Unassociated Document
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
___________________
 
FORM 10-K
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2009
 
OR
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______________ to ______________
 
Commission File Number: 1-13991
 
MFA FINANCIAL, INC.
(Exact name of registrant as specified in its charter)
 
_______________________
 
Maryland
(State or other jurisdiction of
incorporation or organization)
 
350 Park Avenue, 21st Floor, New York, New York
(Address of principal executive offices)
13-3974868
(I.R.S. Employer
Identification No.)
 
10022
(Zip Code)
 
(212) 207-6400
(Registrant’s telephone number, including area code)
_______________________
 
Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class
Common Stock, $0.01 par value
 
8.50% Series A Cumulative Redeemable
Preferred Stock, $0.01 par value
Name of Each Exchange on Which Registered
New York Stock Exchange
 
New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:  None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes   ü   No      
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes        No   ü  
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes     ü  No       
 
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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ___No ___
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   ü    
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “ accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer x
Non-accelerated filer o
 
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        No   ü  
 
On June 30, 2009, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $1,532,115,431 based on the closing sales price of our common stock on such date as reported on the New York Stock Exchange.
 
On February 8, 2010, the registrant had a total of 280,764,063 shares of Common Stock outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s proxy statement for the 2010 annual meeting of stockholders scheduled to be held on or about May 20, 2010 are incorporated by reference into Part III of this annual report on Form 10-K.
 
 
TABLE OF CONTENTS

PART I
 
Item 1.
1
Item 1A.
5
Item 1B.
17
Item 2.
17
Item 3.
17
Item 4.
17
Item 4A.
17
 
PART II
 
Item 5.
19
Item 6.
21
Item 7.
22
Item 7A.
40
Item 8.
47
Item 9.
82
Item 9A.
82
Item 9B.
84
 
PART III
 
Item 10.
84
Item 11.
84
Item 12.
84
Item 13.
84
Item 14.
84
 
PART IV
 
Item 15.
85
87
 
 
CAUTIONARY STATEMENT – This annual report on Form 10-K may contain “forward-looking” statements within the meaning of Section 27A of the Securities Act of 1933, as amended (or 1933 Act), and Section 21E of the Securities Exchange Act of 1934, as amended (or 1934 Act).  We caution that any such forward-looking statements made by us are not guarantees of future performance and that actual results may differ materially from those in such forward-looking statements.  Some of the factors that could cause actual results to differ materially from estimates contained in our forward-looking statements are set forth in this annual report on Form 10-K for the year ended December 31, 2009.  See Item 1A “Risk Factors” of this annual report on Form 10-K.
 
 
In this annual report on Form 10-K, references to “we,” “us,” or “our” refer to MFA Financial, Inc. and its subsidiaries unless specifically stated otherwise or the context otherwise indicates.  The following defines certain of the commonly used terms in this annual report on Form 10-K:  MBS refers to residential mortgage-backed securities; Agency MBS refers to MBS that are issued or guaranteed by a federally chartered corporation, such as Fannie Mae or Freddie Mac, or an agency of the U.S. Government, such as Ginnie Mae; Non-Agency MBS are MBS secured by pools of residential mortgages and are not guaranteed by any agency of the U.S. Government or any federally chartered corporation; Hybrids refer to hybrid mortgage loans that have interest rates that are fixed for a specified period of time and, thereafter, generally adjust annually to an increment over a specified interest rate index; ARMs refer to Hybrids and adjustable-rate mortgage loans which typically have interest rates that adjust annually to an increment over a specified interest rate index; ARM-MBS refers to residential MBS that are secured by ARMs; and MBS Forwards refer to forward contracts to repurchase MBS where the initial MBS purchase and repurchase financing were with the same counterparty and are considered linked transactions and are reported at fair value on a net basis.
 
PART I
 
Item 1.  Business.
 
GENERAL
 
We are primarily engaged in the business of investing, on a leveraged basis, in residential Agency and Non-Agency ARM-MBS.  At December 31, 2009, we had total assets of approximately $9.627 billion, of which $8.758 billion, or 91.0%, represented our MBS portfolio.  At such date, our MBS portfolio was comprised of $7.665 billion of Agency MBS and $1.093 billion of Non-Agency MBS, of which 99.8% represented the senior most tranches within the MBS structure.  Our remaining investment-related assets were primarily comprised of cash and cash equivalents, MBS Forwards, restricted cash and MBS-related receivables.  Our principal business objective is to generate net income for distribution to our stockholders resulting from the difference between the interest and other income we earn on our investments and the interest expense we pay on the borrowings that we use to finance our leveraged investments and our operating costs.
 
We were incorporated in Maryland on July 24, 1997 and began operations on April 10, 1998.  We have elected to be taxed as a real estate investment trust (or REIT) for U.S. federal income tax purposes.  One of the requirements of maintaining our qualification as a REIT is that we must distribute at least 90% of our annual REIT taxable income to our stockholders.  On January 1, 2009, we changed our name from MFA Mortgage Investments, Inc. to MFA Financial, Inc.
 
INVESTMENT STRATEGY
 
Our operating policies require that at least 50% of our investment portfolio consist of ARM-MBS that are either (i) Agency MBS or (ii) rated in one of the two highest rating categories by at least one of a nationally recognized rating agency, such as Moody’s Investors Services, Inc. (or Moody’s), Standard & Poor’s Corporation (or S&P) or Fitch, Inc. (or collectively, the Rating Agencies).  The remainder of our assets may consist of direct or indirect investments in: (i) other types of MBS and residential mortgage loans; (ii) other mortgage and real estate-related debt and equity; (iii) other yield instruments (corporate or government); and (iv) other types of assets approved by our Board of Directors (or Board) or a committee thereof.  At December 31, 2009, 85.6% of our investment portfolio, which for purposes of our investment policy includes the MBS underlying our MBS Forwards, consisted of ARM-MBS that were either Agency MBS or rated in one of the two highest rating categories by a Rating Agency.
 
The ARMs collateralizing our MBS include Hybrids, with initial fixed-rate periods generally ranging from three to ten years, and, to a lesser extent, adjustable-rate mortgages with interest rates that reset annually, or on a more frequent basis.  Interest rates on the mortgage loans collateralizing our ARM-MBS reset based on specific index rates, generally London Interbank Offered Rate (or LIBOR) and the one-year constant maturity treasury (or CMT) rate.  The mortgages collateralizing our ARM-MBS typically have interim and lifetime caps on interest rate adjustments.  At December 31, 2009, 99.1% of our MBS portfolio was comprised of ARM-MBS and the remaining 0.9% consisted of fixed-rate MBS.  At December 31, 2009, approximately $7.777 billion or 88.8%, of our MBS portfolio was in its contractual fixed-rate period (including fixed-rate MBS) and approximately $981.3 million, or 11.2%, was in its contractual adjustable-rate period.  Our MBS in their contractual adjustable-rate period include MBS collateralized by Hybrids for which the initial fixed-rate period has elapsed and the current interest rate on
 
 
such MBS is generally adjusted on an annual or semi-annual basis.
 
Because the coupons earned on ARM-MBS adjust over time as interest rates change (typically after an initial fixed-rate period) the market values of these assets are generally less sensitive to changes in interest rates than are fixed-rate MBS.  In order to mitigate our interest rate risks, our strategy is to maintain a substantial majority of our portfolio in ARM-MBS.
 
Non-Agency MBS Portfolio
 
While our primary portfolio holdings remains Agency MBS, as part of our investment strategy we have increased our investments in Non-Agency MBS during 2009.  By blending Non-Agency MBS with Agency MBS, we seek to generate attractive returns with less overall leverage and less sensitivity to yield curve and interest rate cycles and prepayments.  The Non-Agency MBS that we own through our wholly-owned subsidiary MFResidential Assets I, LLC (or MFR) were acquired at discounts to face (or par) value with limited use of leverage (or MFR MBS).  A portion of the purchase discount on these Non-Agency MBS is designated as a credit discount, which is available to absorb future principal losses on the mortgages collateralizing such MBS.  The portion of the purchase discount that is not designated as credit discount is accreted into interest income as MBS principal is repaid over the life of the security, increasing the yield on such MBS above the stated coupon rate.  To the extent that the expected yields on our Non-Agency MBS are significantly greater than the expected yields on non-credit sensitive assets, these Non-Agency MBS will generally exhibit less sensitivity to changes in market interest rates than lower yielding non-credit sensitive assets.  Yields on Non-Agency MBS, unlike Agency MBS, will exhibit sensitivity to changes in credit performance.  The extent to which our yield on Non-Agency MBS is impacted by the accretion of purchase discounts will vary by security over time, based upon the amount of purchase discount, actual credit performance and constant prepayment rates (or CPRs) experienced.  At December 31, 2009, $1.093 billion, or 12.5%, of our MBS portfolio was invested in Non-Agency MBS.  In addition, at December 31, 2009, we had MFR MBS with a fair value of $329.5 million that were part of linked transactions and, as such, were reported as a component of our MBS Forwards.
 
FINANCING STRATEGY
 
Our financing strategy is designed to increase the size of our MBS portfolio by borrowing against a substantial portion of the market value of the MBS in our portfolio.  We currently utilize repurchase agreements to finance the acquisition of our Agency MBS and, to a lesser extent, our Non-Agency MBS.  We enter into interest rate swap agreements (or Swaps) to hedge the interest rate risk associated with a portion of our repurchase agreements.  At December 31, 2009, we had $7.196 billion outstanding under repurchase agreements, of which $3.007 billion was hedged with 123 fixed-pay Swaps.  At December 31, 2009, our debt-to-equity ratio was 3.3 to 1.
 
Repurchase agreements are financing contracts (i.e., borrowings) under which we pledge our MBS as collateral to secure loans with repurchase agreement counterparties (i.e., lenders).  The amount borrowed under a repurchase agreement is limited to a specified percentage of the fair value of the MBS pledged as collateral.  The portion of the pledged collateral held by the lender in excess of the amount borrowed under the repurchase agreement is the margin requirement for that borrowing.  Repurchase agreements take the form of a sale of the pledged collateral to a lender at an agreed upon price in return for such lender’s simultaneous agreement to resell the same security back to the borrower at a future date (i.e., the maturity of the borrowing) at a higher price.  The difference between the sale price and repurchase price is the cost, or interest expense, of borrowing under a repurchase agreement.  Our cost of borrowings under repurchase agreements generally corresponds to LIBOR.  Under our repurchase agreements, we retain beneficial ownership of the pledged collateral, while the lender maintains custody of such collateral.  At the maturity of a repurchase financing, we are required to repay the loan and concurrently receive back our pledged collateral or, with the consent of the lender, we may renew the repurchase financing at the then prevailing market interest rate.  Under our repurchase agreements, we routinely experience margin calls pursuant to which a lender may require that we pledge additional securities and/or cash as further collateral to secure such borrowings, when the fair value of our existing pledged collateral declines below the margin requirement during the term of the borrowing.  Our pledged collateral fluctuates in value primarily due to principal payments on such collateral and changes in market interest rates, prevailing market yields and other market conditions.  To date, we have satisfied all of our margin calls and have never sold assets to meet any margin calls.
 
We currently use repurchase financing on a limited portion of our Non-Agency MBS.  In general, when a newly purchased Non-Agency MBS is financed through a repurchase transaction with the same counterparty from whom such security was purchased, such transaction is considered linked.  Our linked transactions are reported net, as
 
 
MBS Forwards, on our consolidated balance sheet.  The changes in the fair value of MBS Forwards are reported as a net gain/(loss) on our statements of operations.  As of December 31, 2009, we had $245.0 million of repurchase agreements that were considered linked transactions and, as such were reported as a component of our MBS Forwards.
 
In order to reduce our exposure to counterparty-related risk, we generally seek to diversify our exposure by entering into repurchase agreements with multiple counterparties with a maximum loan from any lender of no more than three times our stockholders’ equity.  At December 31, 2009, we had outstanding balances under repurchase agreements with 17 separate lenders with a maximum net exposure (the difference between the amount loaned to us, including interest payable, and the value of the securities pledged by us as collateral, including accrued interest receivable on such securities) to any single lender of $108.6 million.  In addition, we enter into Swaps with certain of our repurchase agreement counterparties and other institutions, which also may require us to post collateral.  At December 31, 2009, our aggregate maximum net exposure to any single counterparty for repurchase agreements and Swaps was $173.8 million.
 
In addition to repurchase agreements and subject to maintaining our qualification as a REIT, we may also use other sources of funding in the future to finance our MBS portfolio, including, but not limited to, other types of collateralized borrowings, loan agreements, lines of credit, commercial paper or the issuance of debt securities.
 
OTHER INVESTMENTS
 
At December 31, 2009, we had an indirect investment of $11.0 million in a 191-unit multi-family apartment property subject to a $9.1 million fixed-rate mortgage loan that matures on February 1, 2011.  (See Note 6 to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
 
We continue to explore alternative business strategies, investments and financing sources and other strategic initiatives, including, but not limited to; expanding our investments in Non-Agency MBS, developing or acquiring asset management or third-party advisory services, creating new investment vehicles to manage MBS and/or other real estate-related assets.  However, no assurance can be provided that any such strategic initiatives will or will not be implemented in the future or, if undertaken, that any such strategic initiative will favorably impact us.
 
CORPORATE GOVERNANCE
 
We strive to maintain an ethical workplace in which the highest standards of professional conduct are practiced.
 
 
·
Our Board is composed of a majority of independent directors.  Our Audit, Nominating and Corporate Governance and Compensation Committees are composed exclusively of independent directors.
 
 
·
In order to foster the highest standards of ethics and conduct in all of our business relationships, we have adopted a Code of Business Conduct and Ethics and Corporate Governance Guidelines, which cover a wide range of business practices and procedures that apply to all of our directors, officers and employees.  In addition, we have implemented Whistle Blowing Procedures for Accounting and Auditing Matters that set forth procedures by which any officer or employee may raise, on a confidential basis, concerns regarding any questionable or unethical accounting, internal accounting controls or auditing matters with our Audit Committee.
 
 
·
We have an insider trading policy that prohibits any of our directors, officers or employees from buying or selling our common and preferred stock on the basis of material nonpublic information and prohibits communicating material nonpublic information to others.
 
 
·
We have a related party transaction policy that sets forth procedures for the reviewing, approving and monitoring of transactions involving us and “related persons” (directors, executive officers and their immediate family members and stockholders beneficially owning 5% or more of our outstanding capital stock) that relate to amounts in excess of $120,000 and in which the related party has a direct or indirect material interest.
 
 
·
We have a formal internal audit function, which is provided by a third-party, to further the effective review of our internal controls and procedures.  Our internal audit plan, which is approved annually by our Audit Committee, is based on a formal risk assessment and is intended to provide management and our Audit Committee with an effective tool to identify and address areas of financial or operational concerns and to ensure that appropriate controls and procedures are in place.  We have implemented
 
 
Section 404 of the Sarbanes-Oxley Act of 2002, as amended (or the SOX Act), which requires an evaluation of internal control over financial reporting in association with our financial statements for the year ending December 31, 2009.  (See Item 9A, “Controls and Procedures” included in this annual report on Form 10-K.)
 
COMPETITION
 
We operate in the mortgage-REIT industry.  We believe that our principal competitors in the business of acquiring and holding MBS of the types in which we invest are financial institutions, such as banks, savings and loan institutions, life insurance companies, institutional investors, including mutual funds and pension funds, hedge funds, and other mortgage-REITs.  Some of these entities may not be subject to the same regulatory constraints (i.e., REIT compliance or maintaining an exemption under the Investment Company Act of 1940, as amended (or the Investment Company Act)) as us.  In addition, many of these entities have greater financial resources and access to capital than us.  The existence of these entities, as well as the possibility of additional entities forming in the future, may increase the competition for the acquisition of MBS, resulting in higher prices and lower yields on such assets.
 
EMPLOYEES
 
At December 31, 2009, we had 25 employees, all of whom were full-time.  We believe that our relationship with our employees is good.  None of our employees is unionized or represented under a collective bargaining agreement.
 
AVAILABLE INFORMATION
 
We maintain a website at www.mfa-reit.com.  We make available, free of charge, on our website our (a) annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K (including any amendments thereto), proxy statements and other information (or, collectively, the Company Documents) filed with, or furnished to, the Securities and Exchange Commission (or SEC), as soon as reasonably practicable after such documents are so filed or furnished, (b) Corporate Governance Guidelines, (c) Code of Business Conduct and Ethics and (d) written charters of the Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee of our Board.  Our Company Documents filed with, or furnished to, the SEC are also available at the SEC’s website at www.sec.gov.  We also provide copies of our Corporate Governance Guidelines and Code of Business Conduct and Ethics, free of charge, to stockholders who request it.  Requests should be directed to Timothy W. Korth, General Counsel, Senior Vice President and Corporate Secretary, at MFA Financial, Inc., 350 Park Avenue, 21st floor, New York, New York 10022.
 
 
Item 1A.  Risk Factors.
 
Our business and operations are subject to a number of risks and uncertainties, the occurrence of which could adversely affect our business, financial condition, results of operations and ability to make distributions to stockholders and could cause the value of our capital stock to decline.

General.
 
Our business and operations are affected by a number of factors, many of which are beyond our control, and primarily depend on, among other things, the level of our net interest income, the market value of our assets, the supply of, and demand for, MBS in the market place and the availability of acceptable financing.  Our net interest income varies primarily as a result of changes in interest rates, the slope of the yield curve (i.e., the differential between long-term and short-term interest rates), borrowing costs (i.e., interest expense) and prepayment speeds on our MBS portfolio, the behavior of which involves various risks and uncertainties.  Interest rates and prepayment speeds, as measured by the CPR, vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty.  Our operating results also depend upon our ability to effectively manage the risks associated with our business operations, including interest rate, prepayment, financing and credit risks, while maintaining our qualification as a REIT.
 
Risks Associated With Adverse Developments in the Mortgage Finance and Credit Markets
 
Volatile market conditions for mortgages and mortgage-related assets as well as the broader financial markets may adversely affect the value of the assets in which we invest.
 
Our results of operations are materially affected by conditions in the markets for mortgages and mortgage-related assets, including MBS, as well as the broader financial markets and the economy generally.  Beginning in 2007, significant adverse changes in financial market conditions resulted in a deleveraging of the entire global financial system and the forced sale of large quantities of mortgage-related and other financial assets.  More recently, concerns over economic recession, geopolitical issues, unemployment, the availability and cost of financing, the mortgage market and a declining real estate market have contributed to increased volatility and diminished expectations for the economy and markets.  In particular, the residential mortgage market in the United States has experienced a variety of difficulties and changed economic conditions, including defaults, credit losses and liquidity concerns.  Certain commercial banks, investment banks and insurance companies have announced extensive losses from exposure to the residential mortgage market.  These losses have reduced financial industry capital, leading to a contraction in liquidity for some institutions.  These factors have impacted investor perception of the risk associated with residential MBS, real estate-related securities and various other asset classes in which we may invest.  As a result, values for residential MBS, real estate-related securities and various other asset classes in which we may invest have experienced volatility.  Any decline in the value of our investments, or perceived market uncertainty about their value, would likely make it difficult for us to obtain financing on favorable terms or at all, or maintain our compliance with terms of any financing arrangements already in place.  Further increased volatility and deterioration in the broader residential mortgage and MBS markets may adversely affect the performance and market value of our investments.
 
The federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between Fannie Mae and Freddie Mac and the U.S. Government, may adversely affect our business.
 
The payments of principal and interest we receive on our Agency MBS, which depend directly upon payments on the mortgages underlying such securities, are guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae.  Fannie Mae and Freddie Mac are U.S. Government-sponsored entities (or GSEs), but their guarantees are not backed by the full faith and credit of the United States.  Ginnie Mae is part of a U.S. Government agency and its guarantees are backed by the full faith and credit of the United States.
 
In response to general market instability and, more specifically, the financial conditions of Fannie Mae and Freddie Mac, in July 2008, the Housing and Economic Recovery Act of 2008 (or the HERA) established a new regulator for Fannie Mae and Freddie Mac, the U.S. Federal Housing Finance Agency (or the FHFA).  In September 2008, the U.S. Treasury, the FHFA, and the U.S. Federal Reserve announced a comprehensive action plan to help stabilize the financial markets, support the availability of mortgage finance and protect taxpayers.  Under this plan, among other things, the FHFA was appointed as conservator of both Fannie Mae and Freddie Mac, allowing the FHFA to control the actions of the two GSEs, without forcing them to liquidate, which would be the case under
 
 
receivership.  Importantly, the primary focus of the plan was to increase the availability of mortgage financing by allowing these GSEs to continue to grow their guarantee business without limit, while limiting the size of their retained mortgage and Agency MBS portfolios and requiring that these portfolios are reduced over time.
 
In an effort to further stabilize the U.S. mortgage market, the U.S. Treasury pursued three additional initiatives beginning in 2008.  First, it entered into preferred stock purchase agreements, which have been subsequently amended, with each of the GSEs to ensure that they maintained a positive net worth.  Second, it established a new secured short-term credit facility, which was available to Fannie Mae and Freddie Mac (as well as Federal Home Loan Banks) when other funding sources were unavailable.  Third, it established an Agency MBS purchase program under which the U.S. Treasury purchased Agency MBS in the open market.  In addition, separate from the U.S. Treasury’s Agency MBS purchase program, the U.S. Federal Reserve established its own Agency MBS purchase program in November 2008.  In December 2009, the U.S. Treasury reported that these preferred stock purchase agreements were being amended to allow the cap on funding by the U.S. Treasury to increase as necessary to accommodate any cumulative reduction in net worth over the next three years.  In December 2009, the U.S. Treasury also reported that, as of September 30, 2009, funding provided to Fannie Mae and Freddie Mac under the preferred stock purchase agreements amount to approximately $60 billion and $51 billion, respectively.  Pursuant to these agreements, each of Fannie Mae’s and Freddie Mac’s mortgage and Agency MBS portfolio may not exceed $900 billion as of December 31, 2009.  Both the secured short-term credit facility and the Agency MBS program initiated by the U.S. Treasury expired on December 31, 2009 and the $1.25 trillion Agency MBS program initiated by the U.S. Federal Reserve is scheduled to end on March 31, 2010.
 
As reported in late 2009, the U.S. Treasury anticipated that, as of December 31, 2009, it would have purchased approximately $220 billion of securities through its Agency MBS purchase program.  In addition, in December 2009, the U.S. Federal Reserve reported that it was in the process of purchasing $1.25 trillion of Agency MBS and that, as it gradually slows the pace of these purchases, it anticipates that these transactions will be executed by March 31, 2010.  Subject to specified investment guidelines, the portfolios of Agency MBS purchased through the programs established by the U.S. Treasury and the U.S. Federal Reserve may be held to maturity and, based on mortgage market conditions, adjustments may be made to these portfolios.  This flexibility may adversely affect the pricing and availability of Agency MBS that we seek to acquire during the remaining term of these portfolios.
 
Although the U.S. Government has committed capital to Fannie Mae and Freddie Mac, there can be no assurance that these actions will be adequate for their needs.  These uncertainties lead to questions about the future of the GSEs in their current form, or at all, and the availability of, and trading market for, Agency MBS.  Despite the steps taken by the U.S. Government, Fannie Mae and Freddie Mac could default on their guarantee obligations which would materially and adversely affect the value of our Agency MBS.  Accordingly, if these government actions are inadequate and the GSEs continue to suffer losses or cease to exist, our business, operations and financial condition could be materially and adversely affected.
 
The U.S. Treasury could also stop providing credit support to Fannie Mae and Freddie Mac in the future.  On December 24, 2009, the U.S. Treasury announced that as part of their commitment to wind down certain programs established during the financial crisis, they would be terminating the short-term credit facility and the Agency MBS purchase program on December 31, 2009.  The problems faced by Fannie Mae and Freddie Mac resulting in their being placed into federal conservatorship have stirred debate among some federal policy makers regarding the continued role of the U.S. Government in providing liquidity for mortgage loans.  Although the U.S. Treasury has amended the preferred stock purchase agreements under the HERA to give Fannie Mae and Freddie Mac some additional flexibility by increasing the funding cap under these agreements, following expiration of the current authorization, each of Fannie Mae and Freddie Mac could be dissolved and the U.S. Government could determine to stop providing liquidity support of any kind to the mortgage market.  The future roles of Fannie Mae and Freddie Mac could be significantly reduced and the nature of their guarantee obligations could be considerably limited relative to historical measurements.  Any changes to the nature of their guarantee obligations could redefine what constitutes an Agency MBS and could have broad adverse implications for the market and our business, operations and financial condition.  If Fannie Mae or Freddie Mac were eliminated, or their structures were to change radically (i.e., limitation or removal of the guarantee obligation), we may be unable to acquire additional Agency MBS and our existing Agency MBS could be materially and adversely impacted.
 
We could be negatively affected in a number of ways depending on the manner in which related events unfold for Fannie Mae and Freddie Mac.  We rely on our Agency MBS as collateral for our financings under our repurchase agreements.  Any decline in their value, or perceived market uncertainty about their value, would make it more difficult for us to obtain financing on our Agency MBS on acceptable terms or at all, or to maintain our
 
 
compliance with the terms of any financing transactions.  Further, the current credit support provided by the U.S. Treasury to Fannie Mae and Freddie Mac, and any additional credit support it may provide in the future, could have the effect of lowering the interest rates we expect to receive from Agency MBS, thereby tightening the spread between the interest we earn on our Agency MBS and the cost of financing those assets.  A reduction in the supply of Agency MBS could also negatively affect the pricing of Agency MBS by reducing the spread between the interest we earn on our portfolio of Agency MBS and our cost of financing that portfolio.
 
As indicated above, recent legislation has changed the relationship between Fannie Mae and Freddie Mac and the U.S. Government.  Future legislation could further change the relationship between Fannie Mae and Freddie Mac and the U.S. Government, and could also nationalize or eliminate such entities entirely.  Any law affecting these GSEs may create market uncertainty and have the effect of reducing the actual or perceived credit quality of securities issued or guaranteed by Fannie Mae or Freddie Mac.  As a result, such laws could increase the risk of loss on our investments in Agency MBS guaranteed by Fannie Mae and/or Freddie Mac.  It also is possible that such laws could adversely impact the market for such securities and spreads at which they trade.  All of the foregoing could materially and adversely affect our business, operations and financial condition.
 
Mortgage loan modification programs and future legislative action may adversely affect the value of, and the returns on, our MBS.
 
The U.S. Government, through the Federal Reserve, the Federal Housing Administration (or the FHA) and the Federal Deposit Insurance Corporation (or FDIC), has implemented a number of federal programs designed to assist homeowners, including the Home Affordable Modification Program (or HAMP), which provides homeowners with assistance in avoiding residential mortgage loan foreclosures, the Hope for Homeowners Act (or H4H Program), which allows certain distressed borrowers to refinance their mortgages into FHA-insured loans in order to avoid residential mortgage loan foreclosures, and the Home Affordable Refinance Program, which allows borrowers who are current on their mortgage payments to refinance and reduce their monthly mortgage payments at loan-to-value ratios up to 125 percent without new mortgage insurance.  HAMP, the H4H Program and other loan modification programs may involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans (through forbearance and/or forgiveness) and/or the rate of interest payable on the loans, or to extend the payment terms of the loans.  Especially with Non-Agency MBS, a significant number of loan modifications with respect to a given security, including, but not limited to, those related to principal forgiveness and coupon reduction, could negatively impact the realized yields and cash flows on such security.  These loan modification programs, future legislative or regulatory actions, including amendments to the bankruptcy laws, which result in the modification of outstanding residential mortgage loans, as well as changes in the requirements necessary to qualify for refinancing mortgage loans with Fannie Mae, Freddie Mac or Ginnie Mae, may adversely affect the value of, and the returns on, our MBS.
 
There can be no assurance that the actions of the U.S. Government, Federal Reserve, U.S. Treasury and other governmental and regulatory bodies for the purpose of stabilizing the financial markets, or market response to those actions, will achieve the intended effect or benefit our business.
 
In response to the financial issues affecting the banking system and financial markets and going concern threats to commercial banks, investment banks and other financial institutions, the Emergency Economic Stabilization Act of 2008 (or EESA), was enacted by the U.S. Congress.  There can be no assurance that the EESA or any other U.S. Government actions will have a beneficial impact on the financial markets.  To the extent the markets do not respond favorably to any such actions by the U.S. Government or such actions do not function as intended, our business may not receive the anticipated positive impact from the legislation and such result may have broad adverse market implications.  In addition, U.S. Government, Federal Reserve, U.S. Treasury and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis.  We cannot predict whether or when such actions may occur or what affect, if any, such actions could have on our business, results of operations and financial condition.
 
Prepayment rates on the mortgage loans underlying our MBS may adversely affect our profitability.
 
The MBS that we acquire are primarily secured by pools of mortgages on residential properties.  In general, the mortgages collateralizing our MBS may be prepaid at any time without penalty.  Prepayments on our MBS result when homeowners/mortgagees satisfy (i.e., pay off) the mortgage upon selling or refinancing their mortgaged property.  When we acquire a particular MBS, we anticipate that the underlying mortgage loans will prepay at a projected rate which, together with expected coupon income, provides us with an expected yield on such MBS.  If
 
 
we purchase assets at a premium to par value, and borrowers prepay their mortgage loans faster than expected, the corresponding prepayments on the MBS may reduce the expected yield on such securities because we will have to amortize the related premium on an accelerated basis.  Conversely, if we purchase assets at a discount to par value, when borrowers prepay their mortgage loans slower than expected, the decrease in corresponding prepayments on the MBS may reduce the expected yield on such securities because we will not be able to accrete the related discount as quickly as originally anticipated.  Prepayment rates on loans are influenced by changes in mortgage and market interest rates and a variety of governmental, economic, geographic and other factors, all of which are beyond our control.  Consequently, such prepayment rates cannot be predicted with certainty and no strategy can completely insulate us from prepayment or other such risks.  In periods of declining interest rates, prepayment rates on mortgage loans generally increase.  If general interest rates decline at the same time, the proceeds of such prepayments received during such periods are likely to be reinvested by us in assets yielding less than the yields on the assets that were prepaid.  In addition, the market value of our MBS may, because of the risk of prepayment, benefit less than other fixed-income securities from declining interest rates.
 
With respect to Agency MBS, we often purchase securities that have a higher coupon rate than the prevailing market interest rates.  In exchange for a higher coupon rate, we typically pay a premium over par value to acquire these securities.  In accordance with generally accepted accounting principles (or GAAP), we amortize the premiums on our MBS over the life of the related MBS.  If the mortgage loans securing these securities prepay at a more rapid rate than anticipated, we will have to amortize our premiums on an accelerated basis which may adversely affect our profitability.  Defaults on Agency MBS typically have the same effect as prepayments because of the underlying Agency guarantee.  On February 10, 2010, Fannie Mae and Freddie Mac announced their intention to significantly increase their purchases of delinquent loans from the pools of mortgages collateralizing their Agency MBS beginning in March 2010, which could materially impact the rate of principal prepayments on our Agency MBS guaranteed by these two GSEs.  As of December 31, 2009, we had net purchase premiums of $96.9 million, or 1.3% of current par value, on our Agency MBS and net purchase discounts of $603.1 million, or 36.8% of current par value, on our Non-Agency MBS.
 
Prepayments, which are the primary feature of MBS that distinguish them from other types of bonds, are difficult to predict and can vary significantly over time.  As the holder of MBS, on a monthly basis, we receive a payment equal to a portion of our investment principal in a particular MBS as the underlying mortgages are prepaid.  With respect to our Agency MBS, we typically receive notice of monthly principal prepayments on the fifth business day of each month (such day is commonly referred to as factor day) and receive the related scheduled payment on a specified later date, which for (a) Agency MBS guaranteed by Fannie Mae is the 25th day of that month (or next business day thereafter), (b) Agency MBS guaranteed by Freddie Mac is the 15th day of the following month (or next business day thereafter), and (c) Agency MBS guaranteed by Ginnie Mae is the 20th day of that month (or next business day thereafter).  With respect to our Non-Agency MBS, we typically receive notice of monthly principal prepayments and the related scheduled payment on the 25th day of each month (or next business day thereafter).  In general, on the date each month that principal prepayments are announced (i.e., factor day for Agency MBS), the value of our MBS pledged as collateral under our repurchase agreements is reduced by the amount of the prepaid principal and, as a result, our lenders will typically initiate a margin call requiring the pledge of additional collateral or cash, in an amount equal to such prepaid principal, in order to re-establish the required ratio of borrowing to collateral value under such repurchase agreements.  Accordingly, with respect to our Agency MBS, the announcement on factor day of principal prepayments is in advance of our receipt of the related scheduled payment, thereby creating a short-term receivable for us in the amount of any such principal prepayments; however, under our repurchase agreements, we may receive a margin call relating to the related reduction in value of our Agency MBS and, prior to receipt of this short-term receivable, be required to post collateral or cash in the amount of the principal prepayment on or about factor day, which would reduce and, depending on the magnitude of such principal prepayments, materially impact our liquidity during the period in which the short-term receivable is outstanding.  As a result, in order to meet any such margin calls, we could be forced to sell assets or take other actions in order to maintain liquidity.  Forced sales under adverse market conditions may result in lower sales prices than ordinary market sales made in the normal course of business.  If our MBS were liquidated at prices below our amortized cost (i.e., the cost basis) of such assets, we would incur losses, which could adversely affect our earnings.  In addition, in order to continue to earn a return on this prepaid principal, we must reinvest it in additional MBS or other assets; however, if interest rates decline, we may earn a lower return on our new investments as compared to the MBS that prepay.
 
Prepayments may have a negative impact on our financial results, the effects of which depend on, among other things, the timing and amount of the prepayment delay on our Agency MBS, the amount of unamortized premium on our prepaid MBS, the rate at which prepayments are made on our Non-Agency MBS, the reinvestment lag and the availability of suitable reinvestment opportunities.
 
 
Our business strategy involves a significant amount of leverage which may adversely affect our return on our investments and may reduce cash available for distribution to our stockholders as well as increase losses when economic conditions are unfavorable.
 
Pursuant to our leverage strategy, we borrow against a substantial portion of the market value of our MBS and use the borrowed funds to finance the acquisition of additional investment assets.  We are not required to maintain any particular debt-to-equity ratio.  Future increases in the amount by which the collateral value is required to contractually exceed the repurchase transaction loan amount, decreases in the market value of our MBS, increases in interest rate volatility and changes in the availability of acceptable financing could cause us to be unable to achieve the amount of leverage we believe to be optimal.  The return on our assets and cash available for distribution to our stockholders may be reduced to the extent that changes in market conditions prevent us from achieving the desired amount of leverage on our investments or cause the cost of our financing to increase relative to the income earned on our leveraged assets.  In addition, our payment of interest expense on our borrowings reduces cash flow available for distributions to our stockholders.  If the interest income on our MBS purchased with borrowed funds fails to cover the interest expense of the related borrowings, we will experience net interest losses and may experience net losses from operations.  Such losses could be significant as a result of our leveraged structure.  The use of borrowing, or “leverage,” to finance our MBS and other assets involves a number of other risks, including the following:
 
 
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Adverse developments involving major financial institutions or involving one of our lenders could result in a rapid reduction in our ability to borrow and adversely affect our business and profitability.  As of December 31, 2009, we had amounts outstanding under repurchase agreements with 17 separate lenders.  A material adverse development involving one or more major financial institutions or the financial markets in general could result in our lenders reducing our access to funds available under our repurchase agreements or terminating such repurchase agreements altogether.  Dramatic declines in the housing market, with decreasing home prices and increasing foreclosures and unemployment, have resulted in significant asset write-downs by financial institutions, which have caused many financial institutions to seek additional capital, to merge with other institutions and, in some cases, to fail.  Institutions from which we seek to obtain financing may have owned or financed residential mortgage loans, real estate-related securities and real estate loans which have declined in value and caused losses as a result of the downturn in the markets.  Many lenders and institutional investors have reduced and, in some cases, ceased to provide funding to borrowers, including other financial institutions.  If these conditions persist, these institutions may become insolvent or tighten their lending standards, which could make it more difficult for us to obtain acceptable financing or at all.  Because all of our repurchase agreements are uncommitted and renewable at the discretion of our lenders, these conditions could cause our lenders to determine to reduce or terminate our access to future borrowings, which could adversely affect our business and profitability.  Furthermore, if a number of our lenders became unwilling or unable to continue to provide us with financing, we could be forced to sell assets, including MBS in an unrealized loss position, in order to maintain liquidity.  Forced sales under adverse market conditions may result in lower sales prices than ordinary market sales made in the normal course of business.  If our MBS were liquidated at prices below our amortized cost (i.e., the cost basis) of such assets, we would incur losses, which could adversely affect our earnings.
 
 
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Our profitability may be limited by a reduction in our leverage.  As long as we earn a positive spread between interest and other income we earn on our leveraged assets and our borrowing costs, we can generally increase our profitability by using greater amounts of leverage.  We cannot, however, assure you that repurchase financing will remain an efficient source of long-term financing for our assets.  The amount of leverage that we use may be limited because our lenders might not make funding available to us at acceptable rates or they may require that we provide additional collateral to secure our borrowings.  If our financing strategy is not viable, we will have to find alternative forms of financing for our assets which may not be available to us on acceptable terms or at acceptable rates.  In addition, in response to certain interest rate and investment environments or to changes in market liquidity, we could adopt a strategy of reducing our leverage by selling assets or not reinvesting principal payments as MBS amortize and/or prepay, thereby decreasing the outstanding amount of our related borrowings.  Such an action could reduce interest income, interest expense and net income, the extent of which would be dependent on the level of reduction in assets and liabilities as well as the sale prices for which the assets were sold.
 
 
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If we are unable to renew our borrowings at acceptable interest rates, it may force us to sell assets and our profitability may be adversely affected.  Since we rely primarily on borrowings under repurchase
 
 
agreements to finance our MBS, our ability to achieve our investment objectives depends on our ability to borrow funds in sufficient amounts and on acceptable terms and on our ability to renew or replace maturing borrowings on a continuous basis.  Our repurchase agreement credit lines are renewable at the discretion of our lenders and, as such, do not contain guaranteed roll-over terms.  Our ability to enter into repurchase transactions in the future will depend on the market value of our MBS pledged to secure the specific borrowings, the availability of acceptable financing and market liquidity and other conditions existing in the lending market at that time.  If we are not able to renew or replace maturing borrowings, we could be forced to sell assets, including MBS in an unrealized loss position, in order to maintain liquidity.  Forced sales under adverse market conditions may result in lower sales prices than ordinary market sales made in the normal course of business.  If our MBS were liquidated at prices below our amortized cost (i.e., the cost basis) of such assets, we would incur losses, which could adversely affect our earnings.
 
 
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A decline in the market value of our assets may result in margin calls that may force us to sell assets under adverse market conditions.  In general, the market value of our MBS is impacted by changes in interest rates, prevailing market yields and other market conditions.  A decline in the market value of our MBS may limit our ability to borrow against such assets or result in lenders initiating margin calls, which require a pledge of additional collateral or cash to re-establish the required ratio of borrowing to collateral value, under our repurchase agreements.  Posting additional collateral or cash to support our credit will reduce our liquidity and limit our ability to leverage our assets, which could adversely affect our business.  As a result, we could be forced to sell a portion of our assets, including MBS in an unrealized loss position, in order to maintain liquidity.  Forced sales under adverse market conditions may result in lower sales prices than ordinary market sales made in the normal course of business.  If our MBS were liquidated at prices below our amortized cost (i.e., the cost basis) of such assets, we would incur losses, which could adversely affect our earnings.
 
 
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If a counterparty to our repurchase transactions defaults on its obligation to resell the underlying security back to us at the end of the transaction term or if we default on our obligations under the repurchase agreement, we could incur losses.  When we engage in repurchase transactions, we generally sell securities to lenders (i.e., repurchase agreement counterparties) and receive cash from such lenders.  The lenders are obligated to resell the same securities back to us at the end of the term of the transaction.  Because the cash we receive from the lender when we initially sell the securities to the lender is less than the value of those securities (this difference is referred to as the haircut), if the lender defaults on its obligation to resell the same securities back to us we would incur a loss on the transaction equal to the amount of the haircut (assuming there was no change in the value of the securities).  Generally, if we default on one of our obligations under a repurchase transaction with a particular lender, that lender can elect to terminate the transaction and cease entering into additional repurchase transactions with us.  Our repurchase agreements may also contain cross-default provisions, so that if a default occurs under any one agreement, the lenders under our other repurchase agreements could also declare a default.  Any losses we incur on our repurchase transactions could adversely affect our earnings and thus our cash available for distribution to our stockholders.
 
 
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Our use of repurchase agreements to borrow money may give our lenders greater rights in the event of bankruptcy.  Borrowings made under repurchase agreements may qualify for special treatment under the U.S. Bankruptcy Code.  If a lender under one of our repurchase agreements files for bankruptcy, it may be difficult for us to recover our assets pledged as collateral to such lender.  In addition, if we ever file for bankruptcy, lenders under our repurchase agreements may be able to avoid the automatic stay provisions of the Bankruptcy Code and take possession of, and liquidate, our collateral under our repurchase agreements without delay.
 
We have experienced declines in the market value of our assets.
 
A decline in the market value of our MBS or other assets may require us to recognize an “other-than-temporary” impairment against such assets under GAAP.  When the fair value of our MBS is less than its amortized cost, the security is considered impaired.  We assess our impaired securities on at least a quarterly basis and designate such impairments as either “temporary” or “other-than-temporary.”  If we intend to sell an impaired security, or it is more likely than not that we will be required to sell the impaired security before its anticipated recovery, then we must recognize an other-than-temporary impairment through earnings equal to the entire difference between the MBS amortized cost and its fair value at the balance sheet date.  If we do not expect to sell
 
 
an other-than-temporarily impaired security, only the portion of the other-than-temporary impairment related to credit losses is recognized through earnings with the remainder recognized as a component of other comprehensive income/(loss) on our balance sheet.  Impairments we recognize through other comprehensive income/(loss) do not impact our earnings.  Following the recognition of an other-than-temporary impairment through earnings, a new cost basis is established for the MBS and may not be adjusted for subsequent recoveries in fair value through earnings.  However, other-than-temporary impairments recognized through earnings may be accreted back to the amortized cost basis of the security on a prospective basis through interest income.  The determination as to whether an other-than-temporary impairment exists and, if so, the amount we consider other-than-temporarily impaired is subjective, as such determinations are based on both factual and subjective information available at the time of assessment.  As a result, the timing and amount of other-than-temporary impairments constitute material estimates that are susceptible to significant change.  During 2009 and historically, we have experienced declines in the fair value of our MBS and other assets which were determined to be other-than-temporary.  As a result, we recognized other-than-temporary impairments against such assets under GAAP.
 
Our investment strategy may involve credit risk.
 
The holder of a mortgage or MBS assumes a risk that the borrowers may default on their obligations to make full and timely payments of principal and interest.  Pursuant to our investment policy, we have the ability to acquire Non-Agency MBS and other investment assets of lower credit quality.  In general, Non-Agency MBS, carry greater investment risk than Agency MBS because they are not guaranteed as to principal and/or interest by the U.S. Government, any federal agency or any federally chartered corporation.  Unexpectedly high rates of default (e.g., in excess of the default rates forecasted) and/or higher than expected loss severities on the mortgages collateralizing our Non-Agency MBS may adversely affect the value of such assets.  Accordingly, Non-Agency MBS and other investment assets of lower credit quality could cause us to incur losses of income from, and/or losses in market value relating to, these assets if there are defaults of principal and/or interest on these assets.
 
We may have significant credit risk, especially on Non-Agency MBS, in certain geographic areas and may be disproportionately affected by economic or housing downturns, natural disasters, terrorist events, adverse climate changes or other adverse events specific to those markets.
 
A significant number of the mortgages collateralizing our MBS may be concentrated in certain geographic areas.  For example, with respect to our Non-Agency MBS portfolio, we have significantly higher exposure in California, Florida, New York, Virginia and Maryland and any event that adversely affects the economy or real estate market in these states could have a disproportionately adverse effect on our Non-Agency MBS portfolio.  In general, any material decline in the economy or significant difficulties in the real estate markets would be likely to cause a decline in the value of residential properties securing the mortgages in the relevant geographic area.  This, in turn, would increase the risk of delinquency, default and foreclosure on real estate collateralizing our Non-Agency MBS in this area.  This may then adversely affect our credit loss experience on our Non-Agency MBS in such area if unexpectedly high rates of default (e.g., in excess of the default rates forecasted) and/or higher than expected loss severities on the mortgages collateralizing such securities were to occur.
 
The occurrence of a natural disaster (such as an earthquake, tornado, hurricane or a flood) or a significant adverse climate change may cause a sudden decrease in the value of real estate and would likely reduce the value of the properties securing the mortgages collateralizing our Non-Agency MBS.  Since certain natural disasters may not typically be covered by the standard hazard insurance policies maintained by borrowers, the borrowers may have to pay for repairs due to the disasters.  Borrowers may not repair their property or may stop paying their mortgages under those circumstances.  This would likely cause defaults and credit loss severities to increase on the pool of mortgages securing our Non-Agency MBS which, unlike Agency MBS, are not guaranteed as to principal and/or interest by the U.S. Government, any federal agency or federally chartered corporation.
 
An increase in our borrowing costs relative to the interest we receive on our MBS may adversely affect our profitability.
 
Our earnings are primarily generated from the difference between the interest income we earn on our investment portfolio, less net amortization of purchase premiums and discounts, and the interest expense we pay on our borrowings.  We rely primarily on borrowings under repurchase agreements to finance the acquisition of MBS which have longer-term contractual maturities.  Even though most of our MBS have interest rates that adjust over time based on short-term changes in corresponding interest rate indexes, the interest we pay on our borrowings may
 
 
increase at a faster pace than the interest we earn on our MBS.  In general, if the interest expense on our borrowings increases relative to the interest income we earn on our MBS, our profitability may be adversely affected.
 
 
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Changes in interest rates, cyclical or otherwise, may adversely affect our profitability.  Interest rates are highly sensitive to many factors, including fiscal and monetary policies and domestic and international economic and political conditions, as well as other factors beyond our control.  In general, we finance the acquisition of our MBS through borrowings in the form of repurchase transactions, which exposes us to interest rate risk on the financed assets.  The cost of our borrowings is based on prevailing market interest rates.  Because the terms of our repurchase transactions typically range from one to six months at inception, the interest rates on our borrowings generally adjust more frequently (as new repurchase transactions are entered into upon the maturity of existing repurchase transactions) than the interest rates on our MBS.  During a period of rising interest rates, our borrowing costs generally will increase at a faster pace than our interest earnings on the leveraged portion of our MBS portfolio, which could result in a decline in our net interest spread and net interest margin.  The severity of any such decline would depend on our asset/liability composition, including the impact of hedging transactions, at the time as well as the magnitude and period over which interest rates increase.  Further, an increase in short-term interest rates could also have a negative impact on the market value of our MBS portfolio.  If any of these events happen, we could experience a decrease in net income or incur a net loss during these periods, which may negatively impact our distributions to stockholders.
 
 
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Hybrid MBS have fixed interest rates for an initial period which may reduce our profitability if short-term interest rates increase.  The mortgages collateralizing our MBS are primarily comprised of Hybrids, which have interest rates that are fixed for an initial period (typically three to ten years) and, thereafter, generally adjust annually to an increment over a pre-determined interest rate index.  Accordingly, during a period of rising interest rates, the cost of our borrowings (excluding any potential impact of hedging transactions) would increase while the interest income earned on our MBS portfolio would not increase with respect to those Hybrid MBS that were then in their initial fixed rate period.  If this were to happen, we could experience a decrease in net income or incur a net loss during these periods, which may negatively impact our distributions to stockholders.
 
 
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Interest rate caps on the mortgages collateralizing our MBS may adversely affect our profitability if short-term interest rates increase.  The coupons earned on ARM-MBS adjust over time as interest rates change (typically after an initial fixed-rate period for Hybrids).  The financial markets primarily determine the interest rates that we pay on the repurchase transactions used to finance the acquisition of our MBS; however, the level of adjustment to the interest rates earned on our ARM-MBS is typically limited by contract.  The interim and lifetime interest rate caps on the mortgages collateralizing our MBS limit the amount by which the interest rates on such assets can adjust.  Interim interest rate caps limit the amount interest rates on a particular ARM can adjust during any given year or period.  Lifetime interest rate caps limit the amount interest rates can adjust from inception through maturity of a particular ARM.  Our repurchase transactions are not subject to similar restrictions.  Accordingly, in a sustained period of rising interest rates or a period in which interest rates rise rapidly, we could experience a decrease in net income or a net loss because the interest rates paid by us on our borrowings (excluding the impact of hedging transactions) could increase without limitation (as new repurchase transactions are entered into upon the maturity of existing repurchase transactions) while increases in the interest rates earned on the mortgages collateralizing our MBS could be limited due to interim or lifetime interest rate caps.
 
 
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Adjustments of interest rates on our borrowings may not be matched to interest rate indexes on our MBS.  In general, the interest rates on our repurchase transactions are based on LIBOR, while the interest rates on our ARM-MBS may be indexed to LIBOR or another index rate, such as the one-year CMT rate, the Federal Reserve U.S. 12-month cumulative average one-year CMT (or MTA) or the 11th District Cost of Funds Index (or COFI).  Accordingly, any increase in LIBOR relative to one-year CMT rates, MTA or COFI will generally result in an increase in our borrowing costs that is not matched by a corresponding increase in the interest earned on our ARM-MBS.  Any such interest rate index mismatch could adversely affect our profitability, which may negatively impact our distributions to stockholders.
 
 
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A flat or inverted yield curve may adversely affect ARM-MBS prepayment rates and supply.  Our net interest income varies primarily as a result of changes in interest rates as well as changes in interest rates across the yield curve.  When the differential between short-term and long-term benchmark interest rates narrows, the yield curve is said to be “flattening.”  We believe that when the yield curve is relatively flat,
 
 
borrowers have an incentive to refinance into Hybrids with longer initial fixed-rate periods and fixed rate mortgages, causing our MBS to experience faster prepayments.  In addition, a flatter yield curve generally leads to fixed-rate mortgage rates that are closer to the interest rates available on ARMs, potentially decreasing the supply of ARM-MBS.  At times, short-term interest rates may increase and exceed long-term interest rates, causing an inverted yield curve.  When the yield curve is inverted, fixed-rate mortgage rates may approach or be lower than mortgage rates on ARMs, further increasing ARM-MBS prepayments and further negatively impacting ARM-MBS supply.  Increases in prepayments on our MBS portfolio cause our premium amortization to accelerate, lowering the yield on such assets.  If this happens, we could experience a decrease in net income or incur a net loss during these periods, which may negatively impact our distributions to stockholders.
 
Our use of hedging strategies to mitigate our interest rate exposure may not be effective and may expose us to counterparty risks.
 
In accordance with our operating policies, we may pursue various types of hedging strategies, including Swaps, interest rate cap agreements (or Caps) and other derivative transactions, to seek to mitigate or reduce our exposure to losses from adverse changes in interest rates.  Our hedging activity will vary in scope based on the level and volatility of interest rates, the type of assets held and financing sources used and other changing market conditions.  No hedging strategy, however, can completely insulate us from the interest rate risks to which we are exposed and there is no guarantee that the implementation of any hedging strategy would have the desired impact on our results of operations or financial condition.  Certain of the U.S. federal income tax requirements that we must satisfy in order to qualify as a REIT may limit our ability to hedge against such risks.  We will not enter into derivative transactions if we believe that they will jeopardize our qualification as a REIT.
 
Interest rate hedging may fail to protect or could adversely affect us because, among other things:
 
 
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interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;
 
 
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available interest rate hedges may not correspond directly with the interest rate risk for which protection is sought;
 
 
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the duration of the hedge may not match the duration of the related liability;
 
 
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the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and
 
 
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the party owing money in the hedging transaction may default on its obligation to pay.
 
We primarily use Swaps to hedge against future increases in interest rates on our repurchase agreements.  Should a Swap counterparty be unable to make required payments pursuant to such Swap, the hedged liability would cease to be hedged for the remaining term of the Swap.  In addition, we may be at risk for any collateral held by a hedging counterparty to a Swap, should such counterparty become insolvent or file for bankruptcy.  Our hedging transactions, which are intended to limit losses, may actually adversely affect our earnings, which could reduce our cash available for distribution to our stockholders.
 
Hedging instruments involve risk since they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities.  Consequently, there are no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions.  Furthermore, the enforceability of hedging instruments may depend on compliance with applicable statutory and commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements.  The business failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in its default.  Default by a party with whom we enter into a hedging transaction may result in a loss and force us to cover our commitments, if any, at the then current market price.  Although generally we will seek to reserve the right to terminate our hedging positions, it may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty and we may not be able to enter into an offsetting contract in order to cover our risk.  We cannot assure you that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.
 
 
We may enter into hedging instruments that could expose us to contingent liabilities in the future.
 
Subject to maintaining our qualification as a REIT, part of our financing strategy will involve entering into hedging instruments that could require us to fund cash payments in certain circumstances (e.g., the early termination of a hedging instrument caused by an event of default or other voluntary or involuntary termination event or the decision by a hedging counterparty to request the posting of collateral it is contractually owed under the terms of a hedging instrument).  With respect to the termination of an existing Swap, the amount due would generally be equal to the unrealized loss of the open Swap position with the hedging counterparty and could also include other fees and charges.  These economic losses will be reflected in our financial results of operations and our ability to fund these obligations will depend on the liquidity of our assets and access to capital at the time.  Any losses we incur on our hedging instruments could adversely affect our earnings and thus our cash available for distribution to our stockholders.
 
We may change our investment strategy, operating policies and/or asset allocations without stockholder consent.
 
We may change our investment strategy, operating policies and/or asset allocation with respect to investments, acquisitions, leverage, growth, operations, indebtedness, capitalization and distributions at any time without the consent of our stockholders.  A change in our investment strategy may increase our exposure to interest rate and/or credit risk, default risk and real estate market fluctuations.  Furthermore, a change in our asset allocation could result in our making investments in asset categories different from our historical investments.  These changes could adversely affect our financial condition, results of operations, the market price of our common stock or our ability to pay dividends or make distributions.
 
We have not established a minimum dividend payment level.
 
We intend to pay dividends on our common stock in an amount equal to at least 90% of our REIT taxable income, which is calculated generally before the dividends paid deduction and excluding net capital income, in order to maintain our qualification as a REIT for U.S. federal income tax purposes.  Dividends will be declared and paid at the discretion of our Board and will depend on our REIT taxable earnings, our financial condition, maintenance of our REIT qualification and such other factors as our Board may deem relevant from time to time.  We have not established a minimum dividend payment level for our common stock and our ability to pay dividends may be negatively impacted by adverse changes in our operating results.
 
We are dependent on our executive officers and key personnel for our success.
 
Our success is dependent upon the efforts, experience, diligence, skill and network of business contacts of our executive officers and key personnel.  The departure of any of our executive officers and/or key personnel could have a material adverse effect on our operations and performance.
 
We are dependent on information systems and systems’ failures could significantly disrupt our business.
 
Our business is highly dependent on our communications and information systems.  Any failure or interruption of our systems could cause delays or other problems in our securities trading activities, which could have a material adverse effect on our operation and performance.
 
We may be subject to risks associated with our investment in real property.
 
Real property investments are subject to varying degrees of risk.  The economic returns from our indirect investment in Lealand Place, a 191-unit multi-family apartment property located in Lawrenceville, Georgia (or Lealand), may be impacted by a number of factors, including general and local economic conditions, the relative supply of apartments and other housing in the area, interest rates on mortgage loans, the need for and costs of repairs and maintenance of the property, government regulations and the cost of complying with them, taxes, inflation and certain types of uninsured extraordinary losses, such as natural disasters and extreme climate-related issues.  In general, local conditions in the applicable market area significantly affect occupancy or rental rates for multi-family apartment properties.  Real property investments are relatively illiquid and, therefore, we will have limited ability to dispose of our investment quickly in response to changes in economic or other conditions.  In addition, under certain circumstances, we may be subject to significant tax liability in the event that we sell our investment in the property.
 
 
Under various federal, state and local environmental laws, regulations and ordinances, we may be required, regardless of knowledge or responsibility, to investigate and remediate the effects of hazardous or toxic substances or petroleum product releases at the property and may be held liable to a governmental entity or to third parties for property or personal injury damages and for investigation and remediation costs incurred as a result of contamination.  These damages and costs may be substantial.  The presence of such substances, or the failure to properly remediate the contamination, may adversely affect our ability to borrow against, sell or rent the affected property.  We must operate the property in compliance with numerous federal, state and local laws and regulations, including landlord tenant laws, the Americans with Disabilities Act of 1990 and other laws generally applicable to business operations.  Noncompliance with such laws could expose us to liability.
 
We operate in a highly competitive market for investment opportunities and competition may limit our ability to acquire desirable investment securities.
 
We operate in a highly competitive market for investment opportunities.  Our profitability depends, in large part, on our ability to acquire MBS or other investment securities at favorable prices.  In acquiring our investment securities, we compete with a variety of institutional investors, including other REITs, public and private funds, commercial and investment banks, commercial finance and insurance companies and other financial institutions.  Many of our competitors are substantially larger and have considerably greater financial, technical, marketing and other resources than we do.  Some competitors may have a lower cost of funds and access to funding sources that are not available to us.  Many of our competitors are not subject to the operating constraints associated with REIT compliance or maintenance of an exemption from the Investment Company Act.  In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish additional business relationships than us.  Furthermore, government or regulatory action and competition for investment securities of the types and classes which we acquire may lead to the price of such assets increasing, which may further limit our ability to generate desired returns.  We cannot assure you that the competitive pressures we face will not have a material adverse effect on our business, financial condition and results of operations.  Also, as a result of this competition, desirable investments may be limited in the future and we may not be able to take advantage of attractive investment opportunities from time to time, as we can provide no assurance that we will be able to identify and make investments that are consistent with our investment objectives.
 
Our qualification as a REIT.
 
We have elected to qualify as a REIT and intend to comply with the provisions of the Internal Revenue Code of 1986, as amended (or the Code).  Accordingly, we will not be subjected to income tax to the extent we distribute 100% of our REIT taxable income (which is generally ordinary income, computed by excluding the dividends paid deduction, income from prohibited transactions, income from foreclosure property and any net capital income) to stockholders and provided that we comply with certain income, asset and ownership tests applicable to REITs.  We believe that we currently meet all of the REIT requirements and, therefore, continue to qualify as a REIT under the provisions of the Code.  Many of the REIT requirements, however, are highly technical and complex.  The determination that we are a REIT requires an analysis of various factual matters and circumstances, some of which may not be totally within our control and some of which involve interpretation.  For example, as set forth in the REIT tax laws, to qualify as a REIT, annually at least 75% of our gross income must come from, among other sources, interest on obligations secured by mortgages on real property or interests in real property, gain from the disposition of non-dealer real property, including mortgages or interest in real property, dividends, other distributions and gains from the disposition of shares in other REITs, commitment fees received for agreements to make real estate loans and certain temporary investment income.  In addition, the composition of our assets must meet certain requirements at the close of each quarter.  There can be no assurance that the Internal Revenue Service (or IRS) or a court would agree with any conclusions or positions we have taken in interpreting the REIT requirements.  Also in order to maintain our qualification as a REIT, we must distribute at least 90% of our REIT taxable income on an annual basis to our stockholders.  Such dividend distribution requirement limits the amount of cash we have available for other business purposes, including amounts to fund our growth.  Also, it is possible that because of differences in timing between the recognition of taxable income and the actual receipt of cash, we may have to borrow funds on a short-term basis to meet the 90% dividend distribution requirement.  Even a technical or inadvertent mistake could jeopardize our REIT qualification unless we meet certain statutory relief provisions.  Furthermore, Congress and the IRS might make changes to the tax laws and regulations, and the courts might issue new rulings, that make it more difficult or impossible for us to remain qualified as a REIT.
 
 
If we fail to qualify as a REIT in any taxable year, and we do not qualify for certain statutory relief provisions, we would be required to pay U.S. federal income tax on our taxable income, and distributions to our stockholders would not be deductible by us in determining our taxable income.  In such a case, we might need to borrow money or sell assets in order to pay our taxes.  Our payment of income tax would decrease the amount of our income available for distribution to our stockholders.  Furthermore, if we fail to maintain our qualification as a REIT, we no longer would be required to distribute substantially all of our taxable income to our stockholders.  In addition, unless we were eligible for certain statutory relief provisions, we could not re-elect to qualify as a REIT until the fifth calendar year following the year in which we failed to qualify.
 
Even if we qualify as a REIT for U.S. federal income tax purposes, we may be required to pay certain federal, state and local taxes on our income.  Any of these taxes will reduce our operating cash flow.
 
Compliance with securities laws and regulations could be costly.
 
The SOX Act and the rules and regulations promulgated by the SEC and the New York Stock Exchange affect the scope, complexity and cost of corporate governance, regulatory compliance and reporting, and disclosure practices.  We believe that these rules and regulations will continue to make it costly for us to obtain director and officer liability insurance and we may be required to accept reduced coverage or incur substantially higher costs to obtain the same coverage.  These rules and regulations could also make it more difficult for us to attract and retain qualified members of management and our Board (particularly with respect to Board members serving on our Audit Committee).
 
In addition, our management is required to deliver a report that assesses the effectiveness of our internal controls over financial reporting, pursuant to Section 302 of the SOX Act.  Section 404 of the SOX Act requires our independent registered public accounting firm to deliver an attestation report on management’s assessment of, and the operating effectiveness of, our internal controls over financial reporting in conjunction with their opinion on our audited financial statements as of each December 31.  We cannot give any assurances that material weaknesses will not be identified in the future in connection with our compliance with the provisions of Sections 302 and 404 of the SOX Act.  The existence of any such material weakness would preclude a conclusion by management and our independent auditors that we maintained effective internal control over financial reporting.  Our management may be required to devote significant time and expense to remediate any material weaknesses that may be discovered and may not be able to remediate any material weaknesses in a timely manner.  The existence of any material weakness in our internal control over financial reporting could also result in errors in our financial statements that could require us to restate our financial statements, cause us to fail to meet our reporting obligations and cause stockholders to lose confidence in our reported financial information, all of which could lead to a decline in the market price of our capital stock.
 
Loss of our Investment Company Act exemption would adversely affect us.
 
We intend to conduct our business so as to maintain our exempt status under, and not to become regulated as an investment company for purposes of, the Investment Company Act.  The Investment Company Act exempts entities that are “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.”  Under current interpretations of the SEC staff, this exemption generally means that at least 55% of our assets must be comprised of qualifying assets and at least 80% of our portfolio must be comprised of qualifying assets and real estate-related assets under the Investment Company Act.  Qualifying assets for this purpose include whole pool Agency MBS that the SEC staff in various no-action letters has determined are the functional equivalent of mortgage loans for the purposes of the Investment Company Act.  We intend to treat as real estate-related assets MBS that do not represent all of the certificates issued with respect to the entire pool of mortgages.  Compliance with this exemption limits the types of assets we may acquire from time to time.  In addition, although we intend to monitor our portfolio periodically and prior to each investment acquisition, there can be no assurance that we will be able to maintain this exemption.  Further, to the extent that the SEC staff provides different guidance regarding any of the matters bearing upon this exemption, we may be required to adjust our strategy which may require us to sell a substantial portion of our assets under potentially adverse market conditions or acquire assets in order for us to regain compliance.  If we fail to maintain our exempt status under the Investment Company Act and become regulated as an investment company, our ability to, among other things, use leverage would be substantially reduced and, as a result, we would be unable to conduct our business as described in this annual report on Form 10-K.
 
 
Item 1B.  Unresolved Staff Comments.
 
None.
 
Item 2.     Properties.
 
Executive Offices
 
We have a lease for our corporate headquarters in New York, New York which extends through April 30, 2017 and provides for aggregate cash payments ranging over time from approximately $1.1 million to $1.4 million per year, paid on a monthly basis, exclusive of escalation charges and landlord incentives.  In connection with this lease, we established a $350,000 irrevocable standby letter of credit in lieu of lease security through April 30, 2017.  The letter of credit may be drawn upon by the landlord in the event that we default under certain terms of the lease.  In addition, we have a lease through December 2011 for our off-site back-up facility located in Rockville Centre, New York, which provides for, among other things, rent of approximately $29,000 per year, paid on a monthly basis.  We believe that our current facilities are adequate to meet our needs in the foreseeable future.
 
Properties Owned Through Subsidiary Corporations
 
At December 31, 2009, we indirectly owned 100% interest in Lealand, an apartment property located at 2945 Cruse Road, Lawrenceville, Georgia.  (See Note 6 to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
 
Item 3.     Legal Proceedings.
 
The Company is not a party to any legal proceedings.
 
To date, we have not been required to make any payments to the IRS as a penalty for failing to make disclosures required with respect to certain transactions that have been identified by the IRS as abusive or that have a significant tax avoidance purpose.
 
Item 4.     Submission of Matters to a Vote of Security Holders.
 
None.
 
Item 4A.  Executive Officers of the Company.
 
The following table sets forth certain information with respect to each of our executive officers at December 31, 2009.  The Board appoints or annually reaffirms the appointment of all of our executive officers:
 
Officer
  
Age
  
Position Held
Stewart Zimmerman
  
65
  
Chairman of the Board and Chief Executive Officer
William S. Gorin
  
51
  
President and Chief Financial Officer
Ronald A. Freydberg
  
49
  
Executive Vice President and Chief Investment and Administrative Officer
Craig L. Knutson
  
50
  
Executive Vice President – Investments
Teresa D. Covello
  
44
  
Senior Vice President, Chief Accounting Officer and Treasurer
Timothy W. Korth
  
44
  
General Counsel, Senior Vice President and Corporate Secretary
Kathleen A. Hanrahan
  
44
  
Senior Vice President – Accounting

Stewart Zimmerman has served as our Chief Executive Officer and a Director since 1997 and was appointed Chairman of the Board during 2003.  From 1997 through 2008, Mr. Zimmerman also served as our President.  From 1989 through 1997, he initially served as a consultant to The America First Companies and became Executive Vice President of America First Companies, L.L.C.  During this time, he held a number of positions:  President and Chief Operating Officer of America First REIT, Inc. and President of several mortgage funds, including America First Participating/Preferred Equity Mortgage Fund, America First PREP Fund 2, America First PREP Fund II Pension Series L.P., Capital Source L.P., Capital Source II L.P.-A, America First Tax Exempt Mortgage Fund Limited Partnership and America First Tax Exempt Fund 2-Limited Partnership.  Previously, Mr. Zimmerman held various progressive positions with other companies, including Security Pacific Merchant Bank, EF Hutton & Company Inc., Lehman Brothers, Bankers Trust Company and Zenith Mortgage Company.  Mr. Zimmerman holds a Bachelors of Arts degree from Michigan State University.
 
 
William S. Gorin serves as our President and Chief Financial Officer.  He served as Executive Vice President from 1997 through his appointment as our President during 2008, and has been our Chief Financial Officer since 2001.  Mr. Gorin has also served as our Secretary and Treasurer.  From 1989 to 1997, Mr. Gorin held various positions with PaineWebber Incorporated/Kidder, Peabody & Co. Incorporated, serving as a First Vice President in the Research Department.  Prior to that position, Mr. Gorin was Senior Vice President in the Special Products Group.  From 1982 to 1988, Mr. Gorin was employed by Shearson Lehman Hutton, Inc./E.F. Hutton & Company Inc. in various positions in corporate finance and direct investments.  Mr. Gorin has a Masters of Business Administration degree from Stanford University and a Bachelor of Arts degree in Economics from Brandeis University.
 
Ronald A. Freydberg serves as our Executive Vice President and Chief Investment and Administrative Officer.  He served as Executive Vice President and Chief Investment Officer through his appointment as our Chief Investment and Administrative Officer in 2009 and as Executive Vice President and Chief Portfolio Officer from 2001 through his appointment as Chief Investment Officer during 2008.  From 1997 to 2001, he served as our Senior Vice President.  From 1995 to 1997, Mr. Freydberg served as a Vice President of Pentalpha Capital, in Greenwich, Connecticut, where he was a fixed-income quantitative analysis and structuring specialist.  From 1988 to 1995, Mr. Freydberg held various positions with J.P. Morgan & Co.  From 1994 to 1995, he was with the Global Markets Group.  In that position, he was involved in commercial mortgage-backed securitization and sale of distressed commercial real estate, including structuring, due diligence and marketing.  From 1985 to 1988, Mr. Freydberg was employed by Citicorp.  Mr. Freydberg holds a Masters of Business Administration from George Washington University and a Bachelor of Arts degree in Business Administration from Muhlenberg College.
 
Craig L. Knutson serves as our Executive Vice President - Investments.  He served as Senior Vice President during 2008 through his appointment as Executive Vice President during 2009.  From 2004 to 2007, Mr. Knutson served as Senior Executive Vice President of CBA Commercial, LLC, an acquirer and securitizer of small balance commercial mortgages.  From 2001 to 2004, Mr. Knutson served as President and Chief Operating Officer of ARIASYS Inc.  From 1986 to 1999, Mr. Knutson held various progressive positions in the mortgage trading departments of First Boston Corporation (later Credit Suisse), Smith Barney and Morgan Stanley.  In these capacities, Mr. Knutson traded Agency and private label MBS as well as whole loans (unsecuritized mortgages).  From 1981 to 1984, Mr. Knutson served as an Analyst and then Associate in the Investment Banking Department of E.F. Hutton & Company Inc. Mr. Knutson holds a Masters of Business Administration degree from Harvard University and a Bachelor of Arts degree in Economics and French from Hamilton College.
 
Teresa D. Covello serves as our Senior Vice President, Chief Accounting Officer and Treasurer, which positions she was appointed to in 2003.  From 2001 to 2003, Ms. Covello served as our Senior Vice President and Controller.  From 2000 until joining us in 2001, Ms. Covello was a self-employed financial consultant, concentrating in investment banking within the financial services sector.  From 1990 to 2000, she was the Director of Financial Reporting and served on the Strategic Planning Team for JSB Financial, Inc.  Ms. Covello began her career in public accounting with KPMG Peat Marwick (predecessor to KPMG LLP).  She currently serves as a director and president of the board of directors of Commerce Plaza, Inc., a not-for-profit organization.  Ms. Covello is a Certified Public Accountant and has a Bachelor of Science degree in Public Accounting from Hofstra University.
 
Timothy W. Korth II serves as our General Counsel, Senior Vice President and Corporate Secretary, which positions he has held since July 2003.  From 2001 to 2003, Mr. Korth was a Counsel at the law firm of Clifford Chance US LLP, where he specialized in corporate and securities transactions involving REITs and other real estate companies and, prior to such time, had practiced law with that firm and its predecessor, Rogers & Wells LLP, since 1992.  Mr. Korth is admitted as an attorney in the State of New York and has a Juris Doctor and a Bachelor of Business Administration degree in Finance from the University of Notre Dame.
 
Kathleen A. Hanrahan serves as our Senior Vice President – Accounting, which position she was appointed to in May 2008.  From 2007 until joining us in 2008, Ms. Hanrahan was Vice President – Financial Reporting with Arbor Commercial Mortgage LLC.  From 1997 to 2006, she was the First Vice President of Financial Reporting and served on the Disclosure, Corporate Benefits and Sarbanes-Oxley Committees for Independence Community Bank Corp.  From 1992 – 1997, Ms. Hanrahan held various positions, including Controller, with North Side Savings Bank.  Ms. Hanrahan began her career in public accounting with KPMG Peat Marwick (predecessor to KPMG LLP).  Ms. Hanrahan is a Certified Public Accountant and has a Bachelor of Business Administration degree in Public Accounting from Pace University.
 
 
PART II
 

Item 5.     Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
 
Market Information
 
Our common stock is listed on the New York Stock Exchange, under the symbol “MFA.”  On February 8, 2010, the last sales price for our common stock on the New York Stock Exchange was $7.32 per share.  The following table sets forth the high and low sales prices per share of our common stock during each calendar quarter for the years ended December 31, 2009 and 2008:
 
   
2009
  
2008
Quarter Ended
  
High
  
Low
  
High
  
Low
March 31
  
$  6.36
  
$   5.03
  
$  11.07
  
$    5.00
June 30
  
$  6.95
  
$   5.42
  
$    7.47
  
$    6.10
September 30
  
$  8.39
  
$   6.56
  
$    7.70
  
$    5.24
December 31
  
$  8.11
  
$   7.12
  
$    6.36
  
$    3.98
 
Holders
 
As of February 2, 2010, we had 833 registered holders and approximately 55,361 beneficial owners of our common stock.  Such information was obtained through our registrar and transfer agent, based on the results of a broker search.
 
Dividends
 
No dividends may be paid on our common stock unless full cumulative dividends have been paid on our preferred stock.  We have paid full cumulative dividends on our preferred stock on a quarterly basis through December 31, 2009.  We have historically declared cash dividends on our common stock on a quarterly basis.  During 2009 and 2008, we declared total cash dividends to holders of our common stock of $250.6 million ($0.99 per share) and $158.5 million ($0.81 per share), respectively.  In general, our common stock dividends have been characterized as ordinary income to our stockholders for income tax purposes.  However, a portion of our common stock dividends may, from time to time, be characterized as capital gains or return of capital.  For 2009 and 2008, our common stock dividends were characterized as ordinary income to stockholders.  (For additional dividend information, see Notes 10(a) and 10(b) to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
 
We elected to be taxed as a REIT for U.S. federal income tax purposes commencing with our taxable year ended December 31, 1998 and, as such, have distributed and anticipate distributing annually at least 90% of our REIT taxable income.  Although we may borrow funds to make distributions, cash for such distributions has generally been, and is expected to continue to be, largely generated from our results of our operations.
 
We declared and paid the following dividends on our common stock during the years 2009 and 2008:
 
Year
  
Declaration Date
  
Record Date
  
Payment Date
  
Dividend
per Share
2009
  
April 1, 2009
  
April 13, 2009
  
April 30, 2009
  
$     0.22
   
July 1, 2009
  
July 13, 2009
  
July 31, 2009
  
$     0.25
   
October 1, 2009
  
October 13, 2009
  
October 30, 2009
  
$     0.25
   
December 16, 2009
  
December 31, 2009
  
January 29, 2010
  
$     0.27
                 
2008
  
April 1, 2008
  
April 14, 2008
  
April 30, 2008
  
$     0.18
   
July 1, 2008
  
July 14, 2008
  
July 31, 2008
  
$     0.20
   
October 1, 2008
  
October 14, 2008
  
October 31, 2008
  
$     0.22
   
December 11, 2008
  
December 31, 2008
  
January 30, 2009
  
$     0.21 (1)
 
(1)
For income tax purposes, a portion of the dividend declared on December 11, 2008 was treated as a dividend for stockholders in 2009.
 
 
Dividends are declared and paid at the discretion of our Board and depend on our cash available for distribution, financial condition, ability to maintain our qualification as a REIT, and such other factors that our Board may deem relevant.  We have not established a minimum payout level for our common stock.  See Item 1A, “Risk Factors”, and Item 7, “Management’s Discussion and Analysis of Financial Conditions and Results of Operations”, of this annual report on Form 10-K, for information regarding the sources of funds used for dividends and for a discussion of factors, if any, which may adversely affect our ability to pay dividends.
 
Discount Waiver, Direct Stock Purchase and Dividend Reinvestment Plan
 
In September 2003, we initiated a Discount Waiver, Direct Stock Purchase and Dividend Reinvestment Plan (or the DRSPP) to provide existing stockholders and new investors with a convenient and economical way to purchase shares of our common stock.  Under the DRSPP, existing stockholders may elect to automatically reinvest all or a portion of their cash dividends in additional shares of our common stock and existing stockholders and new investors may make optional cash purchases of shares of our common stock in amounts ranging from $50 (or $1,000 for new investors) to $10,000 on a monthly basis and, with our prior approval, in excess of $10,000.  At our discretion, we may issue shares of our common stock under the DRSPP at discounts of up to 5% from the prevailing market price at the time of purchase.  The Bank of New York Mellon is the administrator of the DRSPP (or the Plan Agent).  Stockholders who own common stock that is registered in their own name and want to participate in the DRSPP must deliver a completed enrollment form to the Plan Agent.  Stockholders who own common stock that is registered in a name other than their own (e.g., broker, bank or other nominee) and want to participate in the DRSPP must either request such nominee holder to participate on their behalf or request that such nominee holder re-register our common stock in the stockholder’s name and deliver a completed enrollment form to the Plan Agent.  Additional information regarding the DRSPP (including a DRSPP prospectus) and enrollment forms are available online from the Plan Agent via Investor Service Direct at www.bnymellon.com/shareowner/isd or from our website at www.mfa-reit.com.  During 2009, we sold 59,090 shares of common stock through the DRSPP generating net proceeds of $394,854.
 
Controlled Equity Offering Program
 
On August 20, 2004, we initiated a controlled equity offering program (or the CEO Program) through which we may, from time to time, publicly offer and sell shares of our common stock through Cantor Fitzgerald & Co. (or Cantor) in privately negotiated and/or at-the-market transactions.  During 2009, we issued 2,810,000 shares of common stock in at-the-market transactions through our CEO Program, raising net proceeds of $16,355,764 and, in connection with these transactions, paid Cantor fees and commissions of $333,791.
 
Securities Authorized For Issuance Under Equity Compensation Plans
 
During 2004, we adopted the 2004 Equity Compensation Plan (or the 2004 Plan), as approved by our stockholders.  During 2008, the 2004 Plan was amended by the Board to bring it into compliance with Section 409A of the Code.  (For a description of the 2004 Plan, see Note 12(a) to the consolidated financial statements included under Item 8 of this annual report on Form 10-K.)
 
The following table presents certain information about our equity compensation plans as of December 31, 2009:
 
Plan Category
  
Number of securities to be issued upon exercise of outstanding options, warrants and rights
  
Weighted-average exercise price of outstanding options, warrants and rights
  
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in the first column of this table)
Equity compensation plans approved by stockholders
  
532,000
  
$ 10.14
  
1,123,974
Equity compensation plans not approved by stockholders
  
-
  
-
  
-
  Total
  
532,000
  
$ 10.14
  
1,123,974
 
 
Item 6.  Selected Financial Data.
 
Our selected financial data set forth below is derived from our audited financial statements and should be read in conjunction with our consolidated financial statements and the accompanying notes, included under Item 8 of this annual report on Form 10-K.
 
   
At or For the Year Ended December 31,
  
(In Thousands, Except per Share Amounts)
  
2009
    
2008
    
2007
    
2006
    
2005
  
Operating Data:
                              
Interest and dividend income on investment securities
   $ 504,464     $ 519,788     $ 380,328     $ 216,871     $ 235,798  
Interest income on cash and cash equivalent investments
     1,097       7,729       4,493       2,321       2,921  
Interest expense
     (229,406 )     (342,688 )     (321,305 )     (181,922 )     (183,833 )
Gain on MBS Forwards, net
     8,829       -       -       -       -  
Net gain/(loss) on sale of investment securities (1)
     22,617       (24,530 )     (21,793 )     (23,113 )     (18,354 )
Loss on termination of Swaps, net (2)
     -       (92,467 )     (384 )     -       -  
Impairments recognized in earnings (3)
     (17,928 )     (5,051 )     -       -       (20,720 )
Other income
     1,563       1,901       2,317       2,264       1,811  
Operating and other expense
     (23,047 )     (18,885 )     (13,446 )     (11,185 )     (10,829 )
Income from continuing operations
     268,189       45,797       30,210       5,236       6,794  
Discontinued operations, net
     -       -       -       3,522       (86 )
Net income
   $ 268,189     $ 45,797     $ 30,210     $ 8,758     $ 6,708  
Preferred stock dividends
     8,160       8,160       8,160       8,160       8,160  
Net income/(loss) to common stockholders
   $ 260,029     $ 37,637     $ 22,050     $ 598     $ (1,452 )
Income/(loss) per common share from continuing
  operations – basic and diluted
   $ 1.06     $ 0.21     $ 0.24     $ (0.03 )   $ (0.02 )
Income per common share from discontinued operations – basic and diluted
   $ -     $ -     $ -     $ 0.04     $ -  
Income/(loss) per common share – basic and diluted
   $ 1.06     $ 0.21     $ 0.24     $ 0.01     $ (0.02 )
Dividends declared per share of common stock (4)
   $ 0.990     $ 0.810     $ 0.415     $ 0.210     $ 0.405  
Dividends declared per share of preferred stock
   $ 2.125     $ 2.125     $ 2.125     $ 2.125     $ 2.125  
                                         
Balance Sheet Data:
                                        
Investment securities
   $ 8,757,954     $ 10,122,583     $ 8,302,797     $ 6,340,668     $ 5,714,906  
Total assets
     9,627,209       10,641,419       8,605,859       6,443,967       5,846,917  
Repurchase agreements
     7,195,827       9,038,836       7,526,014       5,722,711       5,099,532  
Preferred stock, liquidation preference
     96,000       96,000       96,000       96,000       96,000  
Total stockholders’ equity
     2,168,262       1,257,077       927,263       678,558       661,102  
 
(1)
2009:  During 2009, we sold 36 of our longer-term Agency MBS with an amortized cost of $628.3 million for $650.9 million, realizing gross gains of $22.6 million.  2008:  In response to tightening of market credit conditions in the first quarter, we adjusted our balance sheet strategy, decreasing our target debt-to-equity multiple range from 8x to 9x to 7x to 9x.  In order to implement this strategy, we reduced our borrowings, by selling MBS with an amortized cost of $1.876 billion, realizing aggregate net losses of $24.5 million, comprised of gross losses of $25.1 million and gross gains of $571,000.  2007:  We selectively sold $844.5 million of Agency and AAA rated MBS, realizing a net loss of $21.8 million.  2006 and 2005: Beginning in the fourth quarter of 2005 through the second quarter of 2006, we reduced our asset base through a strategy under which we, among other things, sold our higher duration and lower yielding MBS.  During 2006, we sold approximately $1.844 billion of MBS, realizing net losses of $23.1 million, comprised of gross losses of $25.2 million and gross gains of $2.1 million, and, during 2005, sold $564.8 million of MBS, which resulted in an $18.4 million loss on sale.  (See Note (3) below.)
 
(2)
In March 2008, we terminated 48 Swaps, with an aggregate notional amount of $1.637 billion, in connection with the repayment of the repurchase agreements hedged by such Swaps.  These transactions resulted in the Company recognizing net losses of $91.5 million.  (See Note (1), above).  In addition, during 2008, we recognized losses of $986,000 in connection with two Swaps terminated in connection with the bankruptcies related to Lehman Brothers Holdings Inc. (or Lehman) in September 2008.
 
(3)
2009:  Reflects total other-than-temporary impairment losses of $85.1 million on Non-Agency MBS acquired prior to July 2007, of which $17.9 million was credit related and recognized through earnings and $67.2 million was related to other factors and recognized in other comprehensive income.  2008:  Includes impairments of $5.1 million, of which $4.9 million reflected a full write-off of two unrated investment securities and $183,000 was an impairment charge against one Non-Agency MBS that was rated BB.  2005: As part of a repositioning of our MBS portfolio, at December 31, 2005 we determined that we no longer had the intent to continue to hold certain MBS that were in an unrealized loss position.  As a result, we recognized other-than-temporary impairment charges of $20.7 million against 30 MBS with an amortized cost of $842.2 million.  The subsequent sale of these securities during 2006 resulted in a gain/recovery of $1.6 million.
 
(4)
We generally declare dividends on our common stock in the month subsequent to the end of each calendar quarter, with the exception of the fourth quarter dividend, which is typically declared during the fourth calendar quarter for tax reasons.
 
 
Item 7.     Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
The following discussion should be read in conjunction with our financial statements and accompanying notes included in Item 8 of this annual report on Form 10-K.
 
GENERAL
 
Our principal business objective is to generate net income for distribution to our stockholders resulting from the difference between the interest and other income we earn on our investments and the interest expense we pay on the borrowings that we use to finance our leveraged investments and our operating costs.
 
At December 31, 2009, we had total assets of $9.627 billion, of which $8.758 billion, or 91.0%, represented our MBS portfolio.  At such date, our MBS portfolio was comprised of $7.665 billion of Agency MBS and $1.093 billion of Non-Agency MBS, of which 99.8% represented the senior most tranches within the MBS structure.  Our remaining investment-related assets were primarily comprised of cash and cash equivalents, MBS Forwards, restricted cash and MBS-related receivables.
 
The results of our business operations are affected by a number of factors, many of which are beyond our control, and primarily depend on, among other things, the level of our net interest income, the market value of our assets, the supply and demand for MBS, the availability of adequate financing for our leveraged investments, and the credit performance of our Non-Agency MBS.  Our net interest income varies primarily as a result of changes in interest rates, the slope of the yield curve (i.e., the differential between long-term and short-term interest rates), borrowing costs (i.e., our interest expense) and prepayment speeds on our MBS, the behavior of which involves various risks and uncertainties.  Interest rates and prepayment speeds, as measured by the CPR, vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty.
 
With respect to our business operations, increases in interest rates, in general, may over time cause:  (i) the interest expense associated with our repurchase agreement borrowings to increase; (ii) the value of our MBS portfolio and, correspondingly, our stockholders’ equity to decline; (iii) coupons on our ARM-MBS to reset, on a delayed basis, to higher interest rates; (iv) prepayments on our MBS to decline, thereby slowing the amortization of our MBS purchase premiums and the accretion of our purchase discounts; and (v) the value of our Swaps and, correspondingly, our stockholders’ equity to increase.  Conversely, decreases in interest rates, in general, may over time cause:  (i) the interest expense associated with our repurchase agreement borrowings to decrease; (ii) the value of our MBS portfolio and, correspondingly, our stockholders’ equity to increase; (iii) coupons on our ARM-MBS to reset, on a delayed basis, to lower interest rates; (iv) prepayments on our MBS to increase, thereby accelerating the amortization of our MBS purchase premiums and the accretion of our purchase discounts; and (v) the value of our Swaps and, correspondingly, our stockholders’ equity to decrease.  In addition, our borrowing costs and credit lines are further affected by the type of collateral we pledge and general conditions in the credit market.
 
The mortgages collateralizing our MBS portfolio predominantly include Hybrids and ARMs and, to a significantly lesser extent, fixed-rate mortgages.   In general, we expect that over time ARM-MBS will prepay faster than fixed-rate MBS, as we believe that homeowners with Hybrids and ARMs exhibit more rapid housing turnover levels or refinancing activity compared to fixed-rate borrowers.  In addition, we anticipate that prepayments on ARM-MBS accelerate significantly as the coupon reset date approaches.
 
At December 31, 2009, 81.3% of our Non-Agency MBS were purchased at a discount, a portion of which is accreted into interest income over the life of the security.  The accretion of purchase discounts increases the yield on such MBS above the stated coupon interest rate.  The extent to which our yield on Non-Agency MBS is impacted by the accretion of purchase discounts will vary by security over time, based upon the amount of purchase discount, actual credit performance and CPRs experienced.
 
Over the last consecutive eight quarters, ending with December 31, 2009, the average three-month CPR on our MBS portfolio ranged from a low of 8.5% to a high of 20.2%, with an average three-month CPR of 14.3%.  Our premium amortization, which reduces the yield earned on our MBS purchased at a premium to par, is impacted by the amount of our purchase premiums relative to our MBS investments and is also affected by the speed at which such MBS prepay.  At December 31, 2009, we had net purchase premiums of $96.9 million, or 1.3% of current par value, on our Agency MBS and net purchase discounts of $603.1 million, or 36.8% of current par value, on Non-Agency MBS.  Purchase discounts on our Non-Agency MBS included $455.0 million designated as credit reserves that are not expected to be accreted into interest income.  In addition, included in our MBS Forwards of $86.0
 
 
million were linked MBS with a fair value of $329.5 million, with related purchase discounts of $55.9 million, of which $33.3 million was designated as credit reserves.
 
CPR levels are impacted by conditions in the housing market, new regulations, government and private sector initiatives, interest rates, availability of credit to home borrowers, underwriting standards and the economy in general.  In particular, CPR reflects the constant repayment rates (or CRR), which measures voluntary prepayments of mortgages collateralizing a particular MBS, and the constant default rates (or CDR), which measures involuntary prepayments resulting from defaults.  CPRs on Agency and Non-Agency MBS may differ significantly.  For the year ended December 31, 2009, our Agency MBS portfolio experienced a weighted average CPR of 16.8%, and our Non-Agency MBS portfolio (including linked MBS, which are reported as a component of MBS Forwards) experienced a CPR of 14.9%. The following table presents the quarterly average CPR experienced on our MBS portfolio, on an annualized basis, for the quarterly periods presented:
 
   
CPR
Quarter Ended
  
2009
  
2008
December 31
     19.0 %     8.5 %
September 30
     20.2       10.3  
June 30
     16.0       15.8  
March 31
     12.2       14.3  
 
As of December 31, 2009, assuming a 15% CPR on our Agency MBS, which approximates the speed at which we estimate that our Agency MBS generally prepay over time, 29.4% of our Agency MBS portfolio was expected to reset or prepay during the next 12 months and 89.2% of our Agency MBS were expected to reset or prepay during the next 60 months, with an average time period until our assets prepay or reset of approximately 29 months.  As of December 31, 2009, our repurchase financings secured by our Agency MBS were scheduled to reset in approximately 13 months on average, including the impact of Swaps, resulting in an asset/liability mismatch of approximately 16 months for our Agency MBS and related repurchase financings.  (See following discussion on “Recent Market Conditions and Our Strategy.”)
 
Loans underlying Agency MBS generally reset based on the same benchmark index, while Non-Agency MBS may be collateralized by mortgage loans that reset based on various benchmark indices and may contain fixed-rate mortgages.  The ARMs collateralizing our Agency MBS are primarily comprised of Hybrids, which have interest rates that are typically fixed for three to ten years at origination and, thereafter, generally adjust annually to an increment over a specified interest rate index and, to a lesser extent, ARMs, which have interest rates that generally adjust annually (although some may adjust more frequently) to an increment over a specified interest rate index.  At December 31, 2009, our Agency ARM-MBS were indexed as follows: 77.1% to 12-month LIBOR; 5.7% to six-month LIBOR; 12.7% to the one-year CMT, 4.1% to the 12-month MTA and 0.4% to COFI.
 
Our MFR MBS were purchased at significant discounts to par value, a portion of which is accreted into interest income over the life of the security, thus increasing the yield on such MBS above the stated coupon rate.  The amount of purchase discount not designated as credit reserve is accreted as principal is repaid on the MBS.  MBS principal repayments will result from scheduled amortization and prepayments on the underlying mortgage loans or, in the event of default, from proceeds received for the liquidation of the underlying mortgaged property.
 
To the extent that the expected yields on our Non-Agency MBS are significantly greater than expected yields on non-credit sensitive assets, Non-Agency MBS will generally exhibit less sensitivity to changes in market interest rates than non-credit sensitive assets.  The extent to which our yield is impacted by the accretion of purchase discounts will vary over time, by security, based upon the amount of purchase discount, the actual credit performance and CPRs experienced on each MBS.
 
 
The amount by which our ARM-MBS can reset is limited by the interim and lifetime caps on the underlying mortgages.  The following table presents information about the interim and lifetime caps on our Agency ARM-MBS portfolio at December 31, 2009:
 
Lifetime Caps on Agency ARMs
  
Interim Interest Rate Caps on Agency ARMs
Maximum Lifetime Interest Rate
  
% of Total
  
Maximum Interim Change in Rate
  
% of Total
8.0% to 10.0%
  
         24.5%
  
≤1.0%
  
           1.2%
>10.0% to 12.0%
  
         70.6
  
>1.0% and ≤3.0%
  
           6.8
>12.0% to 15.0%
  
           4.9
  
>3.0% and ≤5.0%
  
         82.1
   
       100.0%
  
>5.0%
  
           5.3
       
No interim caps
  
           4.6
           
       100.0%
 
As of December 31, 2009, approximately $7.777 billion, or 88.8%, of our MBS portfolio was in its contractual fixed-rate period or were fixed-rate MBS and approximately $981.3 million, or 11.2%, was in its contractual adjustable-rate period.  Our ARM-MBS in their contractual adjustable-rate period primarily include MBS collateralized by Hybrids for which the initial fixed-rate period has elapsed, such that the interest rate will typically adjust on an annual or semi-annual basis.  In addition, at December 31, 2009, we had $442.6 million of MBS with interest rates that reset monthly.
 
It is our business strategy to hold our MBS as long-term investments.  On at least a quarterly basis, we assess our ability and intent to continue to hold each security and, as part of this process, we monitor our securities for other-than-temporary impairment.  A change in our ability and/or intent to continue to hold any of our securities that are in an unrealized loss position, or a deterioration in the underlying characteristics of these securities, could result in our recognizing future impairment charges or a loss upon the sale of any such security.  At December 31, 2009, we had net unrealized gains of $263.3 million on our Agency MBS, comprised of gross unrealized gains of $267.0 million and gross unrealized losses of $3.7 million, and had net unrealized gains on our Non-Agency MBS of $76.1 million, comprised of gross unrealized gains of $135.8 million and gross unrealized losses of $59.7 million.  We did not intend to sell any of our MBS that were in an unrealized loss position at December 31, 2009 and expect that we will be able to hold such MBS until recovery, which may be at their maturity.  (See following discussion on “Market Conditions”.)
 
We rely primarily on borrowings under repurchase agreements to finance the acquisition of Agency MBS and, to a lesser extent, Non-Agency MBS.  Our MBS have longer-term contractual maturities than our borrowings.  Even though most of our MBS have interest rates that adjust over time based on short-term changes in corresponding interest rate indices (typically following an initial fixed-rate period for our Hybrids), the interest rates we pay on our borrowings may change at a faster pace than the interest rates we earn on our MBS.  In order to reduce this interest rate risk exposure, we may enter into hedging transactions, which were comprised entirely of Swaps during 2009.  Our Swaps are designated as cash-flow hedges against a portion of our current and forecasted LIBOR-based repurchase agreements.  While our Swaps do not extend the maturities of our repurchase agreements, they do however lock in a fixed rate of interest over their term for a corresponding amount of our repurchase agreements that such Swaps hedge.  During 2009, we did not enter into any new Swaps and had Swaps with an aggregate notional amount of $963.4 million expire.
 
At December 31, 2009, our Swaps were in an unrealized loss position of $152.5 million.  We expect the unrealized losses on our Swaps to lessen over the course of 2010, as our Swaps amortize and their remaining term shortens.  During 2010, $821.2 million, or 27.3% of our $3.007 billion Swap notional amount, is scheduled to expire.
 
We continue to explore alternative business strategies, investments and financing sources and other strategic initiatives, including, but not limited to: expanding our investments in Non-Agency MBS, developing or acquiring asset management or third-party advisory services, creating new investment vehicles to manage MBS and/or other real estate-related assets.  However, no assurance can be provided that any such strategic initiatives will or will not be implemented in the future or, if undertaken, that any such strategic initiatives will favorably impact us.
 
 
Recent Market Conditions and Our Strategy
 
The current financial environment is driven by exceptional monetary easing.  Funding through repurchase agreements remains available to us at attractive rates from multiple counterparties.  However, we continue to refrain from adding interest-rate sensitive Agency MBS at high purchase premiums and historically low yields and instead continue to acquire Non-Agency MBS at a discount.  At December 31, 2009, our MFR MBS portfolio was $888.4 million.  In addition, at December 31, 2009, through MFR, we had Non-Agency MBS of $329.5 million with linked repurchase borrowings of $245.0 million that, along with associated interest receivables and payables, were reported net, as MBS Forwards on our consolidated balance sheet.  By blending Non-Agency MBS with Agency MBS, we seek to generate attractive returns with less leverage and less sensitivity to yield curve and interest rate cycles and prepayments.
 
At December 31, 2009, we had borrowings under repurchase agreements with 17 counterparties and a resulting debt-to-equity multiple of 3.3 times.  To protect against unforeseen reductions in our borrowing capabilities, we maintain unused capacity under our existing repurchase agreement credit lines with multiple counterparties and  cash and collateral to meet potential margin calls (or our Cushion).  Our Cushion is comprised of cash and cash equivalents, unpledged Agency MBS and collateral in excess of margin requirements held by our counterparties.  At December 31, 2009, our Cushion was $762.4 million, consisting of $653.5 million of cash and cash equivalents, $54.8 million of unpledged Agency MBS and $54.1 million of excess collateral.
 
The following table presents certain benchmark interest rates at the dates indicated:
 
Year
  
Quarter Ended
  
30-Day LIBOR
  
Six-Month LIBOR
  
12-Month LIBOR
  
One-Year CMT
  
Two-Year Treasury
  
10-Year
Treasury
  
Target Federal Funds Rate/Range
2009
  
December 31
  
      0.23%
  
     0.43%
  
     0.98%
  
        0.47%
  
     1.14%
  
       3.84%
  
       0.00 - 0.25%
   
September 30
  
      0.25
  
     0.63
  
     1.26
  
        0.40
  
     0.96
  
       3.31
  
       0.00 – 0.25
   
June 30
  
      0.31
  
     1.11
  
     1.61
  
        0.56
  
     1.11
  
       3.52
  
       0.00 – 0.25
   
March 31
  
      0.50
  
     1.74
  
     1.97
  
        0.57
  
     0.80
  
       2.69
  
       0.00 – 0.25
           
 
                    
2008
  
December 31
  
      0.44%
  
     1.75%
  
     2.00%
  
        0.37%
  
     0.77%
  
       2.21%
  
       0.00 - 0.25%
   
September 30
  
      3.93
  
     3.98
  
     3.96
  
        1.78
  
     1.99
  
       3.83
  
                 2.00
   
June 30
  
      2.46
  
     3.11
  
     3.31
  
        2.36
  
     2.62
  
       3.98
  
                 2.00
   
March 31
  
      2.70
  
     2.61
  
     2.49
  
        1.55
  
     1.63
  
       3.43
  
                 2.25
 
The market value of our Agency MBS was positively impacted by the Federal Reserve’s program to purchase $1.25 trillion of Agency MBS.  These governmental purchases increased market prices of Agency MBS during 2009, thereby reducing their market yield.  As a result, we did not acquire any Agency MBS during 2009, and instead opportunistically sold 36 of our longer term-to-reset Agency MBS.  These sales of $650.9 million of Agency MBS resulted in gross gains of $22.6 million and decreased our sensitivity to the impact of potential increases in market interest rates in the future.  The Federal Reserve has indicated it will complete its planned purchases of Agency MBS by the end of March 2010.  If no further action is taken by the Federal Reserve, the market value of Agency MBS may decline, which among other things, could cause the market value of our Agency MBS to decline while providing an opportunity for us to invest in such assets at higher yields during 2010.
 
During 2009, we acquired Non-Agency MBS at an aggregate cost of $1.148 billion (including linked MBS) at an average price to par value of 63.3%.  At December 31, 2009, the MFR MBS (including linked MBS) had weighted average structural credit enhancement of 10.0%.  We are exposed to credit risk in our Non-Agency MBS portfolio; however, the credit support built into MBS deal structures is designed to provide a level of protection against potential credit losses.  In addition, the discounted purchase prices paid on the MFR MBS provides further insulation from credit losses in the event, as we expect, that we receive less than 100% of par on such assets.  Our Non-Agency investment process involves comprehensive analysis focused primarily on quantifying and pricing credit risk.  When we purchase MFR MBS, we assign certain assumptions to each of the MBS with respect to voluntary prepayment rates, default rates and loss severities, and establish a credit discount amount for substantially all of these MBS.  As part of our surveillance process, we review our Non-Agency MBS by tracking their actual performance versus our expected performance at purchase or, if we have modified our original purchase assumptions, versus our revised performance expectations.  To the extent that actual performance of a MFR MBS deviates materially from our expected performance parameters, we may revise our performance expectations, including revisions to the credit discounts established for these MBS.  Nevertheless, unanticipated credit losses
 
 
could occur, adversely impacting our operating results.
 
Unlike our Agency MBS, the yield on the MFR MBS are expected to increase if prepayment rates on such assets exceed our prepayment assumptions, as purchase discounts are accreted into income.  During 2009, our Non-Agency MBS portfolio earned $64.1 million, of which $48.0 million was attributable to MFR MBS and $16.1 million was earned on Non-Agency MBS that we acquired prior to July 2007 (or Legacy Non-Agency MBS).  In addition, we had a net gain of $8.8 million on our MBS Forwards, all of which was attributable to MFR MBS purchased as part of linked transactions during the second half of 2009.  At December 31, 2009, $1.093 billion, or 12.5%, of our MBS portfolio was invested in Non-Agency MBS, of which $888.4 million were MFR MBS and $204.7 million were Legacy Non-Agency MBS.  In addition, we had forward contracts to repurchase $329.5 million of MFR MBS that are accounted for as linked transactions and reported as a component of our MBS Forwards.
 
Market demand for Non-Agency MBS increased over the course of 2009 and as a result, the fair values of our Non-Agency MBS increased.  Accordingly, while Non-Agency MBS remain available at a discount, such discounts have narrowed relative to discounts available in early 2009 and late 2008 and may continue to narrow in the future, reducing the market yields on these assets.  Nevertheless, we believe that despite higher market prices and lower yields, that loss-adjusted returns on Non-Agency MBS continue to represent attractive investment opportunities, and we are positioned to continue to take advantage of such opportunities and, based on market conditions, currently anticipate allocating additional capital to invest in such assets during 2010.  However, we expect that the majority of our assets will remain in whole-pool Agency MBS, due to the long-term attractiveness of the asset class.
 
 
MFR MBS
 
The tables below present our MFR MBS portfolio.  (See the tables on page 44 of this annual report on Form 10-K for information about our entire Non-Agency MBS portfolio)  Information presented with respect to weighted average loan to value, weighted average Fair Isaac Corporation (or FICO) scores and other information aggregated based on information reported at the time of mortgage origination are historical and, as such, does not reflect the impact of the general decline in home prices or any changes in a borrowers’ credit score or the current use or status of the mortgaged property.  The tables below include Non-Agency MBS with a fair value of $329.5 million that are accounted for as linked transactions and reported as a component of our MBS Forwards.  Transactions that are currently linked may or may not be linked in the future and, if no longer linked, will be included in our MBS portfolio.  In assessing our asset/liability management and performance, we consider linked MBS as part of our MBS portfolio.  As such, we have included MBS that are a component of linked transactions in the tables below.
 
The following table presents certain information, detailed by year of initial MBS securitization and FICO score, about the underlying loan characteristics of our MFR MBS at December 31, 2009:
 
 
Securities with Average Loan FICO
of 715 or Higher  (1)
Securities with Average Loan FICO
Below 715  (1)
  
Year of Securitization (2)
2007
2006
2005
and Prior
2007
2006
2005
and Prior
Total
(Dollars in Thousands)
              
Number of securities
             28
             43
              38
                8
             14
                5
              136
MBS current face
$  344,081
$  505,638
$   461,367
  $ 108,462
$  289,437
$     36,078
  $1,745,063
Gross purchase discounts
$ (128,116)
$ (197,996)
$  (117,195)
  $  (63,131)
$ (140,299)
$    (13,454)
  $  (660,191)
Purchase discounts designated as credit reserves (3)
$   (89,111)
$ (132,317)
$    (68,329)
  $  (56,061)
$ (132,540)
$      (9,901)
  $  (488,259)
MBS amortized cost
$  215,965
$  307,642
$   344,172
  $   45,331
$  149,138
$     22,624
  $1,084,872
MBS fair value
$  248,808
$  357,546
$   370,712
  $   58,465
$  157,978
$     24,438
  $1,217,947
Weighted average fair value to current face
          72.3%
          70.7%
           80.4%
           53.9%
          54.6%
           67.7%
             69.8%
Weighted average coupon (4)
          5.60%
          5.42%
           4.55%
           3.73%
          2.75%
           3.22%
             4.63%
Weighted average loan age (months) (4) (5)
             38
             44
              57
              35
             43
              57
                46
Weighted average loan to value at origination (4) (6)
             70%
             71%
              69%
              76%
             74%
              74%
                71%
Weighted average FICO score at origination (4) (6)
           736
           731
            734
            706
           703
            707
              726
Owner-occupied loans
          90.1%
          87.3%
           84.5%
           81.7%
          82.6%
           81.0%
             85.9%
Rate-term refinancings
          27.2%
          20.0%
           19.1%
           21.8%
          13.5%
           10.2%
             20.0%
Cash-out refinancings
          26.9%
          30.4%
           21.9%
           32.7%
          32.8%
           31.5%
             28.0%
3 Month CPR (5)
          17.2%
          14.5%
           16.3%
           20.2%
          16.5%
           21.2%
             16.4%
3 Month CRR (5) (7)
          11.4%
            8.4%
           10.3%
             5.9%
            3.7%
             6.0%
               8.5%
3 Month CDR (5) (7)
            6.0%
            6.1%
             6.1%
           14.5%
          12.9%
           15.4%
               7.9%
60+ days delinquent (6)
          20.0%
          21.1%
           11.6%
           45.3%
          34.2%
           27.7%
             22.2%
Credit enhancement (6) (8)
            8.0%
            9.7%
           10.2%
           11.2%
          10.7%
           18.9%
             10.0%
 
(1)
FICO score is a credit score used by major credit bureaus to indicate a borrower’s credit worthiness.  FICO scores are reported borrower FICO scores at origination for each loan.
(2)
Certain of our Non-Agency MBS have been re-securitized.  The historical information presented in the table is based on the initial securitization date and data available at the time of original securitization (and not the date of re-securitization).  No information has been updated with respect to any MBS that have been re-securitized.
(3)
Purchase discounts designated as credit discounts are not expected to be accreted into interest income.
(4)
Weighted average is based on MBS current face at December 31, 2009.
(5)
Information provided is based on loans for individual group owned by us.
(6)
Information provided is based on loans for all groups that provide credit support for our MBS.
(7)
CRR represents voluntary prepayments and CDR represents involuntary prepayments.
(8)
Credit enhancement for a security consists of all securities and/or other credit support that absorb initial credit losses generated by a pool of securitized loans before such losses affect that security.
 
 
The mortgages securing our MFR MBS are located in many geographic regions across the United States.  The following table presents the six largest geographic concentrations of the mortgages collateralizing our Non-Agency MBS, including linked MBS, held at December 31, 2009:
 
Property Location
  
Percent
Southern California
     28.4 %
Northern California
     19.8 %
Florida
     7.8 %
New York
     5.0 %
Virginia
     4.1 %
Maryland
     3.1 %
 
Regulatory Developments
 
The U.S. Government, Federal Reserve, U.S. Treasury, FDIC and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis.  We are unable to predict whether or when such actions may occur or what impact, if any, such actions could have on our business, results of operations and financial condition.
 
 
RESULTS OF OPERATIONS
 
Year Ended December 31, 2009, Compared to Year Ended December 31, 2008
 
For 2009, we had net income available to our common stockholders of $260.0 million, or $1.06 per common share, compared to net income of $37.6 million, or $0.21 per common share for 2008.
 
Interest income on our MBS portfolio for 2009 was $504.5 million compared to $519.7 million for 2008.  Excluding changes in market values, our average investment in MBS decreased by $261.3 million, or 2.7%, to $9.395 billion for 2009 from $9.656 billion for 2008.  The net yield on our MBS portfolio was essentially flat at 5.37% for 2009 compared to 5.38% for 2008.  For 2009, our MBS portfolio yield reflected the net impact of a decrease in the net yield on our Agency MBS portfolio that was offset by the positive impact of the yield on our significantly smaller MFR MBS portfolio.  The decrease in the net yield on our Agency MBS portfolio reflects the impact of the general decline in market interest rates, which caused prepayments on our Agency MBS to increase, the amortization of purchase premiums to accelerate, and the interest rates scheduled to adjust to reset to lower market rates.  During 2009, our average net purchase premiums on our MBS portfolio decreased significantly, as we continued to purchase Non-Agency MBS through MFR at discounts to par.  During 2009, we recognized net purchase premium amortization of $6.6 million, comprised of net premium amortization of $23.8 million, or 25 basis points, primarily on our Agency and Legacy Non-Agency MBS portfolio, and purchase discount accretion of $17.2 million, or 18 basis points, primarily on our MFR MBS.  During 2008, we recognized net premium amortization of $18.9 million, comprised of gross premium amortization of $19.1 million and gross discount accretion of $253,000.  Our average CPR for 2009 was 16.7% compared to 12.0% for 2008.  At December 31, 2009, we had net purchase premiums of $96.9 million, or 1.3% of current par value, on our Agency MBS and net purchase discounts of $603.1 million, including purchase credit discounts of $455.0 million, on our Non-Agency MBS.
 
 
The following table presents information about our average balances on our MBS portfolio categories and associated income generated from each of our investment security categories during the year ended December 31, 2009 and December 31, 2008:
 
   
Average Balance of
Amortized
Cost
    
Coupon
Interest
    
Net (Premium
Amortization)/
Discount
Accretion
    
Interest
Income
    
Net Asset
Yield
  
(Dollars in Thousands)
                              
Year Ended December 31, 2009
                              
Agency MBS
   $ 8,747,168     $ 464,260     $ (23,903 )   $ 440,357       5.03 %
MFR MBS (1)
     352,993       30,753       17,251       48,004       13.60  
Legacy Non-Agency MBS
     295,048       16,019       84       16,103       5.46  
     Total
   $ 9,395,209     $ 511,032     $ (6,568 )   $ 504,464       5.37 %
Year Ended December 31, 2008
                                        
Agency MBS
   $ 9,298,811     $ 518,504     $ (18,617 )   $ 499,887       5.38 %
MFR MBS
     503       57       -       57       11.33  
Legacy Non-Agency MBS and other
     358,815       20,098       (254 )     19,844       5.53  
     Total
   $ 9,658,129     $ 538,659     $ (18,871 )   $ 519,788       5.38 %
(1)
Does not include linked MBS, which had a fair value of $329.5 million at December 31, 2009.  Had the linked MFR MBS not been accounted for as linked transactions, our MFR MBS would have had an average amortized cost of $440.7 million, coupon interest of $35.4 million, discount accretion of $18.9 million, resulting in interest income of $54.3 million and a net asset yield of 12.3%. (See Note 4 to the accompanying consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
 
The following table presents the components of the net yield earned on our MBS portfolios and CPRs experienced for the quarterly periods presented:
 
Year
Quarter Ended
Gross Yield/Stated Coupon
  
Net (Premium Amortization)/
Discount Accretion
  
Other (1)
  
Net Yield
  
CPR
  
2009
December 31, 2009
         5.28%
  
         0.08%
  
        0.21%
  
       5.57%
  
        19.0%
  
 
September 30, 2009
         5.37
  
        (0.03)
  
        0.09
  
       5.43
  
        20.2
  
 
June 30, 2009
         5.46
  
        (0.15)
  
       (0.04)
  
       5.27
  
        16.0
  
 
March 31, 2009
         5.50
  
        (0.17)
  
       (0.10)
  
       5.23
  
        12.2
  
                       
2008
December 31, 2008
         5.54
  
        (0.14)
  
       (0.11)
  
       5.29
  
          8.5
  
 
September 30, 2008
         5.58
  
        (0.17)
  
       (0.11)
  
       5.30
  
        10.3
  
 
June 30, 2008
         5.77
  
        (0.26)
  
       (0.15)
  
       5.36
  
        15.8
  
 
March 31, 2008
         6.01
  
        (0.24)
  
       (0.15)
  
       5.62
  
        14.3
  
 
(1)
Reflects the cost of delay in receiving principal on the MBS and the (cost)/benefit to carry purchase (premiums)/discounts respectively.
 
Interest income from our cash investments, which are comprised of high quality money-market investments, decreased by $6.6 million to $1.1 million for 2009 from $7.7 million for 2008.  Our average cash investments increased to $458.6 million and yielded 0.24% for 2009 compared to average cash investments of $322.0 million yielding 2.40% for 2008.  In general, we manage our cash investments relative to our investing, financing and operating requirements, investment opportunities and current and anticipated market conditions.  During 2009, we raised net proceeds of $386.7 million through a public offering of our common stock.  The cash proceeds of this transaction were temporarily held in money market accounts until invested in Non-Agency MBS.  The yield on our cash investments generally follows the direction of the target federal funds rate, which has remained at a range of 0% to 0.25% since December 2008.
 
Our interest expense for 2009 decreased by $113.3 million, or 33.1%, to $229.4 million from $342.7 million for 2008, reflecting the decrease in short-term interest rates and decrease in our average borrowings.  We experienced a 113 basis point decrease in the cost of our borrowings to 2.83% for 2009, from 3.96% for 2008.  The average amount outstanding under our repurchase agreements for 2009 was $8.120 billion compared to $8.653 billion for 2008, reflecting our increased emphasis on purchasing Non-Agency MBS with limited or no leverage.  Payments made/received on our Swaps are a component of our borrowing costs.  Swaps accounted for interest
 
 
expense of $120.8 million, or 149 basis points, for 2009 and $54.0 million, or 62 basis points, for 2008.  As a result of the reduction in our Agency MBS portfolio, we have substantially reduced our reliance on leverage through repurchase financings.  As of December 31, 2009, MFA’s overall debt-to-equity multiple was 3.3x versus 7.2x as of December 31, 2008.  By utilizing less leverage, we believe that future earnings will be less sensitive to changes in interest rates and the yield curve.  We expect that our funding costs will be flat or may decline modestly during the first quarter of 2010, as the notional balances of our Swaps continue to amortize.  Our funding costs for the remainder of 2010 will be impacted by market interest rates and the extent to which our borrowings under repurchase agreements change, which will be driven by market conditions, none of which can be predicted with any certainty.  (See Notes 2(l) and 4 to the accompanying consolidated financial statements, included under Item 8.)
 
The following table presents our leverage multiples, as measured by debt-to-equity, at the dates presented:
 
At the Period Ended
  
Leverage
Multiple
December 31, 2009
  
3.3x
September 30, 2009
  
3.4
June 30, 2009
  
4.8
March 31, 2009
  
6.0
December 31, 2008
  
7.2
 
For 2009, our net interest income increased by $91.4 million to $276.2 million from $184.8 million for 2008.  This increase reflects an improvement in our net interest spread as MBS yields relative to our funding costs widened due to declining interest rates and the accretive impact of our MFR MBS.  Our net interest spread and margin were 2.31% and 2.80%, respectively, for 2009, compared to 1.32% and 1.85%, respectively, for 2008.
 
The following table presents information regarding our average balances, interest income and expense, yields on average interest-earning assets, average cost of funds and net interest income for the quarters presented:
 
Quarter Ended
  
Average Balance of Amortized Cost of
MBS (1)
    
Interest Income on MBS
    
Average Interest Earning Cash (2)
    
Total Interest Income
    
Yield on Average Interest-Earning Assets
  
Average Balance of Repurchase Agreements
    
Interest Expense
    
Average Cost of Funds
  
Net Interest Income
  
(Dollars in Thousands)
                                            
December 31, 2009 (3)
   $ 8,721,342     $ 121,435     $ 579,631     $ 121,512       5.23 %   $ 7,372,074     $ 46,287       2.50 %   $ 75,225  
September 30, 2009 (3)
     9,165,267       124,399       437,444       124,548       5.18       7,774,620       52,976       2.70       71,572  
June 30, 2009
     9,604,374       126,477       358,343       126,737       5.09       8,369,408       58,006       2.78       68,731  
March 31, 2009
     10,107,407       132,153       457,953       132,764       5.03       8,984,456       72,137       3.26       60,627  
December 31, 2008
     10,337,787       136,762       284,178       137,780       5.19       9,120,214       87,522       3.82       50,258  
 
(1) 
Unrealized gains and losses are not reflected in the average balance of amortized cost of MBS.
(2) 
Includes average interest earning cash, cash equivalents and restricted cash.
(3) 
The information for the quarter presented, does not include the MBS or repurchase agreements that are accounted for as linked transactions.
 
 
The following table presents certain quarterly information regarding our net interest spreads and net interest margin for the quarterly periods presented:
 
 
Total Interest-Earning Assets and Interest-Bearing Liabilities
  
MBS Only
Quarter Ended
Net Interest Spread
Net Interest Margin (1)
  
Net Yield on MBS
Cost of Funding MBS
Net MBS Spread
December 31, 2009
           2.73%
           3.24%
  
          5.57%
          2.50%
         3.07%
September 30, 2009
           2.48
           3.00
  
          5.43
          2.70
         2.73
June 30, 2009
           2.31
           2.75
  
          5.27
          2.78
         2.49
March 31, 2009
           1.77
           2.26
  
          5.23
          3.26
         1.97
December 31, 2008
           1.37
           1.91
  
          5.29
          3.82
         1.47
(1)  Net interest income divided by average interest-earning assets.
 
During 2009, we recognized net impairment losses of $17.9 million in connection with 12 Legacy Non-Agency MBS.  At December 31, 2009, these Legacy Non-Agency MBS had an aggregate amortized cost of $188.0 million.  During 2008, we recognized other-than-temporary impairment charges of $5.1 million primarily against unrated investment securities; following these impairment charges, all of our unrated securities were carried at zero.
 
For 2009, we had net other operating income of $33.0 million, which was primarily comprised of gains of $22.6 million realized on the sale of 36 of our longer-term Agency MBS for $650.9 million and net gains of $8.8 million on our MBS Forwards.  While we generally hold our MBS for investment purposes, we may, from time-to-time, sell certain MBS to alter the repricing or other risk characteristics of our MBS portfolio.  The sale of our longer-duration Agency MBS during 2009 has reduced our sensitivity to future increases in market interest rates.  The $8.8 million gain on our MBS Forwards reflects appreciation of $3.8 million in the fair value of the underlying MBS, interest income of $6.2 million on the underlying MBS and interest expense of $1.2 million on the underlying repurchase agreements.  Future gains/losses on MBS Forwards will reflect changes in the market value of the underlying MBS and will be impacted by the amount of additional future linked transactions and the amount of linked transactions that become unlinked in the future, none of which can be predicted with any certainty.  If MBS Forwards become unlinked in the future, the underlying MBS and repurchase agreements and associated interest income and expense will be presented gross on our balance sheet and income statement.  Our net other operating loss of $115.1 million for 2008 reflected losses of $116.0 million incurred in March 2008 to implement our reduced-leverage strategy in response to the significant disruptions in the credit market.  To reduce leverage, we sold 84 MBS for $1.851 billion, resulting in net losses of $24.5 million and terminated 48 Swaps with an aggregate notional amount of $1.637 billion, realizing losses of $91.5 million.  In addition, during 2008, we realized a loss of $986,000 for two Swaps that were terminated in connection with the bankruptcy of Lehman.
 
During 2009, we had operating and other expenses of $23.0 million, including real estate operating expenses and mortgage interest totaling $1.8 million attributable to our remaining real estate investment.  For 2009, our compensation and benefits and other general and administrative expense totaled $21.3 million, or 0.21% of average assets, while compensation and benefits and other general and administrative expense totaled $17.1 million, or 0.17% of average assets, for 2008.  The $3.6 million increase in our compensation expense to $14.1 million for 2009 compared to $10.5 million for 2008, primarily reflects increases to our contractual and general bonus pool, salary expense for additional hires primarily related to our MFR MBS investment strategy, salary increases, and vesting of equity based compensation awards.  Other general and administrative expenses, which were $7.2 million for 2009 compared to $6.6 million for 2008, were comprised primarily of the cost of professional services, including auditing and legal fees, costs of complying with the provisions of the Sarbanes-Oxley Act of 2002, office rent, corporate insurance, data and analytical systems, Board fees and miscellaneous other operating costs.  The increase in these costs primarily reflects expenses to expand our investment analytic capabilities and data system upgrades.  We expect our total operating and other expense to increase for 2010, reflecting a full year of costs related to 2009 hires, the vesting of our equity based compensation awards, and the expansion of our analytical tools/systems.
 
Year Ended December 31, 2008, Compared to Year Ended December 31, 2007
 
For 2008, we had net income available to our common stockholders of $37.6 million, or $0.21 per common share, compared to net income of $22.1 million, or $0.24 per common share, for 2007.
 
Interest income on our investment securities portfolio for 2008 increased by $139.5 million, or 36.7%, to $519.8 million compared to $380.3 million for 2007.  This increase reflects the growth in our MBS portfolio during
 
 
the earlier part of 2008.  Excluding changes in market values, our average investment in MBS increased by $2.769 billion, or 40.2%, to $9.656 billion for 2008 from $6.887 billion for 2007.  The net yield on our MBS portfolio decreased by 14 basis points, to 5.38% for 2008 compared to 5.52% for 2007.  This decrease in the net yield on our MBS portfolio primarily reflects a 40 basis point decrease in the gross yield partially offset by a 21 basis point reduction in the cost of net premium amortization.  The decrease in the gross yield on the MBS portfolio to 5.71% for 2008 from 6.11% for 2007 reflects the impact on our assets of the general decline in market interest rates.  The decrease in the cost of our premium amortization to 20 basis points for 2008 from 41 basis points for 2007 reflects a decrease in the average CPR experienced on our portfolio as well as a decrease in the average premium on our MBS portfolio.  Our average CPR for 2008 was 12.0% compared to 19.1% for 2007, while the average purchase premium on our MBS portfolio was 1.3% for 2008 compared to 1.4% for 2007.  At December 31, 2008, we had net purchase premiums of $125.0 million, or 1.3% of current par value, on our Agency MBS and net purchase discounts of $11.7 million, or 3.4%, on Non-Agency MBS.
 
The following table presents the components of the net yield earned on our MBS portfolio for the quarterly periods presented:
 
Year
Quarter Ended
Gross Yield/Stated Coupon
  
Net Premium Amortization
  
Other (1)
  
Net Yield
2008
December 31, 2008
       5.54%
  
         (0.14)%
  
       (0.11)%
  
      5.29%
 
September 30, 2008
       5.58
  
         (0.17)
  
       (0.11)
  
      5.30
 
June 30, 2008
       5.77
  
         (0.26)
  
       (0.15)
  
      5.36
 
March 31, 2008
       6.01
  
         (0.24)
  
       (0.15)
  
      5.62
                 
2007
December 31, 2007
       6.12%
  
         (0.25)%
  
       (0.14)%
  
      5.73%
 
September 30, 2007
       6.12
  
         (0.38)
  
       (0.16)
  
      5.58
 
June 30, 2007
       6.09
  
         (0.50)
  
       (0.19)
  
      5.40
 
March 31, 2007
       6.11
  
         (0.55)
  
       (0.21)
  
      5.35
(1) Reflects the cost of delay and cost to carry purchase premiums.
 
Interest income from our cash investments increased to $7.7 million for 2008 from $4.5 million for 2007.  This increase reflects the increase in our average cash investments to $322.0 million for 2008 compared to $93.4 million for 2007.  Our cash investments, which are comprised of high quality money market investments, yielded 2.40% for 2008, compared to 4.81% for 2007, reflecting the decrease in market interest rates.  In general, we manage our cash investments relative to our investing, financing and operating requirements, investment opportunities and current and anticipated market conditions.  In response to tightening of market credit conditions in March 2008, we modified our leverage strategy, reducing our target debt-to-equity multiple from 8x to 9x to 7x to 9x.  As a component of this strategy and to address increased volatility in the financial markets we increased our cash investments.
 
Our interest expense for 2008 increased to $342.7 million from $321.3 million for 2007, reflecting a significant increase in our borrowings, partially offset by a significant decrease in the interest rates we paid on such borrowings reflecting the decrease in market interest rates.  The average amount outstanding under our repurchase agreements for 2008 increased by $2.424 billion, or 38.9%, to $8.653 billion from $6.229 billion for 2007.  The increase in our borrowing under repurchase agreements during 2008 primarily reflects our leveraging of multiple equity capital raises.  We experienced a 120 basis point decrease in our effective cost of borrowings to 3.96% for 2008, from 5.16% for 2007.  Payments made/received on our Swaps are a component of our borrowing costs.  Our Swaps accounted for interest expense of $54.0 million, or 62 basis points, for 2008 and decreased the cost of our borrowings by $6.5 million, or ten basis points, for 2007.  (See Notes 2(l) and 4 to the accompanying consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
 
For 2008, our net interest income increased to $184.8 million from $63.5 million for 2007.  This increase reflects the growth in our interest-earning assets and an improvement in our net interest spread, as MBS yields relative to our cost of funding widened.  Our net interest spread and margin were 1.32% and 1.85%, respectively, for 2008, compared to 0.35% and 0.91%, respectively, for 2007.
 
 
The following table presents certain quarterly information regarding our net interest spreads and net interest margin for the quarterly periods presented:
 
 
Total Interest-Earning Assets and Interest-Bearing Liabilities
  
MBS Only
Quarter Ended
Net Interest Spread
Net Interest Margin (1)
  
Net Yield on MBS
Cost of Funding MBS
Net MBS Spread
December 31, 2008
           1.37%
           1.91%
  
          5.29%
          3.82%
         1.47%
September 30, 2008
           1.61
           2.09
  
          5.30
          3.60
         1.70
June 30, 2008
           1.38
           1.89
  
          5.36
          3.85
         1.51
March 31, 2008
           0.90
           1.47
  
          5.62
          4.64
         0.98
December 31, 2007
           0.65
           1.22
  
          5.73
          5.05
         0.68
(1)  Net interest income divided by average interest-earning assets.
 
The following table presents information regarding our average balances, interest income and expense, yield on average interest-earning assets, average cost of funds and net interest income for the quarters presented:
 
 
Quarter Ended
Average Balance of Amortized Cost of
MBS (1)
Interest Income on Investment Securities
Average Interest- Earning Cash, Cash Equivalents and Restricted Cash
Total Interest Income
Yield on Average Interest-Earning Assets
Average Balance of Repurchase Agreements
Interest Expense
Average Cost of Funds
Net Interest Income
(Dollars in Thousands)
                
December 31, 2008
$ 10,337,787
$  136,762
$    284,178
$ 137,780
     5.19%
$ 9,120,214
$ 87,522
    3.82%
$  50,258
September 30, 2008
   10,530,924
    139,419
      281,376
   140,948
     5.21
   9,373,968
   85,033
    3.60
    55,915
June 30, 2008
     8,844,406
    118,542
      375,326
   120,693
     5.23
   8,001,835
   76,661
    3.85
    44,032
March 31, 2008
     8,902,340
    125,065
      347,970
   128,096
     5.54
   8,100,961
   93,472
    4.64
    34,624
December 31, 2007
     7,681,065
    109,999
      196,344
   112,284
     5.70
   6,975,521
   88,881
    5.05
    23,403
(1) Unrealized gains and losses are not reflected in the average balance of amortized cost of MBS.
 
For 2008, we had aggregate net other losses and other-than-temporary impairment charges of $120.1 million compared to net other operating losses of $19.9 million for 2007.  We modified our leverage strategy in March 2008, to reduce risk in light of the significant disruptions in the credit markets, by decreasing our target debt-to-equity multiple range from 8x to 9x to 7x to 9x.  To effect this change, during the first quarter of 2008, we sold 84 MBS for $1.851 billion, resulting in net losses of $24.5 million, and terminated 48 Swaps with an aggregate notional amount of $1.637 billion, realizing losses of $91.5 million.  In addition, during 2008, we recognized losses of $986,000 in connection with two Swaps terminated in response to the Lehman bankruptcy in September 2008.  Lastly, we recognized other-than-temporary impairment charges of $5.1 million, of which $4.9 million reflected a full write-off against two unrated investment securities and $183,000 was an impairment charge against one Non-Agency MBS that was rated BB.  In the aggregate, these transactions resulted in net losses of $122.0 million for 2008.  During 2007, we realized losses of $21.8 million on the sale of Agency and AAA rated MBS, of which $22.0 million were incurred during the third quarter of 2007.  Also included in our other loss, net is revenue from our one real estate investment, which remained relativity flat at approximately $1.6 million.  We earned $303,000 and $424,000 in advisory fees during 2008 and 2007, respectively, and during 2007 recovered $257,000 of built-in-gains taxes paid in 2006 on the sale of real estate, which are included in miscellaneous other income, net.
 
For 2008, we had operating and other expenses of $18.9 million, including real estate operating expenses and mortgage interest totaling $1.8 million attributable to our investment in one multi-family rental property.  In May 2008, in response to equity market conditions, we postponed the initial public offering of MFResidential Investments, Inc. and, as a result, incurred total expenses of $1.2 million through December 31, 2008 in connection with this business initiative.  For 2008, our compensation and benefits and other general and administrative expense were $15.9 million, excluding the non-recurring legal fees of $1.2 million, or 0.16% of average assets, compared to $11.7 million, or 0.17% of average assets, for 2007.  The $3.9 million increase in our employee compensation and benefits expense for 2008 compared to 2007 primarily reflects an increase of $2.1 million for bonuses, an $821,000
 
 
increase in salary expense associated with additional hires and salary increases and a $923,000 increase for equity based compensation for employees.  Other general and administrative expenses, which were $5.5 million (excluding the $1.2 million of non-recurring legal fees discussed above) for 2008 compared to $5.1 million for 2007, were comprised primarily of the cost of professional services, including auditing and legal fees, costs of complying with the provisions of the SOX Act, office rent, corporate insurance, Board fees and miscellaneous other operating costs.
 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 
Our management has the obligation to ensure that our policies and methodologies are in accordance with GAAP.  During 2009, management reviewed and evaluated our critical accounting policies and believes them to be appropriate.
 
Our consolidated financial statements include our accounts and all majority owned and controlled subsidiaries.  The preparation of consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions in certain circumstances that affect amounts reported in the consolidated financial statements.  In preparing these consolidated financial statements, management has made estimates and judgments of certain amounts included in the consolidated financial statements, giving due consideration to materiality.  We do not believe that there is a great likelihood that materially different amounts would be reported related to accounting policies described below.  However, application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates.
 
Our accounting policies are described in Note 2 to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.  Management believes the more significant of these to be as follows:
 
Classifications of Investment Securities and Assessment for Other-Than-Temporary Impairments
 
Our investments in securities are comprised of Agency and Non-Agency MBS, as discussed and detailed in Notes 2(b) and 3 to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.  All of our MBS are designated as available-for-sale and carried on the balance sheet at their fair value with changes in fair value recorded as adjustments to other comprehensive income/(loss), a component of stockholders’ equity.  We do not intend to hold any of our investment securities for trading purposes; however, if available-for-sale securities were classified as trading securities, there could be substantially greater volatility in our earnings.
 
When the fair value of an available-for-sale security is less than its amortized cost at the balance sheet date, the investment is considered impaired.  We assess our impaired securities on at least a quarterly basis and designate such impairments as either “temporary” or “other-than-temporary.”  If we intend to sell an impaired security or it is more likely than not that we will be required to sell the impaired security before its anticipated recovery, then we must recognize an other-than-temporary impairment through earnings equal to the entire difference between the investment’s amortized cost and its fair value at the balance sheet date.  If we do not expect to sell an other-than-temporarily impaired security, only the portion of the other-than-temporary impairment related to credit losses is recognized through earnings with the remainder recognized through other comprehensive income/(loss), a component of stockholder’s equity.
 
In making our assessments about other-than-temporary impairments, we review and consider factual information relating to us and our impaired securities, including the nature of such securities, the contractual collateral requirements impacting us and our investment and leverage strategies, as well as subjective information, including our current and targeted liquidity position, the credit quality and expected cash flows of the underlying assets collateralizing such securities, and current and anticipated market conditions.  Because our assessments are based on factual information as well as subjective information available at the time of assessment, the determination as to whether an other-than-temporary impairment exists and, if so, the amount considered other-than-temporarily impaired, or not impaired, is subjective.  As a result, the timing and amount of other-than-temporary impairments constitute material estimates that are susceptible to significant change.
 
During December 31, 2009, we recognized impairments against certain of our Legacy Non-Agency MBS.  Based on our assessments at December 31, 2009, we believe that we have the ability to continue to hold each of our remaining impaired securities until recovery, which may be at their maturity, and do not have any present plans to sell any MBS that were in an unrealized loss position.  As a result, we consider the impairment on each of our Non-Agency MBS for which no impairment was recognized through earnings at December 31, 2009 to be temporary.
 
 
With respect to our Agency MBS, the full collection of principal, at par, and interest is guaranteed by the respective Agency guarantor, such that we believe that our Agency MBS do not expose us to credit related losses.  At December 31, 2009, we had gross unrealized gains of $267.0 million and gross unrealized losses of $3.7 million on our Agency MBS portfolio.  At December 31, 2009, we did not intend to sell any of our Agency MBS that was in an unrealized loss position and determined that it was unlikely that we would be required to sell any such securities prior to their anticipated recovery based upon our asset quality and strong liquidity and capital position at such date.  Our ability to hold each of our impaired Agency MBS until market recovery is supported by our low leverage relative to our margin requirements at December 31, 2009.  Given that our Agency MBS portfolio was in a net unrealized gain position of $263.3 million at December 31, 2009, we could potentially sell Agency MBS that were in a gain position, if the need arose, allowing us to hold impaired Agency securities until recovery.
 
The payments of principal and interest we receive on our Agency MBS, which depend directly upon payments on the mortgages underlying such securities, are guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae.  Fannie Mae and Freddie Mac are GSEs, but their guarantees are not backed by the full faith and credit of the United States.  Ginnie Mae is part of a U.S. Government agency and its guarantees are backed by the full faith and credit of the United States.  We believe that the stronger backing for the guarantors of Agency MBS resulting from the conservatorship of Fannie Mae and Freddie Mac has further strengthened their credit worthiness; however, there can be no assurance that these actions will be adequate for their needs.  Accordingly, if these government actions are inadequate and the GSEs continue to suffer losses or cease to exist, our view of the credit worthiness of our Agency MBS could materially change.  Given that we rely on our Agency MBS as collateral for our financings under our repurchase agreements, significant declines in their value, or perceived market uncertainty about their value, would make it more difficult for us to obtain financing on our Agency MBS on acceptable terms or at all, or to maintain our compliance with the terms of any of our financing transactions.
 
The assessment of our ability and intent to continue to hold any of our impaired securities may change over time, given, among other things, the dynamic nature of markets and other variables.  Future sales or changes in our assessment of our ability and/or intent to hold impaired investment securities could result in us recognizing other-than-temporary impairment charges or realizing losses on sales of MBS in the future.  (See Note 2(b) to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
 
Fair Value Measurements
 
Fair Value is the exchange price in an orderly transaction, which is not a forced liquidation or distressed sale, between market participants to sell an asset or transfer a liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset/liability.  The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset/liability.  Fair Value focuses on exit price and prioritizes, within a measurement of fair value, the use of market-based inputs over entity-specific inputs.  The framework for measuring fair value is comprised of a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
 
The three levels of valuation hierarchy are as follows:
 
Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or 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 the fair value measurement.
 
Our Agency MBS and our Swaps are valued by a third-party pricing services primarily based upon readily observable market parameters and are classified as Level 2 financial instruments.  The evaluation methodology of our third-party pricing service incorporates commonly used market pricing methods, including a spread measurement to various indices such as the one-year CMT and LIBOR, which are observable inputs.  The evaluation also considers the underlying characteristics of each security, which are also observable inputs, including: coupon; maturity date; loan age; reset date; collateral type; periodic and life cap; geography; and prepayment speeds.
 
 
In valuing our Swaps, we consider our credit worthiness, the credit worthiness of our counterparties and collateral provisions contained in our Swap agreements.  Based on the collateral provisions, no credit related adjustment was made in determining the value of our Swaps (each of which was in a liability position to us) at December 31, 2009.
 
In determining the fair value of our Non-Agency MBS, we consider prices obtained from third-party pricing services, broker quotes received and other applicable market based data.  If listed prices or quotes are not available, then fair value is based upon internally developed models that are primarily based on observable market-based inputs.  Factors such as vintage, credit enhancements and delinquencies are taken into account to assign pricing factors such as spread and prepayment assumptions.  For tranches that are cross-collateralized, performance of all collateral groups involved in the tranche are considered.  The pricing service collects current market intelligence on all major markets including issuer level information, benchmark security evaluations and bid-lists throughout the day from various sources, if available.  Our Non-Agency MBS are valued primarily based upon readily observable market parameters and, as such are classified as Level 2 fair values.
 
We review the valuations provided by our pricing services for reasonableness using internally developed models that apply readily observable market inputs.  We use inputs that are current as of the measurement date, which may include periods of market dislocation, during which, price transparency may be reduced.
 
We review the appropriateness of our classification of assets/liabilities within the fair value hierarchy on a quarterly basis, which could cause such assets/liabilities to be reclassified among the three hierarchy levels.  We use inputs that are current as of the measurement date, which may include periods of market dislocation, during which price transparency may be reduced.  While we believe our valuation methods are appropriate and consistent with other market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.  The methods used to produce a fair value calculation may not be indicative of net realizable value or reflective of future fair values.
 
Interest Income on our Non-Agency MBS
 
Interest income on the Non-Agency MBS that were purchased at a discount to par value and/or were rated below AA at the time of purchase is recognized based on the security’s effective interest rate.  The effective interest rate on these securities is based on the projected cash flows from each security, which are estimated based on our assessment of current information and events and include assumptions related to interest rates, prepayment rates and the timing and amount of credit losses.  On at least a quarterly basis, we review and, if appropriate, make adjustments to our cash flow projections based on input and analysis received from external sources, internal models, and our judgment about interest rates, prepayment rates, the timing and amount of credit losses, and other factors.  Changes in cash flows from those originally projected, or from those estimated at the last evaluation, may result in a prospective change in the yield/interest income recognized on such securities, which may differ significantly from our prior projections.
 
Based on the projected cash flows from our Non-Agency MBS purchased at a discount to par value, a portion of the purchase discount may be designated as credit protection against future credit losses and, therefore, may not be accreted into interest income.  The amount designated as credit discount may be adjusted over time, based on the actual performance of the security, its underlying collateral, actual and projected cash flow from such collateral, economic conditions and other factors.  If the performance of a security with a credit discount is more favorable than forecasted, a portion of the amount designated as credit discount may be accreted into interest income over time.  Conversely, if the performance of a security with a credit discount is less favorable than forecasted, additional amounts of the purchase discount may be designated as credit discount, or impairment charges and write-downs of such securities to a new cost basis could result.
 
Derivative Financial Instruments and Hedging Activities
 
A derivative, which is designated as a hedge, is recognized as an asset/liability and measured at fair value.  Our hedging instruments are currently comprised of Swaps, which hedge against increases in interest rates on our repurchase agreements.  Payments received on our Swaps decrease our interest expense, while payments made by us on our Swaps increase our interest expense.
 
To qualify for hedge accounting, we must, at inception of each hedge, anticipate and document that the hedge will be highly effective.  Thereafter we are required to monitor, on at a quarterly basis, whether the hedge continues to be, or if prior to the start date of the instrument is expected to be, effective.  Provided that the hedge remains
 
 
effective, changes in the fair value of the hedging instrument are included in accumulated other comprehensive income/(loss), a component of stockholders’ equity.  If we determine that the hedge is not effective, or that the hedge is not expected to be effective, the ineffective portion of the hedge will no longer qualify for hedge accounting and, accordingly, subsequent changes in the fair value of the ineffective hedging instrument would be reflected in earnings.
 
The gain or loss from a terminated Swap remains in accumulated other comprehensive income/(loss) until the forecasted interest payments affect earnings.  However, if it is probable that the forecasted interest payments will not occur, then the hedge is no longer considered effective and the entire gain or loss is recognized though earnings.  As a result, if it is determined that a hedge becomes ineffective, it could have a material impact on our results of operations.  To date, except for gains and losses realized on Swaps that have been terminated, none of which occurred during 2009, we have not recognized any change in the value of our hedging instruments through earnings as a result of the hedge or a portion thereof being ineffective.
 
At December 31, 2009, we had 123 Swaps with an aggregate notional balance of $3.007 billion, with gross unrealized losses of $152.5 million.  (See Notes 2(l) and 4 to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
 
Our hedging instruments are carried on the balance sheet at their fair value, as assets, if their fair value is positive, or as liabilities, if their fair value is negative.  (See “Fair Value Measurements” included under Item 7 of this annual report on Form 10-K.)
 
Income Taxes
 
Our financial results generally do not reflect provisions for current or deferred income taxes.  We believe that we operate in, and intend to continue to operate in, a manner that allows and will continue to allow us to be taxed as a REIT.  Provided that we distribute all of our REIT taxable income annually, we do not generally expect to pay corporate level taxes and/or excise taxes.  Many of the REIT requirements, however, are highly technical and complex.  If we were to fail to meet certain of the REIT requirements, we would be subject to U.S. federal, state and local income taxes.
 
Accounting for Stock-Based Compensation
 
We expense our equity based compensation awards over the vesting period of such awards using the straight-line method, based upon the fair value of such awards at the grant date.  Equity-based awards for which there is no risk of forfeiture are expensed upon grant or at such time that there is no longer a risk of forfeiture.  (See Notes 2(h) and 12 to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
 
Estimating the fair value of stock options requires that we use a model to value such options.  We use the Black-Scholes-Merton option model to value our stock options.  There are limitations inherent in this model, as with other models currently used in the market place to value stock options, as they typically were not designed to value stock options which contain significant restrictions and forfeiture risks, such as those contained in the stock options that we issue.  We make significant assumptions in order to determine our option value, all of which are subjective.
 
LIQUIDITY AND CAPITAL RESOURCES
 
Our principal sources of cash generally consist of borrowings under repurchase agreements, payments of principal and interest we receive on our MBS portfolio, cash generated from our operating results and, depending on market conditions, proceeds from capital market transactions.  Our most significant uses of cash are generally to repay principal and pay interest on our repurchase agreements, to purchase MBS, to make dividend payments on our capital stock, to fund our operations and to make other investments that we consider appropriate.
 
We employ a diverse capital raising strategy under which we may issue capital stock.  During the year ended December 31, 2009, we issued 60.6 million shares of common stock, of which 57.5 million shares were issued through a public offering, 2.8 million shares were issued pursuant to our CEO Program in at-the-market transactions, and 59,090 shares were issued pursuant to our DRSPP.  Through these issuances, we raised net capital of $403.4 million during the 2009.  At December 31, 2009, we had the ability to issue an unlimited amount (subject to the terms of our charter) of common stock, preferred stock, depositary shares representing preferred stock and/or warrants pursuant to our automatic shelf registration statement on Form S-3 and 9.3 million shares of common stock available for issuance pursuant to our DRSPP shelf registration statement on Form S-3.
 
 
To the extent we issue additional equity through capital market transactions, we currently anticipate using cash raised from such transactions to purchase additional MBS, to make scheduled payments of principal and interest on our repurchase agreements, and for other general corporate purposes.  We may also acquire other investments consistent with our investment strategies and operating policies.  There can be no assurance, however, that we will be able to raise additional equity capital at any particular time or on any particular terms.
 
Our existing repurchase agreements are renewable at the discretion of our lenders and, as such, generally do not contain guaranteed roll-over terms.  Repurchase financing currently remains available to us at attractive rates from multiple counterparties.  To protect against unforeseen reductions in our borrowing capabilities, we maintain a Cushion, comprised of cash and cash equivalents, unpledged Agency MBS and collateral in excess of margin requirements held by our counterparties.
 
At December 31, 2009, our debt-to-equity multiple was 3.3 times, compared to 7.2 times at December 31, 2008.  This reduction in our leverage multiple reflects a $1.843 billion decrease in our borrowings under repurchase agreements, a $497.3 million increase in our accumulated other comprehensive income reflecting the market appreciation of our MBS, the decrease in unrealized losses on our Swaps, and a $405.3 million increase in equity generated primarily from issuances of our common stock.  At December 31, 2009, we had borrowings under repurchase agreements of $7.196 billion with 17 counterparties and continued to have available capacity under our repurchase agreement credit lines, compared to repurchase agreements of $9.039 billion with 19 counterparties at December 31, 2008.
 
During the year ended December 31, 2009, we received cash of $1.933 billion from prepayments and scheduled amortization on our MBS portfolio and purchased $808.9 million of Non-Agency MBS funded with cash and repurchase financings.  While we generally intend to hold our MBS as long-term investments, certain MBS may be sold in order to manage our interest rate risk and liquidity needs, meet other operating objectives and adapt to market conditions.  During the year ended December 31, 2009, we sold 36 of our longer-term Agency MBS for $650.9 million, reducing the average time-to-reset for our portfolio and realizing gross gains of $22.6 million.  We used net cash of $80.6 million in connection with our MBS Forwards, reflecting net cash used to purchase MBS that were linked to repurchase financings.
 
In connection with our repurchase agreements and Swaps, we routinely receive margin calls from our counterparties and make margin calls to our counterparties (i.e., reverse margin calls).  Margin calls and reverse margin calls, which requirements vary over time, may occur daily between us and any of our counterparties when the value of collateral pledged changes from the amount contractually required.  The value of securities pledged as collateral changes as the face (or par) value of our for MBS changes, reflecting principal amortization and prepayments, market interest rates and/or other market conditions change, and the market value of our Swaps changes.  Margin calls/reverse margin calls are satisfied when we pledge/receive additional collateral in the form of securities and/or cash.
 
Our capacity to meet future margin calls will be impacted by our Cushion, which varies based on the market value of our securities, our future cash position and margin requirements.  Our cash position fluctuates based on the timing of our operating, investing and financing activities.  (See our Consolidated Statements of Cash Flows, included under Item 8 of this annual report on Form 10-K.)
 
At December 31, 2009, we had a total of $7.838 billion of MBS and $67.5 million of restricted cash pledged against our repurchase agreements and Swaps.  At December 31, 2009, we had a Cushion of $762.4 million available to meet potential margin calls, comprised of cash and cash equivalents of $653.5 million, unpledged Agency MBS of $54.8 million, and excess collateral of $54.1 million.  To date, we have satisfied all of our margin calls and have never sold assets in response to a margin call.
 
 
The table below presents quarterly information about our 2009 margin transactions:
 
   
Collateral Pledged to Meet Margin Calls
            
For the Quarter Ended
  
Fair Value of Securities Pledged
  
Cash Pledged
  
Aggregate Assets Pledged For Margin Calls
  
Cash and Securities Received For Reverse Margin Calls
  
Net Assets
(Pledged)/ Received For Margin Activity
(In Thousands)
                          
December 31, 2009
   $ 251,003     $ 47,238     $ 298,241     $ 146,594     $ (151,647 )
September 30, 2009
     305,154       12,770       317,924       269,154       (48,770 )
June 30, 2009
     254,646       27,440       282,086       310,676       28,590  
March 31, 2009
     177,892       74,360       252,252       209,342       (42,910 )
 
The following table summarizes the effect on our liquidity and cash flows of contractual obligations for the principal amounts due (which does not include interest payable) on our repurchase agreements, MBS Forwards, non-cancelable office leases and the mortgage loan on the property held by our real estate subsidiaries at December 31, 2009:
 
     
2010
  
2011
  
2012
  
2013
  
2014
  
Thereafter
(In Thousands)
                          
Repurchase agreements
    
$ 6,790,027
  
 $   289,800
  
 $     92,100
  
 $    23,900
  
 $           -
  
 $              -
MBS Forwards (1)
    
      244,959
  
                 -
  
                 -
  
                -
  
              -
  
                 -
Mortgage loan
    
             209
  
          8,934
  
                 -
  
                -
  
              -
  
                 -
Long-term lease obligations
    
          1,099
  
          1,115
  
          1,183
  
         1,399
  
       1,428
  
          3,331
     
$ 7,036,294
  
 $   299,849
  
 $     93,283
  
 $    25,299
  
 $    1,428
  
 $       3,331
(1)  Reflect payments of principal due on repurchase agreements that are a component of our MBS Forwards.
 
During 2009, we paid cash dividends of $220.7 million on our common stock, $777,000 for dividend equivalent rights (or DERs), and $8.2 million on our preferred stock.  On December 16, 2009, we declared our fourth quarter 2009 common stock dividend of $0.27 per share, which totaled $75.9 million and included DERs of $226,000.  In addition, we had dividends payable on shares of our restricted common stock, which are payable to the extent that such shares vest.  These dividends and DERs were paid on January 29, 2010.
 
We believe that we have adequate financial resources to meet our obligations, including margin calls, as they come due, to fund dividends we declare and to actively pursue our investment strategies.  However, should the value of our MBS suddenly decrease, significant margin calls on our repurchase agreements could result, or should the market intervention by the U.S. Government fail to prevent further significant deterioration in the credit markets, our liquidity position could be adversely affected.
 
OFF-BALANCE SHEET ARRANGEMENTS
 
We do not have any material off-balance-sheet arrangements.
 
INFLATION
 
Substantially all of our assets and liabilities are financial in nature.  As a result, changes in interest rates and other factors impact our performance far more than does inflation.  Our financial statements are prepared in accordance with GAAP and dividends are based upon net ordinary income as calculated for tax purposes; in each case, our results of operations and reported assets, liabilities and equity are measured with reference to historical cost or fair value without considering inflation.
 
FORWARD LOOKING STATEMENTS
 
When used in this annual report on Form 10-K, in future filings with the SEC or in press releases or other written or oral communications, statements which are not historical in nature, including those containing words such as “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” or similar expressions, are intended to identify “forward-looking statements” within the meaning of Section 27A of the 1933
 
 
Act and Section 21E of the 1934 Act and, as such, may involve known and unknown risks, uncertainties and assumptions.
 
Statements regarding the following subjects, among others, may be forward-looking: changes in interest rates and the market value of our MBS; changes in the prepayment rates on the mortgage loans securing our MBS; our ability to borrow to finance our assets; implementation of or changes in government regulations or programs affecting our business; our ability to maintain our qualification as a REIT for federal income tax purposes; our ability to maintain our exemption from registration under the Investment Company Act; and risks associated with investing in real estate assets, including changes in business conditions and the general economy.  These and other risks, uncertainties and factors, including those described in the annual, quarterly and current reports that we file with the SEC, could cause our actual results to differ materially from those projected in any forward-looking statements we make.  All forward-looking statements speak only as of the date they are made.  New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us.  Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.  See Item 1A, “Risk Factors” of this annual report on Form 10-K.
 
Item 7A.  Quantitative and Qualitative Disclosures About Market Risk.
 
We seek to manage our risks related to interest rates, liquidity, prepayment speeds, market value and the credit quality of our assets while, at the same time, seeking to provide an opportunity to stockholders to realize attractive total returns through ownership of our capital stock.  While we do not seek to avoid risk, we seek to: assume risk that can be quantified from historical experience, and actively manage such risk; earn sufficient returns to justify the taking of such risks; and, maintain capital levels consistent with the risks that we undertake.
 
INTEREST RATE RISK
 
We primarily invest in ARM-MBS on a leveraged basis.  We take into account both anticipated coupon resets and expected prepayments when measuring the sensitivity of our ARM-MBS portfolio to changes in interest rates.  In measuring our repricing gap (i.e., the weighted average time period until our ARM-MBS are expected to prepay or reset less the weighted average time period for liabilities to reset (or Repricing Gap)), we measure the difference between: (a) the weighted average months until the next coupon adjustment or projected prepayment on the ARM-MBS portfolios; and (b) the months remaining until our repurchase agreements mature, including the impact of Swaps.  A CPR is applied in order to reflect, to a certain extent, the prepayment characteristics inherent in our interest-earning assets and interest-bearing liabilities.  Over the last consecutive eight quarters, ending with December 31, 2009, the monthly CPR on our MBS portfolio ranged from a high of 20.4% experienced during the quarter ended September 30, 2009 to a low of 7.3% experienced during the quarter ended December 31, 2008, with an average three-month CPR of 14.3%.
 
The following table presents information at December 31, 2009 about our Repricing Gap based on contractual maturities (i.e., 0 CPR), and applying CPRs of 15%, 20% and 25% to our Agency MBS portfolio.
 
CPR
  
Estimated Months to Asset Reset or Expected Prepayment
  
Estimated Months to Liabilities Reset (1)
  
Repricing Gap in Months
  0% (2)
  
41
  
13
  
28
15%
  
29
  
13
  
16
20%
  
26
  
13
  
13
25%
  
23
  
13
  
10
(1)
Reflects the effect of our Swaps.
(2)
0% CPR reflects only scheduled amortization and contractual maturities.
 
At December 31, 2009, our financing obligations under repurchase agreements had a weighted average remaining contractual term of approximately three months.  Upon contractual maturity or an interest reset date, these borrowings are refinanced at then prevailing market rates.  We use Swaps as part of our overall interest rate risk management strategy.  Our Swaps are intended to act as a hedge against future interest rate increases on our repurchase agreements, which rates are typically LIBOR based.
 
 
While our Swaps do not extend the maturities of our repurchase agreements, they do however lock in a fixed rate of interest over their term for a corresponding amount of our repurchase agreements that such Swaps hedge.  For 2009, our Swaps increased our borrowing costs by $120.8 million, or 149 basis points.  At December 31, 2009, we had repurchase agreements of $7.196 billion, of which $3.007 billion were hedged with Swaps.  At December 31, 2009, our Swaps had a weighted average fixed-pay rate of 4.23% and extended 25 months on average with a maximum term of approximately five years.
 
At December 31, 2009, our Swaps were in an unrealized loss position of $152.5 million, compared to an unrealized loss position of $237.3 million at December 31, 2008.  We expect the unrealized losses on our Swaps to lessen over the course of 2010, as our Swaps amortize and their remaining term shortens.  During 2010, $821.2 million, or 27.3%, of our $3.007 billion Swap notional is scheduled to amortize or expire.  During 2009, we did not enter into or terminate any Swaps.
 
The interest rates for most of our ARM-MBS, once in their adjustable period, primarily reset based on LIBOR, and, to a lesser extent, CMT or MTA, while our borrowings, in the form of repurchase agreements, are generally priced off of LIBOR.  While LIBOR, CMT and MTA generally move together, there can be no assurance that the movement of one index will match that of the other index and, in fact, have at times moved inversely.  At December 31, 2009, 82.8% of our Agency ARM-MBS were LIBOR based (of which 77.1% were based on 12-month LIBOR and 5.7% were based on six-month LIBOR), 12.7% were based on CMT, 4.1% were based on MTA and 0. 4% were based on COFI.  Our Non-Agency MBS, which comprised 12.5% of our MBS portfolio (15.7% including linked MBS) at December 31, 2009, have interest rates that reset based on these benchmark indices as well, but are leveraged significantly less than our Agency MBS.  The returns on our Non-Agency MBS, a significant portion of which were purchased at a discount, are impacted to a greater extent by the timing and amount of prepayments and credit performance than by the benchmark rate to which the underlying mortgages are indexed.
 
We acquire interest-rate sensitive assets and fund them with interest-rate sensitive liabilities, a portion of which are hedged with Swaps.  Our adjustable-rate assets reset on various dates that are not matched to the reset dates on our repurchase agreements.  In general, the repricing of our repurchase agreements occurs more quickly, including the impact of Swaps, than the repricing of our assets.  Therefore, on average, our cost of borrowings generally rise or fall more quickly in response to changes in market interest rates than would the yield on our interest-earning assets.
 
The information presented in the following tables projects the potential impact of sudden parallel changes in interest rates on our net interest income and portfolio value, including the impact of Swaps, over the next 12 months based on the assets in our investment portfolio at December 31, 2009 and December 31, 2008.  All changes in income and value are measured as the percentage change from the projected net interest income and portfolio value at the base interest rate scenario at December 31, 2009 and 2008.
 
December 31, 2009 Shock Table
Change in Interest Rates
  
Estimated Value of MBS (1)
  
Estimated Value of Swaps
  
Estimated Value of Financial Instruments Carried at Fair
Value (2)
  
Estimated Change in Fair Value
  
Percentage Change in Net Interest Income
  
Percentage Change in Portfolio Value
(Dollars in Thousands)
                        
+100 Basis Point Increase
  
$  8,897,702
  
$  (98,397)
  
 $8,799,305
  
 $(135,726)
  
   (6.00)%
  
   (1.52)%
+ 50 Basis Point Increase
  
$  9,004,108
  
$(125,430)
  
 $8,878,678
  
 $  (56,353)
  
   (2.88)%
  
   (0.63)%
Actual at December 31, 2009
  
$  9,087,494
  
$(152,463)
  
 $8,935,031
  
                -
  
          -
  
         -
- 50 Basis Point Decrease
  
$  9,147,860
  
$(179,497)
  
 $8,968,363
  
 $   33,332
  
    0.83%
  
    0.37%
-100 Basis Point Decrease
  
$  9,185,205
  
$(206,530)
  
 $8,978,675
  
 $   43,644
  
   (0.48)%
  
    0.49%
(1)
Includes linked MBS that are reported as a component of MBS Forwards on our consolidated balance sheet. Such MBS may not be linked in future periods.
(2) 
Excludes cash investments, which typically have overnight maturities and are not expected to change in value as interest rates change.
 
 
December 31, 2008 Shock Table
Change in Interest Rates
  
Estimated Value of MBS
  
Estimated Value of Swaps
  
Estimated Value of Financial Instruments Carried at Fair
Value (1)
  
Estimated Change in Fair Value
  
Percentage Change in Net Interest Income
  
Percentage Change in Portfolio Value
(Dollars in Thousands)
                        
+100 Basis Point Increase
  
$  9,864,455
  
$(155,435)
  
 $9,709,020
  
 $(176,272)
  
   (6.26)%
  
  (1.78)%
+ 50 Basis Point Increase
  
$10,017,306
  
$(196,363)
  
 $9,820,943
  
 $  (64,349)
  
   (2.36)%
  
  (0.65)%
Actual at December 31, 2008
  
$10,122,583
  
$(237,291)
  
 $9,885,292
  
                -
  
          -
  
        -
- 50 Basis Point Decrease
  
$10,180,280
  
$(278,219)
  
 $9,902,061
  
 $    16,769
  
   (0.84)%
  
   0.17%
-100 Basis Point Decrease
  
$10,190,402
  
$(319,147)
  
 $9,871,255
  
 $  (14,037)
  
   (6.95)%
  
  (0.14)%
(1) 
Excludes cash investments, which have overnight maturities and are not expected to change in value as interest rates change.
 
Certain assumptions have been made in connection with the calculation of the information set forth in the shock tables and, as such, there can be no assurance that assumed events will occur or that other events will not occur that would affect the outcomes.  The base interest rate scenario assumes interest rates at December 31, 2009 and December 31, 2008.  The analysis presented utilizes assumptions and estimates based on management’s judgment and experience.  Furthermore, while we generally expect to retain such assets and the associated interest rate risk to maturity, future purchases and sales of assets could materially change our interest rate risk profile.  It should be specifically noted that the information set forth in the above tables and all related disclosure constitute forward-looking statements within the meaning of Section 27A of the 1933 Act and Section 21E of the 1934 Act.  Actual results could differ significantly from those estimated in the shock tables.
 
The shock tables quantify the potential changes in net interest income and portfolio value, which includes the value of our Swaps (which are carried at fair value), should interest rates immediately change (i.e., shocked).  The shock tables present the estimated impact of interest rates instantaneously rising 50 and 100 basis points, and falling 50 and 100 basis points.  The cash flows associated with our portfolio of MBS for each rate shock are calculated based on assumptions, including, but not limited to, prepayment speeds, yield on future acquisitions, slope of the yield curve and composition of our portfolio.  Assumptions made on the interest rate sensitive liabilities, which are assumed to be repurchase agreements, include anticipated interest rates, collateral requirements as a percent of the repurchase agreement, amount and term of borrowing.  Given the low level of interest rates at December 31, 2009 and December 31, 2008, we applied a floor of 0% for all anticipated interest rates included in our assumptions.  Due to presence of this floor, it is anticipated that any hypothetical interest rate shock decrease would have a limited positive impact on our funding costs; however, because prepayments speeds are unaffected by this floor, it is expected that any increase in our prepayment speeds (occurring as a result of any interest rate shock decrease or otherwise) could result in an acceleration of our premium amortization on our Agency MBS and the reinvestment of such prepaid principal in lower yielding assets.  As a result, because the presence of this floor limits the positive impact of any interest rate decrease on our funding costs, hypothetical interest rate shock decreases could cause the fair value of our financial instruments and our net interest income to decline.
 
When comparing the shock table results for December 31, 2009 to December 31, 2008, we note that the results for 2009 were impacted by our increase in investments in Non-Agency MBS (for which we used limited leverage, which decreased our leverage multiple), shorter terms to repricing on our repurchase agreements, and the decrease in our Swaps that hedge our repurchase agreements.
 
The impact on portfolio value was approximated using the calculated effective duration (i.e., the price sensitivity to changes in interest rates) of 0.99 and expected convexity (i.e., the approximate change in duration relative to the change in interest rates) of (1.01) for December 31, 2009.  The table at December 31, 2008 was approximated using an effective duration of 0.79 and expected convexity of (1.88).  The impact on our net interest income is driven mainly by the difference between portfolio yield and cost of funding of our repurchase agreements, which includes the cost and/or benefit from Swaps that hedge certain of our repurchase agreements.  Our asset/liability structure is generally such that an increase in interest rates would be expected to result in a decrease in net interest income, as our repurchase agreements are generally shorter term than our interest-earning assets.  When
 
 
interest rates are shocked, prepayment assumptions are adjusted based on management’s expectations along with the results from the prepayment model.
 
MARKET VALUE RISK
 
All of our MBS are designated as “available-for-sale” and, as such, are reported at their fair value.  The difference between amortized cost and fair value of our MBS is reflected in accumulated other comprehensive income/(loss), a component of Stockholders’ Equity, except that credit impairments that are identified as other-than-temporary are recognized through earnings.  Changes in the fair value of our MBS Forwards are reported in earnings.  The fair value of our MBS and MBS Forwards fluctuate primarily due to changes in interest rates and yield curves.  At December 31, 2009, our investment securities were comprised of Agency MBS and Non-Agency MBS.  While changes in the fair value of our Agency MBS is generally not credit-related, changes in the fair value of our Non-Agency MBS and MBS Forwards may reflect both market conditions and credit conditions.  At December 31, 2009, our Non-Agency MBS had a fair value of $1.093 billion and an amortized cost of $1.017 billion, comprised of gross unrealized gains of $135.8 million and gross unrealized losses of $59.7 million.  Our MBS Forwards included MBS with a fair value of $329.5 million, including mark-to-market adjustments of $3.8 million, which were included in the $8.8 million net gain recognized on our MBS Forwards for the year ended December 31, 2009.
 
Generally, in a rising interest rate environment, the fair value of our MBS would be expected to decrease; conversely, in a decreasing interest rate environment, the fair value of such MBS would be expected to increase.  If the fair value of our MBS collateralizing our repurchase agreements decreases, we may receive margin calls from our repurchase agreement counterparties for additional MBS collateral or cash due to such decline.  If such margin calls are not met, our lender could liquidate the securities collateralizing our repurchase agreements with such lender, potentially resulting in a loss to us.  To avoid forced liquidations, we could apply a strategy of reducing borrowings and assets, by selling assets or not replacing securities as they amortize and/or prepay, thereby “shrinking the balance sheet”.  Such an action would likely reduce our interest income, interest expense and net income, the extent of which would be dependent on the level of reduction in assets and liabilities as well as the sale price of the assets sold.  Such a decrease in our net interest income could negatively impact cash available for distributions, which in turn could reduce the market price of our issued and outstanding common stock and preferred stock.  Further, if we were unable to meet margin calls, lenders could sell the securities collateralizing such repurchase agreements, which sales could result in a loss to us.  To date, we have satisfied all of our margin calls and have never sold assets to meet any margin calls.
 
Our Non-Agency MBS are secured by pools of residential mortgages, which are not guaranteed by the U.S. Government, any federal agency or any federally chartered corporation.  The loans collateralizing our Non-Agency MBS are primarily comprised of Hybrids, with fixed-rate periods generally ranging from three to ten years, and, to a lesser extent, ARMs and fixed-rate mortgages.  At December 31, 2009, 93.0% of our Non-Agency MBS were ARM-MBS and 7.0% were fixed-rate MBS.
 
 
The following table presents certain information, detailed by the year of initial MBS securitization and FICO score, about the underlying loan characteristics of our Non-Agency MBS (which does not include four MBS with an aggregate amortized cost of approximately $185,000 for which the information is not available) at December 31, 2009.  Information presented with respect to weighted average loan to value, weighted average FICO scores and other information aggregated based on information reported at the time of mortgage origination are historical and, as such, does not reflect the impact of the general decline in home prices or any changes in a borrowers’ credit score or the current use or status of the mortgaged property.  Transactions that are currently linked and, therefore, presented as MBS Forwards, may not be linked in the future and, if no longer linked, will be included in our MBS portfolio.  In assessing our asset/liability management and performance, we consider linked MBS as part of our MBS portfolio.  As such, we have included MBS that are a component of linked transactions in the tables below.
 
 
Securities with Average Loan FICO
of 715 or Higher  (1)
Securities with Average Loan FICO
Below 715  (1)
  
Year of Securitization (2)
2007
2006
2005
and Prior
2007
2006
2005
and Prior