XNYS:NLYPRA Annaly Capital Management Inc Pref Share 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

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:  1-13447

ANNALY CAPITAL MANAGEMENT, INC.
(Exact name of Registrant as specified in its Charter)
 
MARYLAND 22-3479661
(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)

(212) 696-0100
(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 x    No o

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

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” 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 8, 2012
  Common Stock, $.01 par value   974,606,339
 
 
 

 
 
ANNALY CAPITAL MANAGEMENT, INC.
FORM 10-Q
TABLE OF CONTENTS
 
PART I
 
 
PAGE
Part I.     FINANCIAL INFORMATION
 
   
Item 1.  Financial Statements:
 
   
Consolidated Statements of Financial Condition at March 31, 2012 (Unaudited) and December 31, 2011
 
(Derived from the audited Consolidated Statement of Financial Condition at December 31, 2011)
1
   
Consolidated Statements of Operations and Comprehensive Income (Loss) (Unaudited) for the quarters ended March 31, 2012 and 2011
2
   
Consolidated Statements of Stockholders’ Equity (Unaudited) for the quarters ended March 31, 2012 and 2011
3
   
Consolidated Statements of Cash Flows (Unaudited) for the quarters ended March 31, 2012 and 2011
4
   
Notes to Consolidated Financial Statements (Unaudited)
5
   
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
23
   
Item 3. Quantitative and Qualitative Disclosures about Market Risk
39
   
Item 4. Controls and Procedures
40
   
Part II.     OTHER INFORMATION
 
   
Item 1. Legal Proceedings
41
   
Item 1A. Risk Factors
41
   
Item 6. Exhibits
41
   
SIGNATURES
44
 
 
 

 
                                   
PART I
 
Part I
Item 1.  Financial Statements
 
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
 (dollars in thousands, except share and per share amounts)
 
ASSETS
 
March 31, 2012
(Unaudited)
 
December 31,
2011(1)
Cash and cash equivalents
  $ 932,761     $ 994,198  
Reverse repurchase agreements
    2,540,601       860,866  
Investments, at fair value:
               
   U.S. Treasury Securities (including pledged assets of $894,419 and  $352,820, respectively)
    2,622,714       928,547  
   Securities borrowed
    1,122,453       928,732  
   Agency mortgage-backed securities (including pledged assets of $97,383,568 and $90,406,535, respectively)
    110,291,712       104,251,055  
   Agency debentures (including pledged assets of  $434,910 and $567,383, respectively)
    1,499,127       889,580  
   Investments in affiliates
    225,818       211,970  
   Equity securities
    4,470       3,891  
Corporate debt, held for investment
    50,806       52,073  
Receivable for investments sold
    454,278       -  
Accrued interest and dividends receivable
    418,489       409,023  
Receivable from Prime Broker
    3,272       3,272  
Receivable for advisory and service fees (including from affiliates of  $16,359 and $16,245, respectively)
    19,608       19,550  
Intangible for customer relationships (net of accumulated amortization of $6,042 million and $5,432, respectively)
    10,281       10,807  
Goodwill
    55,417       42,030  
Other derivative contracts, at fair value
    321       113  
Other assets
    29,412       24,295  
Total assets   $ 120,281,540     $ 109,630,002  
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Liabilities:
               
 U.S. Treasury Securities sold, not yet purchased, at fair value
  $ 2,577,905     $ 826,912  
  Repurchase agreements
    91,720,865       84,097,885  
  Securities loaned, at fair value
    876,849       804,901  
  Payable for investments purchased
    5,708,412       4,315,796  
  Convertible Senior Notes
    524,420       539,913  
  Accrued interest payable
    129,108       138,965  
  Dividends payable
    534,401       552,806  
  Interest rate swaps, at fair value
    2,211,048       2,552,687  
  Accounts payable and other liabilities
    57,927       7,223  
     Total liabilities
    104,340,935       93,837,088  
                 
6.00% Series B Cumulative Convertible Preferred Stock: 4,600,000 shares authorized, 0 and 1,331,849 shares issued and outstanding, respectively
    -       32,272  
                 
Stockholders’ Equity:
               
   7.875% Series A Cumulative Redeemable Preferred Stock: 7,412,500 authorized, issued and outstanding
    177,088       177,088  
  Common stock, par value $0.01 per share, 1,987,987,500 authorized,  974,325,338 and 970,161,647 issued and outstanding, respectively
    9,743       9,702  
  Additional paid-in capital
    15,127,882       15,068,870  
  Accumulated other comprehensive income (loss)
    2,766,430       3,008,988  
  Accumulated deficit
    (2,140,538 )     (2,504,006 )
     Total stockholders’ equity
    15,940,605       15,760,642  
                 
Total liabilities, Series B Cumulative Convertible Preferred Stock and stockholders’ equity
  $ 120,281,540     $ 109,630,002  
 
(1)  Derived from the audited consolidated financial statements at December 31, 2011.
                
See notes to consolidated financial statements.
 
 
1

 
             
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
 (dollars in thousands, except share and per share amounts)
(Unaudited)
 
   
For the Quarter Ended March 31,
   
2012
 
2011
Interest income:
           
  Investments
  $ 850,959     $ 837,880  
  U.S. Treasury Securities
    1,418       4,825  
  Securities loaned
    2,518       1,343  
    Total interest income
    854,895       844,048  
                 
Interest expense:
               
  Repurchase agreements
    113,914       102,602  
  Convertible Senior Notes
    14,727       6,767  
  U.S. Treasury Securities sold, not yet purchased
    2,644       4,986  
  Securities borrowed
    2,060       1,101  
      Total interest expense
    133,345       115,456  
                 
Net interest income
    721,550       728,592  
                 
Other income (loss):
               
  Investment advisory and other fee income
    20,766       17,207  
  Net gains (losses) on sales of Agency mortgage-backed securities and debentures
    80,299       27,185  
  Dividend income from affiliates
    7,521       6,297  
  Net gains (losses) on trading assets
    5,256       18,812  
  Net unrealized gain (losses) on interest-only Agency mortgage-backed securities
    30,877       -  
  Income (expense) from underwriting
    (8 )     2,904  
     Subtotal
    144,711       72,405  
  Realized gains (losses) on interest rate swaps(1)
    (219,340 )     (206,148 )
  Realized gains (losses) on termination of interest rate swaps
    (2,385 )     -  
  Unrealized gains (losses) on interest rate swaps
    341,639       169,308  
     Subtotal
    119,914       (36,840 )
     Total other income (loss)
    264,625       35,565  
                 
Expenses:
               
  Compensation expense
    59,014       44,530  
  Other general and administrative expenses
    8,893       7,297  
     Total expenses
    67,907       51,827  
                 
Income (loss) before income taxes and income from equity method  investment in affiliate
    918,268       712,330  
 Income taxes
    (16,462 )     (13,575 )
                 
 Income from equity method investment in affiliate
    -       1,140  
                 
 Net income (loss)
    901,806       699,895  
                 
Dividends on preferred stock
    3,938       4,267  
                 
Net income (loss) available (related) to common shareholders
  $ 897,868     $ 695,628  
                 
Net income (loss) available (related) per share to common shareholders:
               
  Basic
  $ 0.92     $ 0.92  
  Diluted
  $ 0.89     $ 0.89  
                 
Weighted average number of common shares outstanding:
               
  Basic
    971,727,701       752,413,605  
  Diluted
    1,010,588,609       790,993,841  
                 
 Net income (loss)
  $ 901,806     $ 699,895  
 Other comprehensive income (loss):
               
  Unrealized gains (losses) on available-for-sale securities
    (162,259 )     (142,227 )
  Unrealized losses on interest rate swaps
    -       14,298  
  Reclassification adjustment for net (gains) losses  included in net income (loss)
    (80,299 )     (27,185 )
  Other comprehensive income (loss)
    (242,558 )     (155,114 )
Comprehensive income (loss)
  $ 659,248     $ 544,781  
 
(1) Interest expense related to the Company’s interest rate swaps is recorded in Realized gains losses on interest rate swaps on the Consolidated Statements of Operations and Comprehensive Income (Loss).
                             
See notes to consolidated financial statements.
 
 
2

 
            
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(dollars in thousands, except per share data)
(Unaudited)
 
   
Preferred
Stock
 
Common
Stock
Par Value
 
Additional
Paid-In
Capital
 
Accumulated Other Comprehensive
Income
 
Accumulated
Deficit
 
 
Total
                                     
BALANCE, DECEMBER  31, 2010
  $ 177,088     $ 6,316     $ 9,175,245     $ 1,164,642     $ (658,391 )   $ 9,864,900  
                                                 
  Net income
    -       -       -       -       699,895       699,895  
  Other comprehensive income (loss)
    -       -       -       (155,114 )     -       (155,114 )
  Exercise of stock options
    -       2       2,435       -       -       2,437  
  Stock option expense and long-term compensation expense
    -       -       1,262       -       -       1,262  
  Conversion of Series B cumulative preferred stock
    -       -       48       -       -       48  
  Net proceeds from direct purchase and dividend reinvestment
    -       1       1,141       -       -       1,142  
  Net proceeds from follow-on offering
    -       1,725       2,939,686       -       -       2,941,411  
  Preferred Series A dividends declared  $0.492 per share
    -       -       -       -       (3,648 )     (3,648 )
  Preferred Series B dividends declared $0.375 per share
    -       -       -       -       (619 )     (619 )
  Common dividends declared, $0.62 per share
    -       -       -       -       (498,697 )     (498,697 )
                                                 
BALANCE, MARCH 31, 2011
  $ 177,088     $ 8,044     $ 12,119,817     $ 1,009,528     $ (461,460 )   $ 12,853,017  
                                                 
BALANCE, DECEMBER  31, 2011
  $ 177,088     $ 9,702     $ 15,068,870     $ 3,008,988     $ (2,504,006 )   $ 15,760,642  
                                                 
  Net income
    -       -       -       -       901,806       901,806  
  Other comprehensive income (loss)
    -       -       -       (242,558 )     -       (242,558 )
  Exercise of stock options
    -       1       1,841       -       -       1,842  
  Stock option expense and long-term compensation expense
    -       -       1,849       -       -       1,849  
  Conversion of Series B cumulative preferred stock
    -       40       32,232       -       -       32,272  
  Contingent beneficial conversion feature on Convertible Senior Notes
    -       -       23,321       -       -       23,321  
  Offering expenses
                    (231 )                     (231 )
  Preferred Series A dividends declared  $0.492 per share
    -       -       -       -       (3,648 )     (3,648 )
  Preferred Series B dividends declared $0.375 per share
    -       -       -       -       (289 )     (289 )
  Common dividends declared, $0.55 per share
    -       -       -       -       (534,401 )     (534,401 )
                                                 
BALANCE, MARCH 31, 2012
  $ 177,088     $ 9,743     $ 15,127,882     $ 2,766,430     $ (2,140,538 )   $ 15,940,605  
                                                 
See notes to consolidated financial statements.
                                         
 
 
3

 
 
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
 (dollars in thousands)
(Unaudited)
 
   
For the Quarters Ended March 31,
   
2012
 
2011
Cash flows from operating activities:
           
    Net income (loss)
  $ 901,806     $ 699,895  
    Adjustments to reconcile net income (loss) to net cash provided by (used in) operating  activities:
               
    Amortization of Investment premiums and discounts, net
    280,336       174,743  
    Amortization of intangibles
    591       366  
    Amortization of deferred expenses
    900       900  
    Amortization of contingent beneficial conversion feature on convertible senior notes
    7,828       -  
    Net (gains) losses on sales of Agency mortgage-backed securities and debentures
    (80,299 )     (27,185 )
    Stock option and long-term compensation expense
    1,849       1,262  
    Unrealized (gains) losses on interest rate swaps
    (341,639 )     (169,308 )
    Net unrealized (gains) losses on interest-only Agency mortgage-backed securities
    (30,877 )     -  
    Net (gains) losses on trading assets
    (2,871 )     (18,812 )
    Gain on investment in affiliate, equity method
    -       (98 )
    Proceeds from repurchase agreements from RCap
    127,052,942       302,730,166  
    Payments on repurchase agreements from RCap
    (122,741,955 )     (297,961,656 )
    Proceeds from reverse repurchase agreements to RCap
    54,896,766       56,147,084  
    Payments on reverse repurchase agreements to RCap
    (56,577,802 )     (56,488,990 )
    Proceeds from reverse repurchase agreements to Shannon
    93,892       -  
    Payments on reverse repurchase agreements to Shannon
    (92,591 )     -  
    Proceeds from securities borrowed
    6,683,283       993,039  
    Payments on securities borrowed
    (6,877,004 )     (1,145,077 )
    Proceeds from securities loaned
    32,002,954       1,175,210  
    Payments on securities loaned
    (31,931,006 )     (1,033,199 )
    Proceeds from U.S. Treasury Securities
    15,808,494       8,123,321  
    Payments on U.S. Treasury Securities
    (14,086,314 )     (8,198,723 )
    Net payments on derivatives
    849       (971 )
    Net change in:
               
      Other assets
    (5,918 )     (64,055 )
      Accrued interest and dividend receivable
    (10,568 )     (48,671 )
      Advisory and service fees receivable
    (58 )     (459 )
      Accrued interest payable
    (9,857 )     (2,665 )
      Accounts payable and other liabilities
    50,704       70,166  
         Net cash provided by (used in) operating activities
    4,994,435       4,956,283  
Cash flows from investing activities:
               
  Payments on purchases of Agency mortgage-backed securities and debentures
    (20,099,149 )     (26,657,476 )
  Proceeds from sales of Agency mortgage-backed securities and debentures
    4,770,341       3,397,846  
  Principal payments on Agency mortgage-backed securities
    7,376,488       5,549,651  
  Proceeds from Agency debentures called
    151,640       594,246  
  Principal payments on corporate debt
    1,335       468  
  Net gains (losses) on other derivative securities
    -       14,998  
  Earn out payment
    (13,387 )        
       Net cash provided by (used in) investing activities
    (7,812,732 )     (17,100,267 )
Cash flows from financing activities:
               
  Proceeds from repurchase agreements
    82,930,109       65,447,646  
  Principal payments on repurchase agreements
    (79,618,116 )     (55,765,779 )
  Proceeds from exercise of stock options
    1,842       2,437  
  Net proceeds from direct purchases and dividend  reinvestments
    -       1,142  
  Net (payment) proceeds from follow-on offerings
    (231 )     2,941,411  
  Dividends paid
    (556,744 )     (408,487 )
       Net cash provided by (used in) financing activities
    2,756,860       12,218,370  
Net (decrease) increase in cash and cash equivalents
    (61,437 )     74,386  
Cash and cash equivalents, beginning of period
    994,198       282,626  
Cash and cash equivalents, end of period
  $ 932,761     $ 357,012  
                 
Supplemental disclosure of cash flow information:
               
  Interest received
  $ 1,125,003     $ 971,380  
  Dividends received
  $ 8,283     $ 7,602  
  Fees received
  $ 20,708     $ 16,748  
  Interest paid (excluding interest paid on interest rate swaps)
  $ 134,099     $ 123,421  
  Net interest paid on interest rate swaps
  $ 220,615     $ 200,848  
  Taxes paid
  $ 21,401     $ 22,401  
                 
Noncash investing activities:
               
  Receivable for Investments sold
  $ 454,278     $ 320,465  
  Payable for Investments purchased
  $ 5,708,412     $ 2,476,409  
  Payable for investments purchased with affiliate
    -     $ 57,500  
  Net change in unrealized loss on available-for-sale securities and interest rate swaps, net of reclassification adjustment
  $ (242,558 )   $ (155,114 )
                 
Noncash financing activities:
               
  Dividends declared, not yet paid
  $ 534,401     $ 498,697  
  Conversion of Series B cumulative preferred stock
  $ 32,232     $ 48  
  Contingent beneficial conversion feature on Convertible Senior Notes
  $ 23,321       -  
 
See notes to consolidated financial statements.
 
 
4

 
 
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)

1.
ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
 
Annaly Capital Management, Inc. (“Annaly” or the “Company”) was incorporated in Maryland on November 25, 1996.  The Company commenced its operations of purchasing and managing an investment portfolio of mortgage-backed securities on February 18, 1997, upon receipt of the net proceeds from the private placement of equity capital, and completed its initial public offering on October 14, 1997.  The Company is a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended.  Fixed Income Discount Advisory Company (“FIDAC”) is a registered investment advisor and is a wholly owned taxable REIT subsidiary of the Company.  On June 27, 2006, the Company made a majority equity investment in an affiliated investment fund (the “Fund”), which is now wholly owned by the Company. During the third quarter of 2008, the Company formed RCap Securities, Inc. (“RCap”).  RCap was granted membership in the Financial Industry Regulatory Authority (“FINRA”) on January 26, 2009, and operates as a broker-dealer.  RCap is a wholly owned taxable REIT subsidiary of the Company.  On October 31, 2008, the Company acquired Merganser Capital Management, Inc. (“Merganser”).  Merganser is a registered investment advisor and is a wholly owned taxable REIT subsidiary of the Company. In 2010, the Company established Shannon Funding LLC (“Shannon”), which provides warehouse financing to residential mortgage originators in the United States.  In 2010, the Company also established Charlesfort Capital Management LLC (“Charlesfort”), which engages in corporate middle market lending transactions. In 2011, FIDAC established FIDAC Europe Limited (“FIDAC Europe”), which provides advice on commercial real estate transactions, including sale-leaseback and single tenant net leased properties across Europe.  In 2011, the Company established FIDAC FSI LLC (“FIDAC FSI”), which invests in trading securities.

A summary of the Company’s significant accounting policies follows:
 
Basis of Accounting
 
The accompanying consolidated financial statements and related notes of the Company have been prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). In the opinion of management, all adjustments considered necessary for a fair presentation of the Company's consolidated financial position, results of operations and cash flows have been included and are of a normal and recurring nature.
 
Principles of Consolidation
 
The consolidated financial statements include the accounts of the Company, FIDAC, FIDAC Europe, FIDAC FSI, Merganser, RCap, Shannon, Charlesfort and the Fund.  All intercompany balances and transactions have been eliminated in consolidation.
 
Beginning with the Company’s consolidated financial statements for the six month period ending June 30, 2011, interest expense related to interest rate swaps for prior periods has been reclassified to conform to the current presentation (i.e., presented in Other income (loss) as Realized gains (losses) on interest rate swaps).
 
Cash and Cash Equivalents - Cash and cash equivalents include cash on hand and cash held in money market funds on an overnight basis.

Reverse Repurchase Agreements - RCap enters into reverse repurchase agreements as part of the Company’s matched book trading activity. Reverse repurchase agreements are recorded on trade date at the contract amount and are collateralized by mortgage-backed or other securities. Margin calls are made by the Company as necessary based on the daily valuation of the underlying collateral as compared to the contract price. The Company generates income from the spread between what is earned on the reverse repurchase agreements and what is paid on the matched repurchase agreements. The Company’s policy is to obtain possession of collateral with a market value in excess of the principal amount loaned under reverse repurchase agreements. To ensure that the market value of the underlying collateral remains sufficient, collateral is valued daily, and the Company will require counterparties to deposit additional collateral, when necessary.  All reverse repurchase activities are transacted under master repurchase agreements that give the Company the right, in the event of default, to liquidate collateral held and to offset receivables and payables with the same counterparty.
 
 
5

 
 
Securities borrowed and loaned transactions – RCap records securities borrowed and loaned transactions at fair value. Securities borrowed transactions require RCap to provide the counterparty with collateral in the form of cash. RCap receives collateral in the form of cash for securities loaned transactions. For these transactions, the fees received or paid by RCap are recorded as interest income or expense, respectively. On a daily basis, market value changes of securities borrowed or loaned against the collateral value and RCap may require counterparties to deposit additional collateral or may require RCap to return collateral pledged, when appropriate.

U.S. Treasury Securities — RCap trades in U.S. Treasury securities for its proprietary portfolio, which consists of long and short positions on U.S Treasury notes and bonds. U.S. Treasury securities are classified as trading investments and are recorded on the trade date at cost. Changes in fair value are reflected in the Company’s statement of operations. Generally the Company does not hold the U.S. Treasury bills, notes and bonds to maturity and realizes gains and losses from trading those positions. Interest income or expense on U.S Treasury notes and bonds is accrued based on the outstanding principal amount of those investments and their stated terms. 

Investment Securities –Agency mortgage-backed securities, Agency debentures, and corporate debt are referred to herein as “Investment Securities.”  Although the Company generally intends to hold most of its Investment Securities until maturity, it may, from time to time, sell any of its Investment Securities as part of its overall management of its portfolio.  Investment Securities classified as available-for-sale are reported at fair values estimated by management that are compared to independent sources for reasonableness, with unrealized gains and losses reported as a component of stockholders’ equity. Investment Securities transactions are recorded on the trade date.  Realized gains and losses on sales of Investment Securities are determined using the average cost.

On April 1, 2011, the Company elected the fair value option for interest-only mortgage-backed securities acquired on or after such date. These Agency interest-only mortgage-backed securities represent the Company’s right to receive a specified proportion of the contractual interest flows of specific Agency mortgaged-backed securities.  Agency Interest-only mortgage-backed securities acquired on or after April 1, 2011 are measured at fair value through earnings in the Company’s Consolidated Statements of Operations and Comprehensive Income (Loss).  The interest-only securities are included in Agency mortgage-backed securities, at fair value on the accompanying Consolidated Statements of Financial Condition.

Agency Mortgage-Backed Securities and Agency Debentures – The Company invests primarily in mortgage pass-through certificates, collateralized mortgage obligations and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans, and certificates guaranteed by Ginnie Mae, Freddie Mac or Fannie Mae (collectively, “Agency mortgage-backed securities”).  The Company also invests in Agency debentures issued by Federal Home Loan Bank (“FHLB”), Freddie Mac, and Fannie Mae.

Interest income from coupon payments is accrued based on the outstanding principal amount of the Investment Securities and their contractual terms.  Premiums and discounts associated with the purchase of the Investment Securities are amortized into interest income over the projected lives of the securities using the interest method.  The Company’s policy for estimating prepayment speeds for calculating the effective yield is to evaluate historical performance, consensus prepayment speeds, and current market conditions.  Adjustments are made for actual prepayment activity.

Equity Securities – The Company invests in equity securities that are classified as available-for-sale or trading.  Equity securities classified as available-for-sale are reported at fair value, based on market quotes, with unrealized gains and losses reported as a component of stockholders’ equity. Equity securities classified as trading are reported at fair value, based on market quotes, with unrealized gains and losses reported in the Statement of Operations and Comprehensive Income (Loss).  Dividends are recorded in earnings on declaration date.

Other-Than-Temporary Impairment –Management evaluates available-for-sale securities for other-than-temporary impairment at least quarterly, and more frequently when economic or market concerns warrant such evaluation.  The Company determines if it (1) has the intent to sell the securities, (2) is more likely than not that it will be required to sell the securities before recovery, or (3) does not expect to recover the entire amortized cost basis of the 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 be recognized in the Consolidated Statements of Operations, while the balance of losses related to other factors will be recognized in other comprehensive income (“OCI”).  There was no other-than-temporary impairment for the quarters ended March 31, 2012 and 2011.
 
 
6

 
 
Derivative Instruments The Company accounts for interest rate swaps at fair value as either assets or liabilities on the Consolidated Statements of Financial Condition.  Changes in the fair value of interest rate swaps are recognized in earnings.  The Company uses interest rate swaps to manage its exposure to changing interest rates on its repurchase agreements. Net payments on interest rate swaps are included in the Consolidated Statements of Cash Flows as a component of operating activities.

The Company elected to net, by counterparty, the fair value of interest rate swap contracts.  These contracts contain legally enforceable provisions that allow for netting or setting off swap receivables and payables with each counterparty and, therefore, the fair value of those swap contracts are netted by counterparty.  The credit support annex provisions of the Company’s interest rate swap contracts allow the parties to mitigate their credit risk by requiring the party which is out of the money to post collateral. As the Company elects to net by counterparty the fair value of interest rate swap contracts, it also nets by counterparty any collateral exchanged as part of the interest rate swap contracts.  Substantially all collateral is non-cash collateral under these contracts.  In addition, the Company’s agreements with certain of its counterparties with whom it has both interest rate swap contracts and master repurchase agreements contain legally enforceable provisions that allow for netting or setting off of on an aggregate basis all receivables, payables and collateral postings required under both the interest rate swap contract and the master repurchase agreement with respect to each such counterparty.

RCap primarily enters into exchange traded U.S. interest rate, equity index, and FX futures and options contracts as well as German interest rate futures contracts for speculative  or hedging purposes. RCap maintains a margin account which is settled daily with futures and options commission merchants. Changes in the unrealized gains or losses on the futures and options contracts are reflected in the Company’s Consolidated Statements of Operations.  Unrealized gains (losses) are excluded from net income (loss) in arriving at cash flows from operating activities in the Consolidated Statements of Cash Flows.

Credit Risk – The Company has limited its exposure to credit losses on its portfolio of Agency mortgage-backed securities by only purchasing securities issued by Freddie Mac, Fannie Mae or Ginnie Mae and Agency debentures issued by the FHLB, Freddie Mac and Fannie Mae.  The payment of principal and interest on the Freddie Mac and Fannie Mae Agency mortgage-backed securities are guaranteed by those respective agencies, and the payment of principal and interest on Ginnie Mae Agency mortgage-backed securities are backed by the full faith and credit of the U.S. government.  Principal and interest on Agency debentures are guaranteed by the agency issuing the debenture.  Substantially all of the Company’s Investment Securities have an actual or implied “AAA” rating.  The Company faces credit risk on the portions of its portfolio which are not Agency mortgage-backed securities and Agency debentures.

Market Risk - Weakness in the mortgage market may adversely affect the performance and market value of the Company’s investments.  This could negatively impact the Company’s net book value.  Furthermore, if many of the Company’s lenders are unwilling or unable to provide additional financing, the Company could be forced to sell its Investment Securities at an inopportune time when prices are depressed. The Company does not anticipate having difficulty converting its assets to cash or extending financing terms due to the fact that its Agency mortgage-backed securities and Agency debentures have an actual or implied “AAA” rating and principal payment is guaranteed by Freddie Mac, Fannie Mae, or Ginnie Mae.
 
Repurchase Agreements - The Company finances the acquisition of a significant portion of its Agency mortgage-backed securities with repurchase agreements.   None of the Company’s repurchase agreements are accounted for as components of linked transactions.  The Company examines each of the specified criteria in ASC 860-10-40-42 and ASC 860-10-40-44 at the inception of each transaction and has determined that each of the financings meet the specified criteria in this guidance.  As a result, the Company separately accounts for the financial assets and related repurchase financings in the accompanying consolidated financial statements.
 
 
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Reverse repurchase agreements and repurchase agreements with the same counterparty and the same maturity are presented net in the Consolidated Statements of Financial Condition when the terms of the agreements permit netting. The Company reports cash flows on repurchase agreements as financing activities in the Consolidated Statements of Cash Flows.  The Company reports cash flows on repurchase agreements entered into by RCap and Shannon as operating activities in the Consolidated Statements of Cash Flows.
 
Convertible Senior Notes – The Company records the Convertible Senior Notes at their contractual amounts, adjusted by the effect of the beneficial conversion feature.  The Convertible Senior Notes have a conversion price adjustment feature that is evaluated at the time of the conversion price adjustment.  A contingent beneficial conversion feature may be recognized as a result of adjustments to the conversion price for dividends declared.  The Company determined the intrinsic value of the contingent beneficial conversion feature.  This intrinsic value is included in “Additional paid in capital” on the Company’s Consolidated Statements of Financial Condition and, therefore, reduces the liability associated with the Convertible Senior Notes.
 
Cumulative Convertible Preferred Stock - The Series B Cumulative Convertible Preferred Stock (the “Series B Preferred Stock”) contains fundamental change provisions that allow the holder to redeem the Series B Preferred Stock for cash if certain events occur.  As redemption under these provisions is not solely within the Company’s control, for the periods that the Company had Series B Preferred Stock issued and outstanding, the Company classified the Series B Preferred Stock as temporary equity in the accompanying Consolidated Statements of Financial Condition.
 
Income Taxes - The Company has elected to be taxed as a REIT and intends to comply with the provisions of the Internal Revenue Code of 1986, as amended (the “Code”), with respect thereto.  Accordingly, the Company will not be subjected to federal income tax to the extent of its distributions to shareholders and as long as certain asset, income and stock ownership tests are met.  The Company and its direct and indirect subsidiaries, FIDAC, FIDAC Europe, Merganser and RCap, have made separate joint elections to treat these subsidiaries as taxable REIT subsidiaries.  As such, each of the taxable REIT subsidiaries are taxable as a domestic C corporation and subject to federal, state, and local income taxes based upon their taxable income.

The provisions of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 740, Income Taxes, clarify the accounting for uncertainty in income taxes recognized in financial statements and prescribe a recognition threshold and measurement attribute for tax positions taken or expected to be taken on a tax return. ASC 740 also requires that interest and penalties related to unrecognized tax benefits be recognized in the financial statements. The Company does not have any unrecognized tax benefits that would affect its financial position.  Thus, no accruals for penalties and interest were necessary as of March 31, 2012.
 
Goodwill and Intangible Assets - The Company’s acquisitions of FIDAC, Merganser, and FIDAC Europe were accounted for using the purchase method.  Under the purchase method, net assets and results of operations of acquired companies are included in the consolidated financial statements from the date of acquisition. The costs of FIDAC and Merganser were allocated to the assets acquired, including identifiable intangible assets, and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of purchase price over the fair value of the net assets acquired was recognized as goodwill.  In addition, FIDAC Europe acquired a customer relationship after its formation. Goodwill and intangible assets are periodically (but not less frequently than annually) reviewed for potential impairment.  Intangible assets with an estimated useful life amortize over the expected life.  During the quarters ended March 31, 2012 and 2011, there were no impairment losses recognized related to goodwill and intangible assets.  
 
Stock Based Compensation - The Company is required to measure and recognize in the consolidated financial statements the compensation cost relating to share-based payment transactions.  The Company recognizes compensation expense on a straight-line basis over the requisite service period for the entire award.

Use of Estimates - The preparation of the consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  All assets classified as trading or available-for-sale and interest rate swaps are reported at their estimated fair value, based on market prices.  The Company’s policy is to obtain fair values from one or more independent sources to compare to internal prices for reasonableness.  Actual results could differ from those estimates.
 
 
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A Summary of Recent Accounting Pronouncements Follows:

Presentation

Balance Sheet (Topic 210)

On December 23, 2011, the FASB released Accounting Standards Update (“ASU”) 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.  Under this update, the Company will be required to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and transactions subject to an agreement similar to a master netting arrangement.  The scope would include derivatives, sale and repurchase agreements and reverse sale and repurchase agreements and securities borrowing and securities lending arrangements.   This disclosure is intended to enable financial statement users to understand the effect of such arrangements on the Company’s financial position.  The objective of this update is to support further convergence between U.S. GAAP and International Financial Reporting Standards (“IFRS”).  This update is effective for annual reporting periods beginning on or after January 1, 2013.

Comprehensive Income (Topic 220)

In June 2011, the FASB released ASU 2011-05 Comprehensive Income: Presentation of Comprehensive Income, which attempts to improve the comparability, consistency, and transparency of financial reporting and increase the prominence of items reported in other comprehensive income (“OCI”).  ASU 2011-05 requires that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of net income and comprehensive income or two separate consecutive statements.  Either presentation requires the presentation on the face of the financial statements any reclassification adjustments for items that are reclassified from OCI to net income in the statements.  There is no change in what must be reported in OCI or when an item of OCI must be reclassified to net income.  This update is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011.  This update resulted in additional disclosure, but had no significant effect on the Company’s consolidated financial statements.  On December 23, 2011, the FASB issued ASU 2011-12, Comprehensive Income: Deferral of Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income In ASU No. 2011-05, which defers those changes in ASU 2011-05 that relate to the presentation of reclassification adjustments out of accumulated OCI.  This was done to allow the FASB time to re-deliberate the presentation on the face of the financial statements the effects of reclassifications out of accumulated OCI on the components of net income and OCI.  No other requirements under ASU 2011-05 are affected by ASU 2011-12.

Assets

Intangibles – Goodwill and Other (Topic 350)

In September 2011, the FASB released ASU 2011-08, Intangibles-Goodwill and Other: Testing Goodwill for Impairment, which allows an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test.   The objective of the update is to simplify how entities test goodwill for impairment.  Under this update, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount.  This update if effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011.  This update is not expected to  have a significant impact on the Company’s consolidated financial statements.

Broad Transactions

Fair Value Measurements and Disclosures (Topic 820)
 
 
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In May 2011, the FASB released ASU 2011-04 Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, further converging U.S. GAAP and IFRS by providing common fair value measurement and disclosure requirements.  FASB made changes to the fair value measurement guidance, which include: 1) Prohibiting the inclusion of block discounts in all fair value measurements, not just Level 1 measurements, 2) Adding guidance on when to include other premiums and discounts in fair value measurements,  3) Clarifying that the concepts of “highest and best use” and “valuation premise” apply only when measuring the fair value of non-financial assets and 4) Adding an exception that allows the measurement of a group of financial assets and liabilities with offsetting risks (e.g., a portfolio of derivative contracts) at their net exposure to a particular risk if certain criteria are met.  ASU 2011-04 also requires additional disclosure related to items categorized as Level 3 in the fair value hierarchy, including a description of the processes for valuing these assets, providing quantitative information about the significant unobservable inputs used to measure fair value, and in certain cases, explaining the sensitivity of the fair value measurements to changes in unobservable inputs.  This guidance is effective for interim and annual reporting periods beginning after December 15, 2011.  The Company does not hold any Level 3 assets and therefore, this update has no significant effect on the Company’s consolidated financial statements.

Transfers and Servicing (Topic 860)

In April 2011, the FASB issued ASU 2011-03, Transfers and Servicing: Reconsideration of Effective Control for Repurchase Agreements.  In a typical repurchase agreement transaction, an entity transfers financial assets to the counterparty in exchange for cash with an agreement for the counterparty to return the same or equivalent financial assets for a fixed price in the future.  Previous to this update, one of the factors in determining whether sale treatment could be used was whether the transferor maintained effective control of the transferred assets and in order to do so, the transferor must have the ability to repurchase such assets. In connection with the issuance of ASU 2011-03, the FASB concluded that the assessment of effective control should focus on a transferor’s contractual rights and obligations with respect to transferred financial assets, rather than whether the transferor has the practical ability to perform in accordance with those rights or obligations.  ASU 2011-03 removes the transferor’s ability criterion from consideration of effective control.  This update is effective for the first interim or annual period beginning on or after December 15, 2011.  As the Company records repurchase agreements as secured borrowings and not sales, this update has no significant effect on the Company’s consolidated financial statements.

Financial Services – Investment Companies (Topic 946)
 
In October 2011, the FASB issued a proposed ASU 2011-20, Financial Services-Investment Companies: Amendments to the Scope, Measurement, and Disclosure Requirements, which would amend the criteria in Topic 946 for determining whether an entity qualifies as an investment company.  As proposed, this ASU would affect the measurement, presentation and disclosure requirements for Investment Companies, as defined, amend the investment company definition in ASC 946, and remove the current exemption for Real Estate Investment Trusts from this topic.  If promulgated in its current form, this proposal may result in a material modification to the presentation of the Company’s consolidated financial statements.  The Company is monitoring developments related to this proposal and is evaluating the effects it would have on the Company’s consolidated financial statements.
 
 
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2.           AGENCY MORTGAGE-BACKED SECURITIES
 
The following tables present the Company’s available-for-sale Agency mortgage-backed securities portfolio as of March 31, 2012 and December 31, 2011 which were carried at their fair value:
 
 
March 31, 2012
 
Freddie Mac
 
Fannie Mae
 
Ginnie Mae
 
Total Mortgage-
Backed Securities
   
(dollars in thousands)
                         
Agency mortgage-backed securities, par value
  $ 42,386,729     $ 60,938,081     $ 422,593     $ 103,747,403  
Unamortized discount
    (10,707 )     (14,002 )     (397 )     (25,106 )
Unamortized premium
    1,574,514       2,257,250       13,618       3,845,382  
Amortized cost
    43,950,536       63,181,329       435,814       107,567,679  
                                 
Gross unrealized gains
    901,495       1,959,082       25,824       2,886,401  
Gross unrealized losses
    (63,301 )     (98,386 )     (681 )     (162,368 )
                                 
Estimated fair value
  $ 44,788,730     $ 65,042,025     $ 460,957     $ 110,291,712  
 
   
Amortized Cost
 
Gross Unrealized
Gain
 
Gross Unrealized
Loss
 
Estimated Fair
Value
   
(dollars in thousands)
                         
Adjustable rate
  $ 8,023,120     $ 362,342     $ (3,274 )   $ 8,382,188  
Fixed rate
    99,544,559       2,524,059       (159,094 )     101,909,524  
                                 
Total
  $ 107,567,679     $ 2,886,401     $ (162,368 )   $ 110,291,712  
 
 
December 31, 2011
 
Freddie Mac
 
Fannie Mae
 
Ginnie Mae
 
Total Mortgage-
Backed Securities
   
(dollars in thousands)
                         
Agency mortgage-backed securities, par value
  $ 34,395,542     $ 63,066,372     $ 500,968     $ 97,962,882  
Unamortized discount
    (9,874 )     (13,632 )     (399 )     (23,905 )
Unamortized premium
    1,139,881       2,205,138       15,949       3,360,968  
Amortized cost
    35,525,549       65,257,878       516,518       101,299,945  
                                 
Gross unrealized gains
    973,476       2,081,282       31,474       3,086,232  
Gross unrealized losses
    (15,243 )     (118,871 )     (1,008 )     (135,122 )
                                 
Estimated fair value
  $ 36,483,782     $ 67,220,289     $ 546,984     $ 104,251,055  
 
   
Amortized Cost
 
Gross Unrealized
Gain
 
Gross Unrealized
Loss
 
Estimated Fair
Value
   
(dollars in thousands)
                         
Adjustable rate
  $ 8,698,746     $ 345,642     $ (3,188 )   $ 9,041,200  
Fixed rate
    92,601,199       2,740,590       (131,934 )     95,209,855  
                                 
Total
  $ 101,299,945     $ 3,086,232     $ (135,122 )   $ 104,251,055  
 
 
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Actual maturities of Agency mortgage-backed securities are generally shorter than stated contractual maturities because actual maturities of Agency mortgage-backed securities are affected by the contractual lives of the underlying mortgages, periodic payments and prepayments of principal.  The following table summarizes the Company’s Agency mortgage-backed securities as of March 31, 2012 and December 31, 2011, according to their estimated weighted-average life classifications:
 
   
March 31, 2012
 
December 31, 2011
            Amortized           Amortized
Weighted-Average Life
 
Fair Value
  Cost  
Fair Value
  Cost
   
(dollars in thousands)
Less than one year
  $ 989,243     $ 978,277     $ 1,715,530     $ 1,697,101  
Greater than one year through five years
    98,216,572       95,495,043       97,344,791       94,534,782  
Greater than five years through ten years
    10,822,643       10,839,087       4,447,540       4,348,841  
Greater than 10 years
    263,254       255,272       743,194       719,221  
Total
  $ 110,291,712     $ 107,567,679     $ 104,251,055     $ 101,299,945  
 
The weighted-average lives of the Agency mortgage-backed securities at March 31, 2012 and December 31, 2011 in the table above are based upon data provided through subscription-based financial information services, assuming constant principal prepayment rates to the reset date of each security.  The prepayment model considers current yield, forward yield, steepness of the yield curve, current mortgage rates, mortgage rate of the outstanding loans, loan age, margin, volatility, and other factors.  The actual weighted average lives of the Agency mortgage-backed securities could be longer or shorter than estimated.

The following table presents the gross unrealized losses and estimated fair value of the Company’s Agency mortgage-backed securities by length of time that such securities have been in a continuous unrealized loss position at March 31, 2012 and December 31, 2011.
 
   
Unrealized Loss Position For:
   
(dollars in thousands)
   
Less than 12 Months
 
12 Months or More
 
Total
   
Estimated
  Unrealized   Estimated   Unrealized   Estimated   Unrealized
   
Fair Value
  Losses  
 Fair Value
  Losses   Fair Value   Losses
                                                 
March 31, 2012
  $ 13,196,248     $ (104,811 )   $ 665,151     $ (57,557 )   $ 13,861,399     $ (162,368 )
December 31, 2011
  $ 1,087,552     $ (118,593 )   $ 883,143     $ (16,529 )   $ 1,970,695     $ (135,122 )
 
The decline in value of these securities is solely due to market conditions and not the quality of the assets.  Substantially all of the Agency mortgage-backed securities are “AAA” rated or carry an implied “AAA” rating.  The investments are not considered to be other-than-temporarily impaired because the Company currently has the ability and intent to hold the investments to maturity or for a period of time sufficient for a forecasted market price recovery up to or beyond the cost of the investments, and it is not more likely than not that the Company will be required to sell the investments before recovery of the amortized cost bases, which may be maturity.  Also, the Company is guaranteed payment of the principal amount of the securities by the respective issuing government agency.

During the quarter ended March 31, 2012, the Company sold $5.1 billion of Agency mortgage-backed securities, resulting in a net realized gain of $80.3 million.  During the quarter ended March 31, 2011, the Company sold $3.3 billion of Agency Mortgage-Backed Securities, resulting in a net realized gain of $20.9 million. Average cost is used for calculating gains or losses on securities sold.

Agency interest-only mortgage-backed securities represent the right to receive a specified portion of the contractual interest flows of the underlying unamortized principal balance of specific Agency mortgage-backed securities.  As of March 31, 2012, Agency interest-only mortgage-backed securities had net unrealized losses of $81.6 million (consisting of net unrealized losses of $16.6 million included in accumulated deficit and net unrealized losses of $65.0 million included in other comprehensive income) and an amortized cost of $492.4 million.
 
 
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3.            INVESTMENTS IN AFFILIATES, AVAILABLE FOR SALE EQUITY SECURITIES

Substantially all of the Company’s available-for-sale equity securities are shares of Chimera Investment Corporation (“Chimera”) and CreXus Investment Corp. (“CreXus”) and are reported at fair value.  The Company owned approximately 45.0 million shares of Chimera at a fair value of approximately $127.3 million at March 31, 2012 and approximately 45.0 million shares of Chimera at a fair value of approximately $112.9 million at December 31, 2011.  At March 31, 2012 and December 31, 2011, the investment in Chimera had an unrealized loss of $11.6 million and an unrealized loss of $25.9 million, respectively. The Company owned approximately 9.5 million shares of CreXus at a fair value of approximately $98.5 million at March 31, 2012 and approximately 9.5 million shares of CreXus at a fair value of approximately $98.9 million at December 31, 2011.  At March 31, 2012 and December 31, 2011, the investment in CreXus had an unrealized loss of $26.9 million and an unrealized loss of $26.5 million, respectively.

The Company has evaluated the near-term prospects of its investment in affiliates in relation to the severity and length of time of the impairment.  Based on this evaluation, management has determined that its investment in affiliates is not considered to be other-than-temporarily impaired as of March 31, 2012 and December 31, 2011 as the Company has the intent and ability to retain its investments for a period of time sufficient to allow for any anticipated recovery in market value.

4.           GOODWILL

Merganser’s prior owners received additional consideration under the merger agreement.  The Company paid $13.4 million of this earn-out during the first quarter of 2012.  Amounts paid under this provision were recorded as additional goodwill.
 

5.           FAIR VALUE MEASUREMENTS
 
The Company follows fair value guidance in accordance with U.S. GAAP to account for its financial instruments.  The Company categorizes its financial instruments, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy.  The fair value hierarchy gives 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).  If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument. Financial assets and liabilities recorded at fair value on the consolidated statements of financial condition or disclosed in the related notes are categorized based on the inputs to the valuation techniques 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.
 
Agency mortgage-backed securities, Agency debentures and interest rate swaps are valued using quoted prices, including dealer quotes, or internally estimated prices for similar assets.  The Company incorporates common market pricing methods, including a spread measurement to the Treasury curve as well as underlying characteristics of the particular security including coupon, periodic and life caps, rate reset period and expected life of the security in its estimates of fair value.  Management ensures that current market conditions are reflected in its estimates of fair value.  Management compares internal prices to independent third party sources and dealer quotes for reasonableness.
 
 
13

 
 
The fair value of securities loaned at fair value, U.S. Treasury securities, securities borrowed and loaned, investments in affiliates and equity investments are based on quoted prices in active markets.
 
The Company’s Investment Securities characteristics are as follows:
 
 
 
Weighted
Average
Coupon
on Fixed
Rate
Investments
Weighted
Average
Coupon on
Adjustable
Rate
Investments
Weighted
Average
Yield on
Fixed Rate
Investments
Weighted
Average Yield
on Adjustable
Rate
Investments
Weighted
Average
Lifetime Cap
on Adjustable
Investments
Weighted
Average
 Term to Next
Adjustment on
Adjustable
Rate
Investments
             
At March 31, 2012
4.63%
3.72%
3.25%
2.78%
8.80%
38 months
At December 31, 2011
4.71%
3.88%
3.07%
2.79%
9.64%
41 months
 
The classification of assets and liabilities by level remains unchanged at March 31, 2012, when compared to December 31, 2011.  The Company’s financial assets and liabilities carried at fair value on a recurring basis are valued as follows:
 
   
Level 1
 
Level 2
 
Level 3
At March 31, 2012
 
(dollars in thousands)
Assets:
                 
U.S. Treasury Securities
  $ 2,622,714     $ -       -  
Securities borrowed
    -       1,122,453       -  
  Agency mortgage-backed securities
    -       110,291,712       -  
  Agency debentures
    -       1,499,127       -  
  Investment in affiliates
    225,818       -       -  
  Equity securities
    4,470       -       -  
  Other derivative contracts
    321       -       -  
Liabilities:
                       
  U.S. Treasury securities sold, not yet purchased
    2,577,905       -       -  
  Interest rate swaps
    -       2,211,048       -  
Securities loaned     -       876,849       -  
 
    Level 2
At December 31, 2011
 
(dollars in thousands)
 
Assets:
                 
  U.S. Treasury securities
  $ 928,547     $ -       -  
  Securities borrowed
    -       928,732       -  
  Agency mortgage-backed securities
    -       104,251,055       -  
  Agency debentures
    -       889,580       -  
  Investments in affiliates
    211,970       -       -  
  Equity securities
    3,891       -       -  
  Other derivative contracts
    113       -       -  
Liabilities:
                       
  U.S. Treasury securities sold, not yet purchased
    826,912       -       -  
  Interest rate swaps
    -       2,552,687       -  
  Securities loaned
    -       804,901       -  
 
 
14

 
 
The following table summarized the estimated fair value for all financial assets and liabilities as of March 31, 2012 and December 31, 2011.
 
   
March 31, 2012
 
December 31, 2011
   
Carrying Value
 
Fair Value
 
Carrying Value
 
Fair Value
   
(dollars in thousands)
Financial assets:
                       
Cash and cash equivalents(1)
  $ 932,761     $ 932,761     $ 994,198     $ 994,198  
Reverse repurchase agreements(1)
    2,540,601       2,540,601       860,866       860,866  
U.S. Treasury Securities(2)
    2,622,714       2,622,714       928,547       928,547  
Securities borrowed(2)
    1,122,453       1,122,453       928,732       928,732  
Agency mortgage-backed securities
    110,291,712       110,291,712       104,251,055       104,251,055  
Agency debentures
    1,499,127       1,499,127       889,580       889,580  
Investment in affiliates(2)
    225,818       225,818       211,970       211,970  
Receivable from Prime Broker
    3,272       3,272       3,272       3,272  
Equity securities(2)
    4,470       4,470       3,891       3,891  
Corporate debt(3)
    50,806       51,558       52,073       52,628  
Other derivatives(2)
    321       321       113       113  
                                 
Financial liabilities:
                               
U.S. Treasury Securities sold, not yet purchased(2)
  $ 2,577,905     $ 2,577,905     $ 826,912     $ 826,912  
Repurchase agreements(1)(4)
    91,720,865       92,025,618       84,097,885       84,369,817  
Securities loaned(2)
    876,849       876,849       804,901       804,901  
Convertible Senior Notes(2)
    524,420       700,284       539,913       685,500  
Interest rate swaps
    2,211,048       2,211,048       2,504,006       2,504,006  
 
(1)
Carrying value approximates fair value due to the short-term maturities of these items.
(2)
Fair value is determined using end of day quoted prices in active markets.
(3) The carrying value of the corporate debt is based on amortized cost. Estimates of fair value of corporate debt require the use of significant judgments and inputs including, but not limited to, the enterprise value of the borrower (i.e., an estimate of the total fair value of the borrower's debt and equity), the nature and realizable value of any collateral, the borrower’s ability to make payments when due and its earnings history.  Management also considers factors that affect the macro and local economic markets in which the borrower operates.
(4) The fair value of repurchase agreements with maturities greater than one year are valued as pay fixed versus receive floating interest rate swaps.
 
6.           REPURCHASE AGREEMENTS

The Company had outstanding $91.7 billion and $84.1 billion of repurchase agreements with weighted average borrowing rates of 1.46% and 1.59%, after giving effect to the Company’s interest rate swaps, and weighted average remaining maturities of 127 days and 103 days as of March 31, 2012 and December 31, 2011, respectively.  Investment Securities and U.S. Treasury Securities pledged as collateral under these repurchase agreements and interest rate swaps had an estimated fair value and accrued interest of $98.7 billion and $353.0 million at March 31, 2012, respectively, and $91.3 billion and $337.0 million at December 31, 2011, respectively.
 
 
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At March 31, 2012 and December 31, 2011, the repurchase agreements had the following remaining maturities and weighted average rates:
 
   
March 31, 2012
 
December 31, 2011
   
Repurchase
Agreements
 
Weighted Average
Rate
 
Repurchase Agreements
 
Weighted Average
Rate
   
(dollars in thousands)
 
1 day
  $ -       -     $ 508,647       0.50 %
2 to 29 days
    33,864,266       0.34 %     33,780,070       0.37 %
30 to 59 days
    17,369,700       0.36 %     28,346,380       0.37 %
60 to 89 days
    4,686,160       0.41 %     3,699,425       0.93 %
90 to 119 days
    12,690,027       0.38 %     6,781,137       0.37 %
Over 120 days
    23,110,712       0.86 %     10,982,226       1.39 %
Total
  $ 91,720,865       0.49 %   $ 84,097,885       0.53 %
 
The Company did not have an amount at risk greater than 10% of the equity of the Company with any counterparty as of March 31, 2012 or December 31, 2011.

 7.       DERIVATIVE INSTRUMENTS

In connection with the Company’s interest rate risk management strategy, the Company economically hedges a portion of its interest rate risk by entering into derivative financial instrument contracts.  As of March 31, 2012, such instruments are comprised of interest rate swaps, which in effect modify the cash flows on repurchase agreements, or convert floating rate liabilities to fixed rates.  The use of interest rate swaps creates exposure to credit risk relating to potential losses that could be recognized if the counterparties to these instruments fail to perform their obligations under the contracts.  The purpose of the swaps is to mitigate the risk of rising interest rates that affect the Company’s cost of funds.  In the event of a default by the counterparty, the Company could have difficulty obtaining its Investment Securities pledged as collateral for swaps.  The Company does not anticipate any defaults by its counterparties.  The Company’s interest rate swaps have not been designated as hedging instruments for accounting purposes.

The location and fair value of interest rate swaps reported in the Consolidated Statements of Financial Condition as of March 31, 2012 and December 31, 2011 are as follows:
 
 
Location on Consolidated Statements of
Financial Condition
 
Notional
Amount
 
Net Estimated Fair
Value
     
(dollars in thousands)
March 31, 2012
Assets:  Interest rate swaps, at fair value
    -       -  
March 31, 2012
Liabilities:   Interest rate swaps, at fair value
  $ 42,112,740     $ (2,211,048 )
December 31, 2011
Assets:   Interest rate swaps, at fair value
    -       -  
December 31, 2011
Liabilities:   Interest rate swaps, at fair value
  $ 40,109,880     $ (2,552,687 )
 
The effect of  interest rate swaps on the Consolidated Statements of Operations and Comprehensive Income (Loss) is as follows:
 
   
Location on Consolidated Statements of Operations and
Comprehensive Income
   
Realized Gains
(Losses) on Interest Rate Swaps*
 
Gain (loss) on Termination of
Interest Rate
Swaps
 
Unrealized Gains (Losses) on Interest Rate Swaps
   
(dollars in thousands)
For the Quarter Ended March 31, 2012
  $ (219,340 )   $ (2,385 )   $ 341,639  
For the Quarter Ended March 31, 2011
  $ (206,148 )     -     $ 169,308  
 
 
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* Net interest payments on interest rate swaps is presented in the Company’s Consolidated Statements of Operations and Comprehensive Income (Loss) as realized gains (losses) on interest rate swaps.
 
The Company’s interest rate swap weighted average pay rate at March 31, 2012 was 2.42% and the weighted average receive rate was 0.31%.  The weighted average pay rate at December 31, 2011 was 2.55% and the weighted average receive rate was 0.33%.  Without netting the market value of the swaps by dealer at March 31, 2012, the gross unrealized losses on interest rate swaps was $2.2 billion, with a notional amount of $39.1 billion and the gross unrealized gains on interest rate swaps was $20.5 million with a notional amount of $3.0 billion.  Without netting the market value of the swaps by dealer at December 31, 2011, the gross unrealized loss on interest rate swaps was $2.6 billion, with a notional amount of $40.1 billion.

In connection with RCap’s proprietary trading activities, it has entered into exchange traded U.S. interest rate, equity index, and FX futures and options contracts as well as German interest rate futures contracts for speculative or hedging purposes. RCap invests in futures and options contracts for economic hedging purposes to reduce exposure to changes in yields of its U.S Treasury securities and for speculative purposes to achieve capital appreciation.  The use of options contracts creates exposure to credit risk relating to potential losses that could be recognized if the counterparties to these instruments fail to perform their obligations under the contracts.  RCap executes these trades through an independent futures and options broker

8.     CONVERTIBLE SENIOR NOTES

In 2010, the Company issued $600.0 million in aggregate principal amount of its 4% convertible senior notes due 2015 (“Convertible Senior Notes”) for net proceeds of approximately $582.0 million.  Interest on the Convertible Senior Notes is paid semi-annually at a rate of 4% per year and the Convertible Senior Notes will mature on February 15, 2015 unless repurchased or converted earlier.  The Convertible Senior Notes are convertible into shares of Common Stock at a conversion rate for each $1,000 principal amount of Convertible Senior Notes.  The initial conversion rate was 46.6070.  The conversion rate at March 31, 2012 was 64.4069, which is equivalent to an initial conversion price and conversion price at March 31, 2012 of approximately $21.4560 and $15.5263 per share of Common Stock, respectively, subject to adjustment in certain circumstances.  There is no limit on the total number of shares of Common Stock that the Company would be required to issue, upon a conversion.

During the quarter ended March 31, 2012, the Company determined that the Convertible Senior Notes included a contingent beneficial conversion feature.  During the quarter ended March 31, 2011, the Convertible Senior Notes were not considered to have a contingent beneficial conversion feature.  The intrinsic value of the contingent beneficial conversion feature was $75.6 million at March 31, 2012, which is reflected in Additional paid in capital on the Company’s Consolidated Statements of Financial Condition, and serves to reduce the Convertible Senior Notes liability.  The $75.6 million discount to the principal amount of the Convertible Senior Notes is recognized in interest expense over the remaining life of the notes using the effective yield method.

9.     PREFERRED STOCK AND COMMON STOCK

(A)  Common Stock
During the quarter ended March 31, 2012, 126,000 options were exercised for an aggregate exercise price of $1.8 million. During the quarter ended March 31, 2011, 183,000 options were exercised for an aggregate exercise price of $2.5 million.

During the quarter ended March 31, 2012, 1.3 million shares of Series B Preferred Stock were converted into 4.0 million shares of common stock. During the quarter ended March 31, 2011, 2,000 shares of Series B Preferred Stock were converted into 5,000 shares of common stock.

During the quarter ended March 31, 2012, the Company did not raise proceeds through the Direct Purchase and Dividend Reinvestment Program. During the quarter ended March 31, 2011, the Company raised $1.1 million by issuing 64,000 shares through the Direct Purchase and Dividend Reinvestment Program.
 
 
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On March 19, 2012, the Company entered into six separate Distribution Agency Agreements (or Distribution Agency Agreements) with each of Merrill Lynch, Pierce, Fenner & Smith Incorporated, Credit Suisse Securities (USA) LLC, Goldman, Sachs & Co., J.P. Morgan Securities LLC, Morgan Stanley & Co. LLC and RCap Securities, Inc. (together, the Agents).  Pursuant to the terms of the Distribution Agency Agreements, the Company may sell from time to time through the Agents, as its sales agents, up to 125,000,000 shares of the Company’s common stock.  The Company did not make any sales under the Distribution Agency Agreements during the quarter ended March 31, 2012.

On January 4, 2011, the Company entered into an agreement pursuant to which it sold 86,250,000 shares of its common stock for net proceeds of approximately $1.5 billion. This transaction settled on January 7, 2011.  

On February 15, 2011, the Company entered into an agreement pursuant to which it sold 86,250,000 shares of its common stock for net proceeds of approximately $1.5 billion. This transaction settled on February 18, 2011.

During the quarter ended March 31, 2011, 183,343 options were exercised for an aggregate exercise price of $2.5 million, and 3,876 shares were granted under the Long-Term Stock Incentive Plan.

During the quarter ended March 31, 2011, 2,000 shares of Series B Preferred Stock were converted into 5,313 shares of common stock, respectively.

During the quarter ended March 31, 2011, the Company raised $1.1 million by issuing 63,795 shares through the Direct Purchase and Dividend Reinvestment Program.

(B) Preferred Stock

At March 31, 2012 and December 31, 2011, the Company had issued and outstanding 7,412,500 shares of Series A Cumulative Redeemable Preferred Stock (“Series A Preferred Stock”), with a par value $0.01 per share and a liquidation preference of $25.00 per share plus accrued and unpaid dividends (whether or not declared). The Series A Preferred Stock is entitled to a dividend at a rate of 7.875% per year based on the $25.00 liquidation preference before the common stock is entitled to receive any dividends. The Series A Preferred Stock is redeemable at $25.00 per share plus accrued and unpaid dividends (whether or not declared) exclusively at the Company's option commencing on April 5, 2009 (subject to the Company's right under limited circumstances to redeem the Series A Preferred Stock earlier in order to preserve its qualification as a REIT). The Series A Preferred Stock is senior to the Company's common stock and is on parity with the Series B Preferred Stock with respect to dividends and distributions, including distributions upon liquidation, dissolution or winding up. The Series A Preferred Stock generally does not have any voting rights, except if the Company fails to pay dividends on the Series A Preferred Stock for six or more quarterly periods (whether or not consecutive). Under such circumstances, the Series A Preferred Stock, together with the Series B Preferred Stock, will be entitled to vote to elect two additional directors to the Board, until all unpaid dividends have been paid or declared and restricted for payment.  In addition, certain material and adverse changes to the terms of the Series A Preferred Stock cannot be made without the affirmative vote of holders of at least two-thirds of the outstanding shares of Series A Preferred Stock and Series B Preferred Stock. Through March 31, 2012, the Company had declared and paid all required quarterly dividends on the Series A Preferred Stock.

At December 31, 2011, the Company had issued and outstanding 1,331,849 shares of Series B Preferred Stock, with a par value $0.01 per share and a liquidation preference of $25.00 per share plus accrued and unpaid dividends (whether or not declared). On March 27, 2012, the Company announced that it elected to convert all outstanding shares of Series B Preferred Stock into shares of common stock.  In this conversion, the Company converted 772,000 shares of Series B Preferred Stock into 2.4 million shares of common stock and the Company had no shares of Series B Preferred Stock outstanding at March 31, 2012.

The Series B Preferred Stock was paid a dividend at a rate of 6% per year on the $25.00 liquidation preference before the common stock received any dividends.  The Series B Preferred Stock was not redeemable. The Series B Preferred Stock was convertible into shares of common stock at a conversion rate that adjusted from time to time upon the occurrence of certain events, including when the Company distributed to its common shareholders in any calendar quarter cash dividends in excess of $0.11 per share. Initially, the conversion rate was 1.7730 shares of common shares per $25 liquidation preference, and the Series B Preferred Stock was converted into common stock at a conversion ratio of 3.0614 shares of common stock for each share of Series B Preferred Stock.  The Series B Preferred Stock was also convertible into common shares at the option of the Series B preferred shareholder anytime at the then prevailing conversion rate. The Series B Preferred Stock was senior to the Company's common stock and on parity with the Series A Preferred Stock with respect to dividends and distributions, including distributions upon liquidation, dissolution or winding up. The Series B Preferred Stock generally did not have any voting rights, except if the Company failed to pay dividends on the Series B Preferred Stock for six or more quarterly periods (whether or not consecutive). Under such circumstances, the Series B Preferred Stock, together with the Series A Preferred Stock, would be entitled to vote to elect two additional directors to the Board, until all unpaid dividends have been paid or declared and restricted for payment. In addition, certain material and adverse changes to the terms of the Series B Preferred Stock could not be made without the affirmative vote of holders of at least two-thirds of the outstanding shares of Series B Preferred Stock and Series A Preferred Stock. Through March 31, 2012, the Company had declared and paid all required quarterly dividends on the Series B Preferred Stock.  During the quarter ended March 31, 2012, 1.3 million shares of Series B Preferred Stock were converted into 4.0 million shares of common stock. During the quarter ended March 31, 2011, 2,000 shares of Series B Preferred Stock were converted into 5,000 shares of common stock.
 
 
18

 
 
 (C) Distributions to Shareholders

During the quarter ended March 31, 2012, the Company declared dividends to common shareholders totaling $534.4 million or $0.55 per share, which were paid to shareholders on April 26, 2012.  During the quarter ended March 31, 2012, the Company declared dividends to Series A Preferred shareholders totaling approximately $3.6 million or $0.492 per share, and Series B shareholders totaling approximately $289,000 or $0.375 per share, which were paid to preferred shareholders on April 2, 2012.

During the quarter ended March 31, 2011, the Company declared dividends to common shareholders totaling $498.7 million or $0.62 per share, which were paid to shareholders on April 27, 2011.  During the quarter ended March 31, 2011, the Company declared dividends to Series A Preferred shareholders totaling approximately $3.6 million or $0.492 per share, and Series B shareholders totaling approximately $619 thousand or $0.375 per share, which were paid to preferred shareholders on March 31, 2011.

10.           NET INCOME PER COMMON SHARE

The following table presents a reconciliation of the net income and shares used in calculating basic and diluted earnings per share for the quarters ended March 31, 2012 and 2011.
 
   
For the Quarter Ended
   
March 31,
2012
 
March 31,
2011
Net income (loss)
  $ 901,806     $ 699,895  
Less: Preferred stock dividends
    3,938       4,267  
Net income (loss) available to common shareholders, prior to adjustment for dilutive potential common shares, if necessary
    897,868       695,628  
Add: Preferred Series B dividends, if dilutive
    -       619  
Add: Interest on Convertible Senior Notes, if dilutive
    6,000       6,000  
Net income (loss) available to common shareholders, as adjusted
  $ 903,868     $ 702,247  
                 
Weighted average shares of common stock outstanding-basic
    971,728       752,414  
Add:  Effect of dilutive stock options, Series B Cumulative Convertible Preferred Stock and Convertible Senior Notes, if dilutive
    38,861       38,580  
Weighted average shares of common stock outstanding-diluted
    1,010,589       790,994  
 
Options to purchase 2.8 million shares of common stock were outstanding and considered anti-dilutive as their exercise price exceeded the average stock price for the quarter ended March 31, 2012.  Options to purchase 565,000 shares of common stock were outstanding and considered anti-dilutive as their exercise price exceeded the average stock price for the quarter ended March 31, 2011.
 
 
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11.            LONG-TERM STOCK INCENTIVE PLANS

The Company has adopted the 2010 Equity Incentive Plan, which authorizes the Compensation Committee of the board of directors to grant options, stock appreciation rights, dividend equivalent rights, or other share-based awards, including restricted shares up to an aggregate of 25,000,000 shares, subject to adjustments as provided in the 2010 Equity Incentive Plan.   The Company had adopted a long term stock incentive plan for executive officers, key employees and non-employee directors (the Prior Plan).  The Prior Plan authorized the Compensation Committee of the board of directors to grant awards, including non-qualified options as well as incentive stock options as defined under Section 422 of the Code.  The Prior Plan authorized the granting of options or other awards for an aggregate of the greater of 500,000 shares or 9.5% of the diluted outstanding shares of the Company’s common stock, up to a ceiling of 8,932,921 shares.  No further awards will be made under the Prior Plan, although existing awards remain effective.

Stock options were issued at the market price on the date of grant, subject to an immediate or four year vesting in four equal installments with a contractual term of 5 or 10 years. 
 
The Company has issued and outstanding the following stock options as of March 31, 2012 and 2011:
 
 
 
For the Quarter Ended
   
March 31, 2012
 
March 31, 2011
   
Number of
Shares
 
Weighted
Average
Exercise Price
 
Number of
Shares
 
Weighted
Average
Exercise Price
Options outstanding at the beginning of period
    6,216,805     $ 15.57       6,891,975     $ 15.33  
Granted
    -       -       -       -  
Exercised
    (126,394 )     14.57       (183,343 )     13.29  
Forfeited
    -       -       -       -  
Expired
    -       -       -       -  
Options outstanding at the end of period
    6,090,411     $ 15.59       6,708,632     $ 15.38  
Options exercisable at the end of the period
    4,325,299     $ 16.22       3,639,501     $ 16.30  
 
The weighted average remaining contractual term was approximately 5.2 years for stock options outstanding and approximately 4.5 years for stock options exercisable as of March 31, 2012.  As of March 31, 2012, there was approximately $3.1 million of total unrecognized compensation cost related to nonvested share-based compensation awards.  That cost is expected to be recognized over a weighted average period of 1 year.

The weighted average remaining contractual term was approximately 6.3 years for stock options outstanding and approximately 5.2 years for stock options exercisable as of March 31, 2011.  As of March 31, 2011, there was approximately $7.6 million of total unrecognized compensation cost related to nonvested share-based compensation awards.  That cost is expected to be recognized over a weighted average period of 1.8 years.

12.             INCOME TAXES

For the period ended March 31, 2012 the Company is qualified to be taxed as a REIT. As a REIT, the Company is not subject to federal income tax to the extent that it distributes its taxable income to its shareholders.  To maintain qualification as a REIT, the Company must distribute at least 90% of its annual REIT taxable income to its shareholders and meet certain other requirements. It is generally the Company’s policy to distribute to its shareholders all of the Company’s taxable income except for the amount of taxable income attributable to certain employee remuneration deductions disallowed for tax purposes pursuant to Internal Revenue Code Section 162(m).  Accordingly, in general, the Company is subject to federal, state and local income taxes on taxable income attributable to the Section 162(m) disallowance. The Company intends to retain its REIT status by complying with the REIT regulations and its distribution policy in the future. The state and city tax jurisdictions for which the Company is subject to tax filing obligations recognized the Company’s status as a REIT.
 
 
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During the quarter ended March 31, 2012, Annaly recorded $14.7 million of income tax expense for the portion of earnings retained based on Section 162(m) limitations. During the quarter ended March 31, 2011, Annaly recorded $9.5 million of income tax expense for the portion of earnings retained based on Section 162(m) limitations.

The Company’s effective tax rate differs from its combined federal, state, and city corporate statutory tax rate primarily due to the deduction of dividend distributions and Sec 162(m) limitations.

                During the quarter ended March 31, 2012, the Company’s taxable REIT subsidiaries recorded $1.8 million of income tax expense.  During the quarter ended March 31, 2011, the Company’s taxable REIT subsidiaries recorded $4.1 million of income tax expense.

The Company’s 2008, 2009 and 2010 federal and state tax returns remain open for examination.

13.           LEASE COMMITMENTS AND CONTINGENCIES
 
Commitments

The Company has a non-cancelable lease for office space which commenced in May 2002 and expires in December 2015.  Merganser has a non-cancelable lease for office space, which commenced on May 2003 and expires in May 2014.  Merganser subleases a portion of its leased space to a subtenant.  FIDAC has a lease for office space which commenced in October 2010 and expires in February 2016. The Company’s aggregate future minimum lease payments total approximately $7.8 million.  The following table details the lease payments.
 
Year Ending December
 
Lease Commitment
 
Sublease Income
  Net Amount
   
(dollars in thousands)
2012 (remaining)
  $ 2,252     $ 134     $ 2,118  
2013
    3,004       60       2,944  
2014
    2,522       -       2,522  
2015
    161       -       161  
2016
    27       -       27  
Thereafter
    -       -       -  
    $ 7,966     $ 194     $ 7,772  
 
Contingencies

From time to time, the Company is involved in various claims and legal actions arising in the ordinary course of business.  In the opinion of management, the ultimate disposition of these matters will not have a material effect on the Company’s consolidated financial statements and therefore no accrual is required as of March 31, 2012 and December 31, 2011.

14.     INTEREST RATE RISK

The primary market risk to the Company is interest rate risk.  Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond the Company’s control.  Changes in the general level of interest rates can affect net interest income, which is the difference between the interest income earned on interest-earning assets and the interest expense incurred in connection with the interest-bearing liabilities, by affecting the spread between the interest-earning assets and interest-bearing liabilities.  Changes in the level of interest rates also can affect the value of the Company’s interest earning assets and the Company’s ability to realize gains from the sale of these assets.  A decline in the value of the interest earning assets pledged as collateral for borrowings under repurchase agreements could result in the counterparties demanding additional collateral pledges or liquidation of some of the existing collateral to reduce borrowing levels.
 
 
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The Company seeks to manage the extent to which net income changes as a function of changes in interest rates by matching adjustable-rate assets with variable-rate borrowings.  The Company may seek to mitigate the potential impact on net income of periodic and lifetime coupon adjustment restrictions in the portfolio of interest earning assets by entering into interest rate agreements such as interest rate caps and interest rate swaps. As of March 31, 2012 and December 31, 2011, the Company entered into interest rate swaps to pay a fixed rate and receive a floating rate of interest, with a total notional amount of $42.1 billion and $40.1 billion, respectively.
 
Changes in interest rates may also have an effect on the rate of mortgage principal prepayments and, as a result, prepayments on Agency mortgage-backed securities.  The Company will seek to mitigate the effect of changes in the mortgage principal repayment rate by balancing assets purchased at a premium with assets purchased at a discount.  To date, the aggregate premium exceeds the aggregate discount on the Agency mortgage-backed securities.  As a result, prepayments, which result in the expensing of unamortized premium, will reduce net income compared to what net income would be absent such prepayments.

15.         RCAP REGULATORY REQUIREMENTS

RCap is subject to regulations of the securities business that include but are not limited to trade practices, use and safekeeping of funds and securities, capital structure, recordkeeping, and conduct of directors, officers and employees. 

As a self clearing, registered broker dealer, RCap is subject to the minimum net capital requirements of the FINRA.  As of March 31, 2012 RCap had a minimum net capital requirement of $293,135 and would be required to notify FINRA if capital was to fall below the early warning threshold of $351,762.  RCap consistently operates with capital significantly in excess of its regulatory capital requirements. RCap’s regulatory net capital as defined by SEC Rule 15c3-1 as of March 31, 2012 was $331.7 million with excess net capital of $331.4 million.

16.           RELATED PARTY TRANSACTIONS
 
For the quarters ended March 31, 2012 and 2011 the Company recorded advisory fees from affiliates totaling $16.4 million and $13.5 million, respectively.  At March 31, 2012 and 2011, the Company had amounts receivable from affiliates of $16.4 million and $13.5 million, respectively.
 
 
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ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Special Note Regarding Forward-Looking Statements

Certain statements contained in this quarterly report, and certain statements contained in our future filings with the Securities and Exchange Commission (the SEC or the Commission"), in our press releases or in our other public or shareholder communications may not be based on historical facts and are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements, which are based on various assumptions, (some of which are beyond our control) may be identified by reference to a future period or periods, or by the use of forward-looking terminology, such as "may," "will," "believe," "expect," "anticipate," "continue," or similar terms or variations on those terms, or the negative of those terms. Actual results could differ materially from those set forth in forward-looking statements due to a variety of factors, including, but not limited to, changes in interest rates, changes in the yield curve, changes in prepayment rates, the availability of mortgage-backed securities and other securities for purchase, the availability of financing, and, if available, the terms of any financings, changes in the market value of our assets, changes in business conditions and the general economy, our ability to consummate any contemplated investment opportunities, changes in governmental regulations affecting our business, our ability to maintain our classification as a REIT for federal income tax purposes, our ability to maintain our exemption from registration under the Investment Company Act of 1940, and risks associated with the business of our subsidiaries, including the investment advisory businesses of our subsidiaries, including the removal by their clients of assets they manage, their regulatory requirements, and competition in the investment advisory business, and risks associated with the broker dealer business of our subsidiary. For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see our most recent Annual Report on Form 10-K and any subsequent Quarterly Reports on Form 10-Q. We do not undertake and specifically disclaim any obligation, to publicly release the result of any revisions which may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.
 
 
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All references to “we,” “us,” or “our” mean Annaly Capital Management, Inc. and all entities owned by us, except where it is made clear that the term means only the parent company.  The following defines certain of the commonly used terms in this quarterly report on Form 10-Q:  Agency refers to a federally chartered corporation, such as Fannie Mae or Freddie Mac, or an agency of the U.S. Government, such as Ginnie Mae; Agency mortgage-backed securities refers to residential mortgage-backed securities that are issued or guaranteed by an Agency; Investment Securities refers to Agency mortgage-backed securities, Agency debentures, corporate debt securities and reverse repurchase agreement loans; and Interest Earning Assets refers to Investment Securities, securities borrowed and U.S. Treasury Securities.

Overview

We own, manage, and finance a portfolio of real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations (or CMOs), Agency callable debentures, and other securities representing interests in or obligations backed by pools of mortgage loans.  Our principal business objective is to generate net income for distribution to our stockholders from the spread between the interest income on our Interest-Earning Assets and the costs of borrowing to finance our acquisition of Interest-Earning Assets  and from dividends we receive from our subsidiaries.  Our wholly-owned subsidiaries offer diversified real estate, asset management and other financial services.  

We are a Maryland corporation that commenced operations on February 18, 1997.  We are self-advised and self-managed. We acquired Fixed Income Discount Advisory Company (or FIDAC) on June 4, 2004 and Merganser Capital Management, Inc. (or Merganser) on October 31, 2008.  FIDAC and Merganser manage a number of investment vehicles and separate accounts for which they earn fee income.  Our subsidiary, RCap Securities, Inc. (or RCap), operates as a broker-dealer, and was granted membership in the Financial Industry Regulatory Authority (or FINRA) in January 2009.  In 2010, we established Shannon Funding LLC (or Shannon), which provides warehouse financing to residential mortgage originators in the United States.  In 2010, we also established Charlesfort Capital Management LLC (or Charlesfort), which engages in corporate middle market lending transactions. In 2011, FIDAC established FIDAC Europe Limited (or FIDAC Europe), which provides advice on commercial real estate transactions, including sale-leaseback and single tenant net leased properties across Europe.  In 2011, we established FIDAC FSI LLC (or FIDAC FSI), which invests in trading securities.  We also own an additional subsidiary which owns trading securities.
 
We have elected and believe that we are organized and have operated in a manner that qualifies us to be taxed as a real estate investment trust (or REIT) under the Internal Revenue Code of 1986, as amended (or the Code).  If we qualify for taxation as a REIT, we generally will not be subject to federal income tax on our taxable income that is distributed to our stockholders.  Therefore, substantially all of our assets, other than FIDAC, Merganser and RCap, which are our taxable REIT subsidiaries, consist of qualified REIT real estate assets (of the type described in Section 856(c)(5)(B) of the Code).  We have financed our purchases of Agency mortgage-backed securities and Agency debentures with the net proceeds of equity offerings and borrowings under repurchase agreements whose interest rates adjust based on changes in short-term market interest rates.

Capital Investment Policy

Under our capital investment policy, at least 75% of our total assets must be comprised of high-quality mortgage-backed securities and short-term investments.  High quality securities means securities that (1) are rated within one of the two highest rating categories by at least one of the nationally recognized rating agencies, (2) are unrated but are guaranteed by the United States government or an agency of the United States government, or (3) are unrated but we determine them to be of comparable quality to high-quality rated mortgage-backed securities.

The remainder of our assets, comprising not more than 25% of our total assets, may consist of other qualified REIT real estate assets which are unrated or rated less than high quality, but which are at least “investment grade” (rated “BBB” or better by Standard & Poor’s Corporation (or S&P) or the equivalent by another nationally recognized rating agency) or, if not rated, we determine them to be of comparable credit quality to an investment which is rated “BBB” or better.  In addition, we may directly or indirectly invest part of this remaining 25% of our assets in other types of securities, including without limitation, unrated debt, equity or derivative securities, to the extent consistent with our REIT qualification requirements.  The derivative securities in which we invest may include securities representing the right to receive interest only or a disproportionately large amount of interest, as well as inverse floaters, which may have imbedded leverage as part of their structural characteristics.
 
 
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We may acquire Agency mortgage-backed securities backed by single-family residential mortgage loans as well as securities backed by loans on multi-family, commercial or other real estate related properties.  To date, substantially all of the Agency mortgage-backed securities that we have acquired have been backed by single-family residential mortgage loans.

The results of our operations are affected by various factors, many of which are beyond our control.  Our results of operations primarily depend on, among other things, 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, the behavior of which involves various risks and uncertainties.  Prepayment speeds, as reflected by the Constant Prepayment Rate, or CPR, and interest rates vary according to the type of investment, conditions in financial markets, competition and other factors, none of which can be predicted with any certainty.  In general, as prepayment speeds on our Agency mortgage-backed securities portfolio increase, related purchase premium amortization increases, thereby reducing the net yield on such assets.  The CPR on our Agency mortgage-backed securities portfolio averaged 19% and 22% for the quarters ended March 31, 2012 and December 31, 2011, respectively.  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.  We continue to explore alternative business strategies, alternative investments and other strategic initiatives to complement our core business strategy of investing, on a leveraged basis, in high quality Investment Securities.  No assurance, however, can be provided that any such strategic initiative will or will not be implemented in the future.

The table below provides quarterly information regarding our average interest-earning assets, interest income, yield on average interest-earning assets,, average interest-bearing liabilities, economic interest expense, average cost of interest-bearing liabilities, economic net interest income and net interest rate spreads for the periods presented.
 
   
Average
Interest-
Earning
Assets(1)
 
Total
Interest
Income
 
Yield on
Average
Interest-
Earning
Assets
 
Average
Interest-
Bearing
Liabilities
 
Economic
Interest
Expense (2)
 
Average
Cost of
Interest-
Bearing
Liabilities
 
Economic
Net
Interest
Income(3)
 
Net
Interest
Rate
Spread
   
(ratios for the quarters have been annualized, dollars in thousands)
Quarter Ended March 31, 20112
  $ 105,706,554     $ 854,895       3.23 %   $ 92,552,175     $ 352,685       1.52 %   $ 502,210       1.71 %
Year Ended December 31, 2011
  $ 96,675,016     $ 3,579,618       3.70 %   $ 84,595,933     $ 1,362,721       1.61 %   $ 2,216,897       2.09 %
Quarter Ended December 31, 2011
  $ 102,339,797     $ 847,700       3.31 %   $ 89,488,111     $ 357,771       1.60 %   $ 489,929       1.71 %
Quarter Ended September 30, 2011
  $ 100,473,505     $ 930,802       3.71 %   $ 86,617,908     $ 353,266       1.63 %   $ 577,536       2.08 %
Quarter Ended June 30, 2011
  $ 94,696,473     $ 957,068       4.04 %   $ 83,042,390     $ 330,080       1.59 %   $ 626,988       2.45 %
Quarter Ended March 31, 2011
  $ 89,190,290     $ 844,048       3.79 %   $ 79,235,324     $ 321,604       1.62 %   $ 522,444       2.17 %
 
(1)
Does not reflect unrealized gains/ (losses) or premium/(discount).
   
(2)
Economic interest expense includes interest expense on interest rate swaps.
   
(3)
Economic net interest income includes interest expense on interest rate swaps.
 
Our net interest rate spread has declined since the quarter ended March 31, 2011.  The declining net interest rate spread is primarily attributable to the continuing low interest rate environment and marginally higher CPR, which as discussed above, reduces the net yield on our Agency mortgage-backed securities portfolio.
 
 
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The following table presents the CPR experienced on our Agency mortgage-backed securities portfolio, on an annualized basis, for the quarterly periods presented.
 
Quarter Ended
CPR
March 31, 2012
19%
December 31, 2011
22%
September 30, 2011
18%
June 30, 2011
11%
March 31, 2011
17%
 
For the purpose of calculating average interest-earning assets and interest-bearing liabilities, daily balances are used.  For the purposes of computing ratios relating to equity measures throughout this report, equity includes Series B preferred stock, which has been treated under GAAP as temporary equity.  For the purpose of computing net interest income and ratios relating to cost of funds measures throughout this report, interest expense includes interest expense on interest rate swaps, which is classified in the Consolidated Statements of Operations and Comprehensive Income (Loss) as Realized gains (losses) on interest rate swaps.  Interest rate swaps are used to hedge the increase in interest expense on repurchase agreements in a rising rate environment.  Presenting the contractual interest payments on interest rate swaps with the interest expense on interest-bearing liabilities reflects total contractual interest payments.  This presentation depicts the economic value of our investment strategy.  Interest expense, including interest payments on interest rate swaps, is referred to as economic interest expense.  Net interest income, including interest payments on interest rate swaps, is referred to as economic net interest income.

The following table compares the GAAP and non-GAAP measurements reflected in the Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
   
GAAP Total Stockholders’
Equity
 
Non-GAAP
Total
Stockholders’
Equity
 
GAAP
Interest
Expense
 
Economic
Interest
Expense
 
GAAP Net
Interest
Income
 
Economic
Net interest
Income
   
(dollars in thousands)
For the Quarter Ended March 31, 2012
  $ 15,940,605     $ 15,940,605     $ 133,345     $ 352,685