restricted stock
          8             20  
Weighted-average common and common equivalent shares outstanding
    7,865       7,873       7,661       7,681  
Net income applicable to common stock
  $ 10,762     $ 10,762     $ 19,785     $ 19,785  
Earnings per common share
  $ 1.37     $ 1.37     $ 2.58     $ 2.58  

The diluted earnings per share for the three months ended March 31, 2012 and 2011 did not include the antidilutive effect of 23,951 and 84,496 shares, respectively, of awarded restricted stock units, stock options and restricted stock.

7.
Commitments and Contingencies:

Litigation and Regulatory Actions
 
The Company received a “Wells Notice” from the staff of the SEC on January 26, 2012 indicating that the staff is considering recommending that the SEC bring a civil injunctive action or institute a public administrative proceeding alleging violations of the federal securities laws. On February 29, 2012, the Company provided a written submission setting forth reasons why a formal proceeding should not be authorized by the SEC.  The Company cannot predict whether or not any proceedings might be initiated, the amount of any claims that might be asserted or remedies that might be sought by the SEC, or the ultimate outcome of any proceedings that might be initiated.
 
8.
Equity:

Equity Offering

On March 26, 2012, the Company completed a public offering of 1,755,000 shares of Class A common stock, at a public offering price of $23.90 per share, for net proceeds of $40,164, after deducting underwriting discounts and commissions and expenses.  The Company also granted the underwriters a 30-day option to purchase up to 263,250 additional shares of Class A common stock to cover over-allotments, if any.  See Note 10 to these consolidated financial statements for information relating to the underwriters’ full exercise of the over-allotment option on April 18, 2012.

Dividends

Pursuant to the Company’s variable dividend policy, the Board of Directors evaluates dividends on a quarterly basis and, in its sole discretion, approves the payment of dividends. The Company’s dividend payments, if any, may vary significantly from quarter to quarter. The Board of Directors has approved and the Company has declared the following dividends to date in 2012:

Quarter Ended
 
Dividend
Amount
 
Declaration Date
 
Record Date
 
Pay Date
 
March 31
 
$
0.875
   
March 16
   
March 26
   
April 30
 

The Board of Directors approved and the Company declared and paid the following dividends for 2011:

Quarter Ended
 
Dividend
Amount
 
Declaration Date
 
Record Date
 
Pay Date
 
December 31
 
$
0.875
   
December 21
   
December 31
   
January 31, 2012
 
September 30
   
0.875
   
September 19
   
September 30
   
October 31
 
June 30
   
0.875
   
June 23
   
July 5
   
July 29
 
March 31
   
0.750
   
March 24
   
April 4
   
April 29
 

 
14


  Long-Term Incentive Plan

On April 13, 2011, the Board of Directors adopted the Arlington Asset Investment Corp. 2011 Long-Term Incentive Plan (2011 Plan). The 2011 Plan was approved by the Company’s shareholders and became effective on June 2, 2011. Under the 2011 Plan, shares of Class A common stock of the Company may be issued to employees, directors, consultants and advisors of the Company and its affiliates. As of March 31, 2012 and December 31, 2011, 532,434 and 530,519 shares, respectively, remained available for issuance under the 2011 Plan.

Restricted Stock

The following tables present the activities and balances related to restricted stock for the dates and periods indicated:

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Shares granted
          14,000  
Weight-average share price
  $     $ 27.66  
Compensation expense recognized during the period
  $ 54     $ 368  

   
March 31, 2012
   
December 31, 2011
 
Restricted Class A shares outstanding, unvested
    10,543       15,206  
Unrecognized compensation cost related to unvested shares
  $ 146     $ 200  
Weighted-average vesting period remaining
 
1.71 years
   
2.02 years
 

  Share Repurchases

From time to time, the Company repurchases shares of its Class A common stock under a share repurchase program authorized by the Board of Directors in July 2010 (Repurchase Program), pursuant to which the Company is authorized to repurchase up to 500,000 shares of its Class A common stock.

Repurchases under the Repurchase Program may be made from time to time on the open market and in private transactions at management’s discretion in accordance with applicable federal securities laws. The timing of repurchases and the exact number of shares of Class A common stock to be repurchased will depend upon market conditions and other factors. The Repurchase Program is funded using the Company’s cash on hand and cash generated from operations. The Repurchase Program has no expiration date and may be suspended or terminated at any time without prior notice.

The following table summarizes the Company’s share repurchase activities for the periods indicated:

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Shares repurchased
          8,910  
Total cost
  $     $ 229  
Average price
  $     $ 25.70  

As of March 31, 2012 and December 31, 2011, 247,275 shares of Class A common stock remained available for repurchases under the Repurchase Program.

9.
Recent Accounting Pronouncements:

In December 2011, the FASB issued Accounting Standards Update No. 2011-11, Disclosures about Offsetting Assets and Liabilities. This standard requires that the disclosures of both gross and net information about instruments and transactions eligible for offset in the statement of financial position as well as instruments and transactions subject to an agreement similar to a master netting arrangement. In addition, the standard requires disclosure of collateral received and posted in connection with master netting agreements or similar arrangements. The new requirements are effective for the Company on January 1, 2013. The Company does not expect a significant impact on its financial positions as a result of adoption of these new requirements.

 
15