Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2010

OR

 

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

For the transition period from              to             

Commission file number 001-13709

 

 

ANWORTH MORTGAGE ASSET CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

MARYLAND   52-2059785

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

1299 Ocean Avenue, Second Floor,

Santa Monica, California

  90401
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (310) 255-4493

 

 

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

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

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

 

Large Accelerated Filer   x    Accelerated Filer   ¨
Non-Accelerated Filer   ¨  (Do not check if a smaller reporting company)    Smaller Reporting Company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

At August 4, 2010, the registrant had 117,947,729 shares of common stock issued and outstanding.

 

 

 


Table of Contents

ANWORTH MORTGAGE ASSET CORPORATION

FORM 10-Q

INDEX

 

              Page
Part I.      FINANCIAL INFORMATION    1
 

Item 1.

  

Consolidated Financial Statements

   1
    

Consolidated Balance Sheets as of June 30, 2010 (unaudited) and December 31, 2009

   1
    

Consolidated Statements of Income for the three and six months ended June 30, 2010 and 2009 (unaudited)

   2
    

Consolidated Statements of Stockholders’ Equity for the three months ended March  31, 2010 and June 30, 2010 (unaudited)

   3
    

Consolidated Statements of Cash Flows for the three and six months ended June 30, 2010 and 2009 (unaudited)

   4
    

Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2010 and 2009 (unaudited)

   5
    

Notes to Unaudited Consolidated Financial Statements

   6
 

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   23
 

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   33
 

Item 4.

  

Controls and Procedures

   37
Part II.      OTHER INFORMATION    38
 

Item 1.

  

Legal Proceedings

   38
 

Item 1A.

  

Risk Factors

   38
 

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   38
 

Item 3.

  

Defaults Upon Senior Securities

   38
 

Item 4.

  

Reserved

   38
 

Item 5.

  

Other Information

   38
 

Item 6.

  

Exhibits

   39
    

Signatures

   42


Table of Contents

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

Part I. FINANCIAL INFORMATION

 

Item 1. Consolidated Financial Statements

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

 

     June 30,
2010
    December 31,
2009
 
     (unaudited)        
ASSETS     

Agency MBS:

    

Agency MBS pledged to counterparties at fair value

   $ 5,433,660      $ 5,749,849   

Agency MBS at fair value

     701,889        725,174   

Paydowns receivable

     13,078        10,778   
                
     6,148,627        6,485,801   

Non-Agency MBS:

    

Non-Agency MBS at fair value

     5,080        4,742   

Cash and cash equivalents

     473        1,812   

Reverse repurchase agreements

     70,500        0   

Interest and dividends receivable

     23,616        28,818   

Derivative instruments at fair value

     0        2,059   

Prepaid expenses and other

     10,689        3,416   
                

Total Assets:

   $ 6,258,985      $ 6,526,648   
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Liabilities:

    

Accrued interest payable

   $ 21,668      $ 20,838   

Repurchase agreements

     5,090,000        5,359,000   

Junior subordinated notes

     37,380        37,380   

Derivative instruments at fair value

     88,644        82,811   

Dividends payable on Series A Preferred Stock

     1,011        1,011   

Dividends payable on Series B Preferred Stock

     430        433   

Dividends payable on common stock

     29,257        32,305   

Payable for securities purchased

     72,075        61,123   

Accrued expenses and other

     4,028        2,436   
                

Total Liabilities:

   $ 5,344,493      $ 5,597,337   
                

Series B Cumulative Convertible Preferred Stock: par value $0.01 per share; liquidating preference $25.00 per share ($27,500 and $27,700, respectively); 1,102 and 1,108 shares issued and outstanding at June 30, 2010 and December 31, 2009, respectively

   $ 25,644      $ 25,803   
                

Stockholders’ Equity:

    

Series A Cumulative Preferred Stock: par value $0.01 per share; liquidating preference $25.00 per share ($46,888 and $46,888, respectively); 1,876 and 1,876 shares issued and outstanding at June 30, 2010 and December 31, 2009, respectively

  

 

$

 

45,397

 

  

  $ 45,397   

Common Stock: par value $0.01 per share; authorized 200,000 shares, 117,028 and 115,563 issued and outstanding at June 30, 2010 and December 31, 2009, respectively

     1,170        1,156   

Additional paid-in capital

     1,026,976        1,016,821   

Accumulated other comprehensive gain consisting of unrealized losses and gains

     64,586        84,259   

Accumulated deficit

     (249,281     (244,125
                

Total Stockholders’ Equity:

   $ 888,848      $ 903,508   
                

Total Liabilities and Stockholders’ Equity:

   $ 6,258,985      $ 6,526,648   
                

See accompanying notes to unaudited consolidated financial statements.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share amounts)

(unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  

Interest income:

        

Interest on Agency MBS

   $ 54,340      $ 67,111      $ 115,491      $ 134,006   

Interest on Non-Agency MBS

     60        72        108        147   

Other income

     19        67        28        112   
                                
     54,419        67,250        115,627        134,265   
                                

Interest expense:

        

Interest expense on repurchase agreements

     24,264        28,796        47,963        60,834   

Interest expense on junior subordinated notes

     322        402        627        857   
                                
     24,586        29,198        48,590        61,691   
                                

Net interest income

     29,833        38,052        67,037        72,574   
                                

Net gain on derivative instruments

     0        0        0        107   

Expenses:

        

Compensation, incentive compensation and benefits

     (2,417     (3,116     (5,615     (6,177

Write-down of Lehman receivable

     (674     0        (674     0   

Other expenses

     (931     (906     (1,688     (1,733
                                

Total expenses

     (4,022     (4,022     (7,977     (7,910
                                

Net income

     25,811        34,030        59,060        64,771   
                                

Dividend on Series A Cumulative Preferred Stock

     (1,011     (1,011     (2,022     (2,022

Dividend on Series B Cumulative Convertible Preferred Stock

     (430     (471     (861     (942
                                

Net income to common stockholders

   $ 24,370      $ 32,548      $ 56,177      $ 61,807   
                                

Basic earnings per common share

   $ 0.21      $ 0.32      $ 0.48      $ 0.62   

Diluted earnings per common share

   $ 0.21      $ 0.31      $ 0.47      $ 0.61   

Basic weighted average number of shares outstanding

     117,541        102,344        117,152        99,177   

Diluted weighted average number of shares outstanding

     121,101        105,849        120,712        102,682   

See accompanying notes to unaudited consolidated financial statements.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands, except per share amounts)

(unaudited)

 

    Series A
Preferred

Stock
Shares
  Common
Stock

Shares
    Series A
Preferred

Stock Par
Value
  Common
Stock
Par

Value
    Additional
Paid-In
Capital
    Accum.
Other
Comp.
Income
Agency
MBS
    Accum.
Other
Comp.
Income
Non-
Agency
MBS
  Accum.
Other
Comp.
(Loss)
Derivatives
    Accum.
(Deficit)
    Comp.
Income
    Total  

Balance, December 31, 2009

  1,876   115,563      $ 45,397   $ 1,156      $ 1,016,821      $ 165,250      $ 492   $ (81,483   $ (244,125     $ 903,508   
                                                                       

Issuance of common stock

    2,901          29        19,230                  19,259   

Retired treasury stock

    (513       (5     (3,511               (3,516

Other comprehensive income (loss), fair value adjustments

              (23,751     1,451     189          (22,111     (22,111

Net income

                    33,249        33,249        33,249   
                           

Comprehensive income

                    $ 11,138     
                           

Amortization of restricted stock

            70                  70   

Dividend declared - $0.539063 per Series A preferred share

                    (1,011       (1,011

Dividend declared - $0.390625 per Series B preferred share

                    (430       (430
                                                                       

Balance, March 31, 2010

  1,876   117,951      $ 45,397   $ 1,180      $ 1,032,610      $ 141,499      $ 1,943   $ (81,294   $ (212,317     $ 929,018   
                                                                       

Issuance of common stock

    1,624          16        10,785                  10,801   

Retired treasury stock

    (2,547       (26     (16,489               (16,515

Other comprehensive income (loss), fair value adjustments

              9,531        864     (7,958       2,437        2,437   

Net income

                    25,811        25,811        25,811   
                           

Comprehensive income

                    $ 28,248     
                           

Amortization of restricted stock

            70                  70   

Dividend declared - $0.539063 per Series A preferred share

                    (1,011       (1,011

Dividend declared - $0.390625 per Series B preferred share

                    (430       (430

Dividend declared - $0.27 per common share

                    (32,076       (32,076

Dividend declared - $0.25 per common share

                    (29,257       (29,257
                                                                       

Balance, June 30, 2010

  1,876   117,028      $ 45,397   $ 1,170      $ 1,026,976      $ 151,030      $ 2,807   $ (89,252   $ (249,280     $ 888,848   
                                                                       

See accompanying notes to unaudited consolidated financial statements.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  

Operating Activities:

        

Net income

   $ 25,811      $ 34,030      $ 59,060      $ 64,771   

Adjustments to reconcile net income to net cash (used in) provided by operating activities:

        

Amortization of premium and discounts (Agency MBS)

     12,439        4,155        24,779        8,646   

(Gain) on derivative instruments

     0        0        0        (107

Amortization of restricted stock

     70        70        141        141   

Write-down of Lehman receivable

     674        0        674        0   

Changes in assets and liabilities:

        

Decrease in interest receivable

     3,512        1,588        5,202        1,000   

(Increase) in prepaid expenses and other

     (7,354     (2,924     (7,947     (3,314

Increase (decrease) in accrued interest payable

     2,285        (2,636     954        (2,656

(Decrease) increase in accrued expenses and payable for securities purchased

     (86,235     2,130        12,543        3,965   
                                

Net cash (used in) provided by operating activities

   $ (48,798   $ 36,413      $ 95,406      $ 72,446   
                                

Investing Activities:

        

Available-for-sale Agency MBS:

        

Purchases

   $ (692,875   $ 0      $ (1,223,070   $ (445,547

Principal payments

     1,071,933        262,889        1,521,243        473,080   

Available-for-sale Non-Agency MBS:

        

Principal payments

     1,109        600        1,977        1,144   

Purchase of reverse repurchase agreements

     (70,500     (79,000     (70,500     (79,000
                                

Net cash provided by (used in) investing activities

   $ 309,667      $ 184,489      $ 229,650      $ (50,323
                                

Financing Activities:

        

Borrowings from repurchase agreements

   $ 7,032,600      $ 6,744,000      $ 14,226,950      $ 14,624,000   

Repayments on repurchase agreements

     (7,254,600     (7,042,000     (14,495,950     (14,802,000

Proceeds from common stock issued, net

     10,801        23,986        29,901        81,325   

Series A Preferred stock dividends paid

     (1,011     (1,011     (2,022     (2,022

Series B Preferred stock dividends paid

     (430     (471     (861     (942

Common stock dividends paid

     (32,076     (30,493     (64,381     (53,938

Treasury stock

     (16,515     0        (20,032     0   
                                

Net cash (used in) provided by financing activities

   $ (261,231   $ (305,989   $ (326,395   $ (153,577
                                

Net decrease in cash and cash equivalents

   $ (362   $ (85,087   $ (1,339   $ (131,454

Cash and cash equivalents at beginning of period

     835        85,603        1,812        131,970   
                                

Cash and cash equivalents at end of period

   $ 473      $ 516      $ 473      $ 516   
                                

Supplemental Disclosure of Cash Flow Information:

        

Cash paid for interest

   $ 22,301      $ 31,835      $ 47,636      $ 64,349   

See accompanying notes to unaudited consolidated financial statements.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

(unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  

Net income

   $ 25,811      $ 34,030      $ 59,060      $ 64,771   
                                

Available-for-sale Agency MBS, fair value adjustment

     9,531        38,901        (14,220     102,622   

Available-for-sale Non-Agency MBS, fair value adjustment

     864        (225     2,315        (365

Unrealized (losses) gains on cash flow hedges

     (28,792     5,877        (49,277     (151

Reclassification adjustment for gains on derivative instruments

     0        0        0        (107

Reclassification adjustment for interest expense included in net income

     20,834        20,190        41,508        37,511   
                                
     2,437        64,743        (19,674     139,510   
                                

Comprehensive income

   $ 28,248      $ 98,773      $ 39,386      $ 204,281   
                                

See accompanying notes to unaudited consolidated financial statements.

 

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Table of Contents

ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

As used in this Quarterly Report on Form 10-Q, “company,” “we,” “us,” “our,” and “Anworth” refer to Anworth Mortgage Asset Corporation.

NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

We were formed in October 1997 and commenced operations on March 17, 1998. We are in the business of investing primarily in United States, or U.S., agency mortgage-backed securities, or MBS, which are obligations guaranteed by the U.S. government, such as Ginnie Mae, or federally sponsored enterprises, such as Fannie Mae or Freddie Mac. Our principal business objective is to generate net income for distribution to stockholders based upon the spread between the interest income on our mortgage-related assets and the costs of borrowing to finance our acquisition of these assets.

We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, or the Code. As a REIT, we routinely distribute substantially all of the income generated from our operations to our stockholders. As long as we retain our REIT status, we generally will not be subject to federal or state taxes on our income to the extent that we distribute our net income to our stockholders.

BASIS OF PRESENTATION AND CONSOLIDATION

The accompanying unaudited consolidated financial statements are prepared on the accrual basis of accounting in accordance with generally accepted accounting principles utilized in the United States of America, or GAAP. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Material estimates that are susceptible to change relate to the determination of the fair value of securities, amortization of security premiums and accretion of security discounts, accounting for derivatives and hedging activities and accounting for impaired securities. Actual results could materially differ from these estimates. Significant intercompany accounts and transactions have been eliminated. In the opinion of management, all material adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation have been included. The operating results for the three and six months ended June 30, 2010 and 2009 are not necessarily indicative of the results that may be expected for the calendar year. The interim financial information in the accompanying unaudited consolidated financial statements and the notes thereto should be read in conjunction with the audited consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009.

The following is a summary of our significant accounting policies:

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less. The carrying amount of cash equivalents approximates their fair value.

Reverse Repurchase Agreements

Securities purchased under agreements to resell (“reverse repurchase agreements”), although legally structured as a purchase and subsequent resale, are treated as financing transactions under which the counterparty pledges securities (principally U.S. treasury securities) and accrued interest as collateral to secure a loan. The difference between the purchase price that we pay and the resale price that we receive represents interest paid to us. It is our policy to generally take possession of securities purchased under agreements to resell at the time such agreements are made. We use these agreements as a means of investing excess cash.

Mortgage-Backed Securities (MBS)

Agency MBS are securities that are obligations (including principal and interest) which are guaranteed by the U.S. government, such as Ginnie Mae, or guaranteed by federally sponsored enterprises, such as Fannie Mae or Freddie Mac, which were placed in the conservatorship of the U.S. government in September 2008. Our investment grade Agency MBS portfolio is invested primarily in fixed-rate and adjustable-rate mortgage-backed pass-through certificates and hybrid adjustable-rate MBS. Hybrid adjustable-rate MBS have an initial interest rate that is fixed for a certain period, usually three to five years, and then adjusts annually for the remainder of the term of the loan. We structure our investment portfolio to be diversified with a variety of prepayment characteristics, investing in mortgage-related assets with prepayment penalties, investing in certain mortgage security structures that have prepayment protections and purchasing mortgage-related assets at a premium and at a discount.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Non-Agency MBS are securities not issued by government-sponsored enterprises which are secured primarily by first-lien residential mortgage loans.

We classify our MBS as either trading investments, available-for-sale investments or held-to-maturity investments. Our management determines the appropriate classification of the securities at the time they are acquired and evaluates the appropriateness of such classifications at each balance sheet date. We currently classify all of our MBS as available-for-sale. All assets that are classified as available-for-sale are carried at fair value and unrealized gains or losses are generally included in “Other comprehensive income or loss” as a component of stockholders’ equity. Losses that are credit-related on securities classified as available-for-sale, which are determined by management to be other-than-temporary in nature, are reclassified from “Other comprehensive income” to income/(loss).

The most significant source of our revenue is derived from our investments in MBS. Interest income on our Agency MBS and Non-Agency MBS is accrued based on the actual coupon rate and the outstanding principal amount of the underlying mortgages. Premiums and discounts are amortized or accreted into interest income over the lives of the securities using the effective interest yield method, adjusted for the effects of actual prepayments based on the Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, 320-10. Our policy for estimating prepayment speeds for calculating the effective yield is to evaluate historical performance, street consensus prepayment speeds and current market conditions. If our estimate of prepayments is incorrect, as compared to the aforementioned references, we may be required to make an adjustment to the amortization or accretion of premiums and discounts that would have an impact on future income, which could be material and adverse.

Securities are recorded on the date the securities are purchased or sold. Realized gains or losses from securities transactions are determined based on the specific identified cost of the securities.

The following table shows our investments’ gross unrealized losses and fair value of those individual securities that have been in a continuous unrealized loss position at June 30, 2010 and December 31, 2009, aggregated by investment category and length of time (dollar amounts in thousands):

June 30, 2010

 

     Less Than 12 Months     12 Months or More     Total  

Description of Securities

   Number
of
Securities
   Fair
Value
   Unrealized
Losses
    Number
of
Securities
   Fair
Value
   Unrealized
Losses
    Number
of
Securities
   Fair
Value
   Unrealized
Losses
 

Agency MBS

   36    $ 240,813    $ (1,847   325    $ 270,179    $ (5,714   361    $ 510,992    $ (7,561

December 31, 2009

 

     Less Than 12 Months     12 Months or More     Total  

Description of Securities

   Number
of
Securities
   Fair
Value
   Unrealized
Losses
    Number
of
Securities
   Fair
Value
   Unrealized
Losses
    Number
of
Securities
   Fair
Value
   Unrealized
Losses
 

Agency MBS

   48    $ 895,549    $ (4,334   360    $ 352,040    $ (7,327   408    $ 1,247,589    $ (11,661

We do not consider those Agency MBS that have been in a continuous loss position for 12 months or more to be other-than-temporarily impaired. The unrealized losses on our investments in Agency MBS were caused by fluctuations in interest rates and recent pricing that is reflective of the liquidity and credit problems surrounding the mortgage markets generally. We purchased the Agency MBS primarily at a premium relative to their face value and the contractual cash flows of those investments are guaranteed by U.S. government or government-sponsored agencies. Since September 2008, the government-sponsored agencies have been in the conservatorship of the U.S. government. We do not expect to sell the Agency MBS at a price less than the amortized cost basis of our investments. Because the decline in market value of the Agency MBS is attributable to changes in interest rates and recent pricing that is reflective of the liquidity and credit problems surrounding the mortgage markets generally and not the credit quality of the Agency MBS in our portfolio, and because we do not have the intent to sell these investments nor is it more likely than not that we will be required to sell these investments before recovery of their amortized cost basis, which may be at maturity, we do not consider these investments to be other-than-temporarily impaired at June 30, 2010.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Repurchase Agreements

We finance the acquisition of our MBS primarily through the use of repurchase agreements. Under these repurchase agreements, we sell securities to a lender and agree to repurchase the same securities in the future for a price that is higher than the original sales price. The difference between the sale price that we receive and the repurchase price that we pay represents interest paid to the lender. Although structured as a sale and repurchase obligation, a repurchase agreement operates as a financing under which we pledge our securities and accrued interest as collateral to secure a loan which is equal in value to a specified percentage of the estimated fair value of the pledged collateral. We retain beneficial ownership of the pledged collateral. Upon the maturity of a repurchase agreement, we are required to repay the loan and concurrently receive back our pledged collateral from the lender or, with the consent of the lender, we may renew such agreement at the then-prevailing financing rate. These repurchase agreements may require us to pledge additional assets to the lender in the event the estimated fair value of the existing pledged collateral declines. We are operating in an environment where, as a result of economic conditions, several large financial institutions involved in repurchase financing of MBS either have been acquired or filed bankruptcy.

Derivative Financial Instruments

Interest Rate Risk Management

We use primarily short-term (less than or equal to 12 months) repurchase agreements to finance the purchase of our MBS. These obligations expose us to variability in interest payments due to changes in interest rates. We continuously monitor changes in interest rate exposures and evaluate hedging opportunities.

Our objective is to limit the impact of interest rate changes on earnings and cash flows. We achieve this by entering into interest rate swap agreements, which effectively convert a percentage of our repurchase agreements to fixed-rate obligations over a period of up to five years. Under interest rate swap contracts, we agree to pay an amount equal to a specified fixed rate of interest times a notional principal amount and to receive in return an amount equal to a specified variable-rate of interest times a notional amount, generally based on LIBOR. The notional amounts are not exchanged. We account for these swap agreements as cash flow hedges in accordance with ASC 815-10. We do not issue or hold derivative contracts for speculative purposes.

We are exposed to credit losses in the event of non-performance by counterparties to these interest rate swap agreements. In order to limit credit risk associated with swap agreements, our current practice is to only enter into swap agreements with large financial institution counterparties who are market makers for these types of instruments, limit our exposure on each swap agreement to a single counterparty under our defined guidelines and either pay or receive collateral to or from each counterparty on a periodic basis to cover the net fair market value position of the swap agreements held with that counterparty.

Accounting for Derivatives and Hedging Activities

In accordance with ASC 815-10, a derivative that is designated as a hedge is recognized as an asset/liability and measured at estimated fair value. In order for our interest rate swap agreements to qualify for hedge accounting, upon entering into the swap agreement, we must anticipate that the hedge will be highly “effective” as defined by ASC 815-10.

On the date we enter into a derivative contract, we designate the derivative as a hedge of the variability of cash flows that are to be received or paid in connection with a recognized asset or liability (a “cash flow” hedge). Changes in the fair value of a derivative that are highly effective and that are designated and qualify as a cash flow hedge, to the extent that the hedge is effective, are recorded in “Other comprehensive income” and reclassified to income when the forecasted transaction affects income (e.g., when periodic settlement interest payments are due on repurchase agreements). The swap agreements are carried on our consolidated balance sheets at their fair value, based on values obtained from large financial institutions who are market makers for these types of instruments. Hedge ineffectiveness, if any, is recorded in current-period income.

We formally assess, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods. If it is determined that a derivative is not (or has ceased to be) highly effective as a hedge, we discontinue hedge accounting.

When we discontinue hedge accounting, the gain or loss on the derivative remains in “Accumulated other comprehensive income” and is reclassified into income when the forecasted transaction affects income. In all situations in which hedge accounting is discontinued and the derivative remains outstanding, we will carry the derivative at its fair value on our balance sheet, recognizing changes in the fair value in current-period income.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

For purposes of the cash flow statement, cash flows from derivative instruments are classified with the cash flows from the hedged item.

For more details on the amounts and other qualitative information on our swap agreements, see Note 12. For more information on the fair value of our swap agreements, see Note 6.

Credit Risk

At June 30, 2010, we have attempted to limit our exposure to credit losses on our MBS by purchasing securities primarily through Freddie Mac and Fannie Mae. The payment of principal and interest on the Freddie Mac and Fannie Mae MBS are guaranteed by those respective enterprises. In September 2008, both Freddie Mac and Fannie Mae were placed in the conservatorship of the U.S. government. While it is hoped that the conservatorship will help stabilize Freddie Mac’s and Fannie Mae’s losses and overall financial position, there can be no assurance that it will succeed or that, if necessary, Freddie Mac or Fannie Mae will be able to satisfy its guarantees of Agency MBS.

Our adjustable-rate MBS are subject to periodic and lifetime interest rate caps. Periodic caps can limit the amount an interest rate can increase during any given period. Some adjustable-rate MBS subject to periodic payment caps may result in a portion of the interest being deferred and added to the principal outstanding.

Other-than-temporary losses on our available-for-sale MBS, as measured by the amount of decline in estimated fair value attributable to credit losses that are considered to be other-than-temporary, are charged against income, resulting in an adjustment of the cost basis of such securities. Based on the criteria in ASC-320-10, the determination of whether a security is other-than-temporarily impaired (OTTI) involves judgments and assumptions based on both subjective and objective factors. When a security is impaired, an OTTI is considered to have occurred if (i) we intend to sell the security, (ii) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, or (iii) we do not expect to recover its amortized cost basis (i.e., there is a credit-related loss). The following are among, but not all of, the factors considered in determining whether and to what extent an OTTI exists and the portion that is related to credit loss: (i) the expected cash flow from the investment; (ii) whether there has been an other-than-temporary deterioration of the credit quality of the underlying mortgages; (iii) the credit protection available to the related mortgage pool for MBS; (iv) any other market information available, including analysts’ assessments and statements, public statements and filings made by the debtor or counterparty; (v) management’s internal analysis of the security, considering all known relevant information at the time of assessment; and (vi) the magnitude and duration of historical decline in market prices. Because management’s 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 decline exists and, if so, the amount considered impaired, is also subjective and therefore constitutes material estimates that are susceptible to significant change.

Income Taxes

We have elected to be taxed as a REIT and to comply with the provisions of the Code with respect thereto. Accordingly, we will not be subject to federal income tax to the extent that our distributions to our stockholders satisfy the REIT requirements and that certain asset, gross income and stock ownership tests are met.

We have no unrecognized tax benefits and do not anticipate any increase in unrecognized benefits during 2010 relative to any tax positions taken prior to January 1, 2010. Should the accrual of any interest or penalties relative to unrecognized tax benefits be necessary, it is our policy to record such accruals in our income taxes accounts; and no such accruals existed at June 30, 2010. We file both REIT and taxable REIT subsidiary U.S. federal and California income tax returns. These returns are generally open to examination by the IRS and the California Franchise Tax Board for all years after 2005 and 2004, respectively.

Cumulative Convertible Preferred Stock

We classify our 6.25% Series B Cumulative Convertible Preferred Stock, or Series B Preferred Stock, on our consolidated balance sheets using the guidance in ASC 480-10-S99. The Series B Preferred Stock contains certain fundamental change provisions that allow the holder to redeem the preferred stock for cash only if certain events occur, such as a change in control. As redemption under these circumstances is not solely within our control, we have classified the Series B Preferred Stock as temporary equity.

We have analyzed whether the conversion features in the Series B Preferred Stock should be bifurcated under the guidance in ASC 815-10 and have determined that bifurcation is not necessary.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Stock-Based Compensation

In accordance with ASC 718-10, any compensation cost relating to share-based payment transactions is recognized in the consolidated financial statements.

Restricted stock is expensed over the vesting period (see Note 11).

Earnings Per Share

Basic earnings per share, or EPS, is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS assumes the conversion, exercise or issuance of all potential common stock equivalents unless the effect is to reduce a loss or increase the income per share.

The computation of EPS for the three and six months ended June 30, 2010 and June 30, 2009 are as follows (amounts in thousands, except per share data):

 

     Net Income
Available to
Common
Stockholders
    Average
Shares
    Earnings
per
Share
 

For the three months ended June 30, 2010

      

Basic EPS

   $ 24,370      117,541      $ 0.21   

Effect of dilutive securities(1)

     430      3,560        0   
                      

Diluted EPS

   $ 24,800      121,101      $ 0.21   
                      

For the three months ended June 30, 2009

      

Basic EPS

   $ 32,548       102,344       $ 0.32   

Effect of dilutive securities(2)

     471      3,505        (0.01 )   
                      

Diluted EPS

   $ 33,019      105,849      $ 0.31   
                      
     Net Income
Available to
Common
Stockholders
    Average
Shares
    Earnings
per
Share
 

For the six months ended June 30, 2010

      

Basic EPS

   $ 56,177      117,152      $ 0.48   

Effect of dilutive securities(1)

     861      3,560        (0.01
                      

Diluted EPS

   $ 57,038      120,712      $ 0.47   
                      

For the six months ended June 30, 2009

      

Basic EPS

   $ 61,807       99,177       $ 0.62   

Effect of dilutive securities(2)

     942      3,505        (0.01 )   
                      

Diluted EPS

   $ 62,749      102,682      $ 0.61   
                      

 

(1) During the three and six months ended June 30, 2010, diluted earnings per common share included the assumed conversion of 1.102 million shares of Series B Preferred Stock at the then-current conversion rate of 3.2317 shares of common stock and adding back the Series B Preferred Stock dividend.
(2) During the three and six months ended June 30, 2009, diluted earnings per common share included the assumed conversion of 1.206 million shares of Series B Preferred Stock at the then-current conversion rate of 2.9075 shares of common stock and adding back the Series B Preferred Stock dividend.

Accumulated Other Comprehensive Income (Loss)

In accordance with ASC 220-10-55-2, comprehensive income is divided into net income and other comprehensive income (loss), which includes unrealized gains and losses on marketable securities classified as available-for-sale, and unrealized gains and losses on derivative financial instruments that qualify for cash flow hedge accounting under ASC 815-10.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

USE OF ESTIMATES

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates.

RECENT ACCOUNTING PRONOUNCEMENTS

On June 12, 2009, the FASB issued SFAS No. 166, “Accounting for Transfers of Financial Assets,” or SFAS 166, and SFAS No. 167, “Amendments to FASB Interpretation No. 46 (R),” or SFAS 167. SFAS 166 is a revision to ASC 860-10 and requires greater disclosure about transfers of financial assets, including securitization transactions, and about companies having on-going exposure to the risks related to transferred financial assets. It eliminates the concept of “a qualifying special-purpose entity,” changes the requirements for derecognizing financial assets and requires additional disclosures. SFAS 167 is a revision to ASC 810-10 and changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. SFAS 166 and SFAS 167 are effective beginning January 1, 2010. On December 23, 2009, the FASB issued two updates, Accounting Standards Updates, or ASU, No. 2009-16, “Transfers and Servicing (Topic 860) – Accounting for Transfers of Financial Assets” and ASU No. 2009-17, “Consolidations (Topic 810) – Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities.” These two ASUs were issued to incorporate the above June 2009 pronouncements into the accounting standards codification. We have adopted these two new standards and updates and they did not have a material impact on our financial statements.

On January 21, 2010, the FASB issued ASU 2010-06, “Improving Disclosures about Fair Value Measurements.” This ASU amends ASC 820, “Fair Value Measurements and Disclosures,” to require additional disclosure about transfers in and out of Levels 1 and 2 in the fair value hierarchy and separate disclosures about purchases, sales, issuances and settlements relating to Level 3 measurements. It also clarifies existing fair value disclosure requirements about the level of disaggregation and about inputs and valuation techniques used to measure fair value. ASC 820’s existing guidance requires entities to provide fair value measurement disclosures by “major category of assets and liabilities.” This ASU requires entities to provide fair value measurements for each class of assets and liabilities. When providing disclosures for equity and debt securities, entities should determine “class” on the basis of the nature and risks of the securities. In determining the nature and risks of the securities, entities should consider activity or business sector, vintage, geographic concentration, credit quality, and economic characteristics. This ASU requires an entity, in determining the appropriate classes of assets and liabilities to consider the nature and risks of the assets and liabilities as well as their placement in the fair value hierarchy (i.e. Level 1, 2 or 3). This ASU became effective for our financial statements for the quarter ending March 31, 2010 and it did not have a material impact on our financial statements.

In February 2010, the FASB issued ASU 2010-09 relating to Subsequent Events. This ASU amends ASC 855 to address certain implementation issues related to an entity’s requirements to perform and disclose subsequent events procedures. This ASU requires SEC filers to evaluate subsequent events through the date the financial statements are issued and exempts SEC filers from disclosing the date through which subsequent events have been evaluated. This ASU was effective immediately for financial statements that are issued or available to be issued as of the date of the pronouncement. This ASU did not have a material impact on our financial statements.

NOTE 2. REVERSE REPURCHASE AGREEMENTS

At June 30, 2010, we had lent approximately $71 million to a counterparty as a means of investing excess cash. These investments were in an overnight reverse repurchase agreement. This amount is carried at its principal, which approximates fair value. The interest rate was 0.12% The collateral for this loan was U.S. Treasury securities with an aggregate fair value of approximately $71 million. At December 31, 2009, there were no reverse repurchase agreements.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

NOTE 3. MORTGAGE-BACKED SECURITIES (MBS)

The following tables summarize our Agency MBS and Non-Agency MBS, classified as available-for-sale, at June 30, 2010 and December 31, 2009, which are carried at their fair value (amounts in thousands):

June 30, 2010

 

Agency MBS (By Agency)

   Ginnie Mae     Freddie Mac     Fannie Mae     Total
Agency MBS
 

Amortized cost

   $ 20,587      $ 999,474      $ 4,964,458      $ 5,984,519   

Paydowns receivable

     0        13,078        0        13,078   

Unrealized gains

     16        48,558        110,017        158,591   

Unrealized losses

     (196     (1,306     (6,059     (7,561
                                

Fair value

   $ 20,407      $ 1,059,804      $ 5,068,416      $ 6,148,627   
                                

 

Agency MBS (By Security Type)

   ARMs     Hybrids     Fixed-Rate    Floating-Rate
CMOs
    Total
Agency
MBS
 

Amortized cost

   $ 1,645,862      $ 3,682,022      $ 651,681    $ 4,954      $ 5,984,519   

Paydowns receivable

     4,248        8,830        0      0        13,078   

Unrealized gains

     23,166        87,943        47,475      7        158,591   

Unrealized losses

     (6,182     (1,378     0      (1     (7,561
                                       

Fair value

   $ 1,667,094      $ 3,777,417      $ 699,156    $ 4,960      $ 6,148,627   
                                       

 

Non-Agency MBS

   Total
Non-Agency
MBS

Amortized cost

   $ 2,273

Paydowns receivable

     0

Unrealized gains

     2,807

Unrealized losses

     0
      

Fair value

   $ 5,080
      

At June 30, 2010, our Non-Agency MBS portfolio consisted of floating-rate collateralized mortgage obligations (option-adjusted ARMs based on one-month LIBOR), or CMOs, with an average coupon of 0.59%, which were acquired at par value. Non-Agency MBS are securities not issued by the government or government-sponsored enterprises and are secured primarily by first-lien residential mortgage loans.

At June 30, 2010, two securities representing the principal balance of our Non-Agency MBS portfolio were rated CC by Standard & Poor’s and Ca by Moody’s Investor Service.

December 31, 2009

 

Agency MBS (By Agency)

   Ginnie Mae     Freddie Mac     Fannie Mae     Total
Agency

MBS
 

Amortized cost

   $ 22,238      $ 1,294,667      $ 4,992,868      $ 6,309,773   

Paydowns receivable

     0        10,778        0        10,778   

Unrealized gains

     10        46,884        130,017        176,911   

Unrealized losses

     (302     (1,881     (9,478     (11,661
                                

Fair value

   $ 21,946      $ 1,350,448      $ 5,113,407      $ 6,485,801   
                                

 

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Table of Contents

Agency MBS (By Security Type)

   ARMs     Hybrids     Fixed-Rate    Floating-Rate
CMOs
    Total
Agency

MBS
 

Amortized cost

   $ 1,622,821      $ 3,875,217      $ 806,020    $ 5,715      $ 6,309,773   

Paydowns receivable

     2,937        7,841        0      0        10,778   

Unrealized gains

     17,298        118,859        40,754      0        176,911   

Unrealized losses

     (8,103     (3,505     0      (53     (11,661
                                       

Fair value

   $ 1,634,953      $ 3,998,412      $ 846,774    $ 5,662      $ 6,485,801   
                                       

 

Non-Agency MBS

   Total
Non-Agency
MBS

Amortized cost

   $ 4,250

Unrealized gains

     492
      

Fair value

   $ 4,742
      

At December 31, 2009, our Non-Agency MBS portfolio consisted of floating-rate CMOs with an average coupon of 0.48%, which were acquired at par value.

NOTE 4. REPURCHASE AGREEMENTS

We have entered into repurchase agreements with large financial institutions to finance most of our Agency MBS. The repurchase agreements are short-term borrowings that are secured by the market value of our MBS and bear fixed interest rates that have historically been based upon LIBOR.

At June 30, 2010 and December 31, 2009, the repurchase agreements had the following balances (in thousands), weighted average maturities and weighted average interest rates:

 

     June 30,
2010
    December 31,
2009
 
     Balance     Weighted
Average
Interest
Rate
    Balance     Weighted
Average
Interest
Rate
 

Overnight

   $ 0      0.00   $ 0      0.00

Less than 30 days

     2,410,000      0.27        2,427,000      0.24

30 days to 90 days

     2,580,000      0.29        2,932,000      0.24

Over 90 days to less than 1 year

     100,000      0.30        0      0.00   

1 year to 2 years

     0      0.00        0      0.00   

Demand

     0      0.00        0      0.00   
                            
   $ 5,090,000      0.28   $ 5,359,000      0.24
                            

Weighted average maturity

     38 days          38 days     

Weighted average term to maturity (after accounting for swap agreements)

     396 days          309 days     

Weighted average borrowing rate (after accounting for swap agreements)

     1.86       1.88  

Agency MBS pledged as collateral under the repurchase agreements and swap agreements

   $ 5,433,660        $ 5,749,849     

One of our former repurchase agreement counterparties, Lehman Brothers, Inc. is in a bankruptcy proceeding. During the second quarter of 2010, Lehman Brothers, Inc. filed with the bankruptcy court its plan of reorganization. The plan listed the various nature and type (secured vs. unsecured) of the claims involved for each Lehman entity and the estimated recovery, ranging from 15% to 44% for unsecured claims. A motion was filed by several creditors opposing the plan and requesting that the various Lehman entities be consolidated as one entity under the plan. It is the belief of these creditors that this would increase the estimated recoveries, but no value has been placed on this. As the bankruptcy court has not yet ruled on the plan, this motion or the nature or type of any particular claim, we believe it is appropriate to write-down this receivable to approximately $289 thousand, which represents 15% of our original claim. At June 30, 2010, the receivable from Lehman Brothers, Inc. of $289 thousand is carried in “Other assets” on our consolidated balance sheets.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

NOTE 5. JUNIOR SUBORDINATED NOTES

On March 15, 2005, we issued $37,380,000 of junior subordinated notes to a newly-formed statutory trust, Anworth Capital Trust I, organized by us under Delaware law. The trust issued $36,250,000 in trust preferred securities to unrelated third party investors. Both the notes and the trust preferred securities require quarterly payments and bear interest at the prevailing three-month LIBOR rate plus 3.10%, reset quarterly. The first interest payment was made on June 30, 2005. Both the notes and the securities will mature in 2035 and may be redeemable, at our option, in whole or in part, without penalty, after March 30, 2010 and April 30, 2010. We used the net proceeds of this private placement to invest in Agency MBS. We have reviewed the structure of the transaction under ASC 810-10 and concluded that Anworth Capital Trust I does not meet the requirements for consolidation. On September 26, 2005, the notes, the trust preferred securities and the related agreements were amended. The only material change was that one of the class holders requested that interest payments be made quarterly on January 30, April 30, July 30 and October 30 instead of at the end of each calendar quarter. This became effective with the quarterly payment after September 30, 2005. As of the date of this filing, we have not redeemed any of the notes or securities.

NOTE 6. FAIR VALUES OF FINANCIAL INSTRUMENTS

As defined in ASC 820-10, fair value is the price that would be received from the sale of an asset or paid to transfer or settle a liability in an orderly transaction between market participants in the principal (or most advantageous) market for the asset or liability. ASC 820-10 establishes a fair value hierarchy that ranks the quality and reliability of the information used to determine fair values. Financial assets and liabilities carried at fair value are classified and disclosed in one of the three following categories:

Level 1: Quoted market prices in active markets for identical assets or liabilities.

Level 2: Observable market based inputs or unobservable inputs that are corroborated by market data. This includes those financial instruments that are valued using models or other valuation methodologies where substantially all of the assumptions are observable in the marketplace, can be derived from observable market data or are supported by observable levels at which transactions are executed in the marketplace. We consider the inputs utilized to fair value our Agency MBS to be Level 2. Management bases the fair value for these investments primarily on third party bid price indications provided by dealers who make markets in these instruments. The Agency MBS market is primarily an over-the-counter market. As such, there are no standard, public market quotations or published trading data for individual MBS securities. As our portfolio consists of hundreds of similar, but distinct, securities that have each been traded with only one broker counterparty, we generally seek to have each Agency MBS security priced by one broker. The prices received are non-binding offers to trade, but are indicative quotations of the market value of our securities as of the market close on the last day of each quarter. The brokers receive trading data from several traders that participate in the active markets for these securities and directly observe numerous trades of securities similar to the securities owned by us. Given the volume of market activity for Agency MBS, it is our belief that the broker pricing accurately reflects market information for actual, contemporaneous transactions. We do not adjust quotes or prices we obtain from brokers and pricing services. In the limited instances where valuations are received on a security from multiple brokers, we use the median value of the prices received to determine fair value. To validate the prices we obtain, to ensure our fair value determinations are consistent with ASC 820, and to ensure that we properly classify these securities in the fair value hierarchy, we evaluate the pricing information we receive taking into account factors such as coupon, prepayment experience, fixed/adjustable rate, coupon index, time to reset and issuing agency, among other factors. Based on these factors, broker prices are compared to prices of similar securities provided by other brokers. If we determine (based on such a comparison and our market knowledge and expertise) that a security is priced significantly differently than similar securities, the broker is contacted and requested to revisit their valuation of the security. If a broker refuses to reconsider its valuation, we will request pricing from another broker and use the median value of the prices received to determine fair value. If we are unable to receive a valuation from another broker, the price received from an independent third party pricing service will be used, if it is determined (based on our market knowledge and expertise) to be more reliable than the broker pricing. However, the fair value reported may not be indicative of the amounts that could be realized in an actual market exchange. Our derivative assets and derivative liabilities are comprised of swap agreements, in which we pay a fixed rate of interest and receive a variable rate of interest that is based on LIBOR. The fair value of these instruments is reported to us independently from dealers who are large financial institutions and are market makers for these types of instruments. The LIBOR swap rate is observable at commonly quoted intervals over the full term of the swap agreements and therefore is considered a Level 2 item. The fair value of the derivative instruments’ assets and liabilities are the estimated amounts the Company would either receive or pay to terminate these agreements at the reporting date, taking into account current interest rates and the Company’s credit worthiness.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Level 3: Unobservable inputs that are not corroborated by market data. This is comprised of financial instruments whose fair value is estimated based on internally developed models or methodologies utilizing significant inputs that are generally less readily observable from objective sources. At June 30, 2010 and December 31, 2009, we considered the inputs utilized to fair value the Non-Agency MBS to be Level 3. Historically (prior to December 31, 2008), we had received non- binding indications of value from brokers who make markets in Non-Agency MBS and also observe market activity in our Non-Agency MBS as well as other similar securities. As the market for Non-Agency MBS became more volatile and less liquid, we received fewer indications of value on these securities. At June 30, 2010 and December 31, 2009, we were unable to get any brokers who made markets in these securities to provide valuation information on our Non-Agency MBS. Instead, we obtained valuations at June 30, 2010 and December 31, 2009 for our Non-Agency MBS from an experienced independent third party pricing service, whose methodologies are based on broker provided pricing information, as well as indirect observation of market activity. Although we continued to monitor market activity for the Non-Agency MBS in our portfolio, as well as for other similar securities, given the lack of trading activity that we were able to observe, we placed more weight on the third party pricing service valuation as it was both independent and specifically determined. As a result of the lack of valuation information from brokers and our own observation of market activity, we determined that the market for our Non-Agency MBS was inactive. We also believe that the valuations obtained from the independent third party pricing service already take into account the illiquidity of the market for Non-Agency MBS and therefore we do not apply our own liquidity discount when determining their fair value. Based on this information, we consider the fair value measurement of the Non-Agency MBS a Level 3 input at June 30, 2010 and December 31, 2009.

In determining the appropriate levels, the Company performs a detailed analysis of the assets and liabilities that are subject to ASC 820-10. At each reporting period, all assets and liabilities for which the fair value measurement is based on significant unobservable inputs are classified as Level 3.

At June 30, 2010, fair value measurements were as follows (in thousands):

 

     Level 1    Level 2    Level 3    Total

Assets:

           

Agency MBS(1)

   $ 0    $ 6,148,627    $ 0    $ 6,148,627

Non-Agency MBS(2)

   $ 0    $ 0    $ 5,080    $ 5,080

Liabilities:

           

Derivative instruments(3)

   $ 0    $ 88,644    $ 0    $ 88,644

 

(1) For more detail about the fair value of our Agency MBS by agency and type of security, see Note 3 in the unaudited consolidated financial statements.
(2) For more detail about the fair value of our Non-Agency MBS, see Note 3 in the unaudited consolidated financial statements.
(3) Derivative instruments are hedging instruments under ASC 815-10. For more detail about our derivative instruments, see Notes 1 and 12 in the unaudited consolidated financial statements.

Cash and cash equivalents, restricted cash, interest receivable, repurchase agreements and interest payable are reflected in our unaudited consolidated financial statements at their costs, which approximate their fair value because of the nature and short term of these instruments.

Junior subordinated notes are variable-rate debt and, as we believe the spread would be consistent with the expectations of market participants as of June 30, 2010 and December 31, 2009, the carrying value approximates fair value.

A reconciliation of the Level 3 Non-Agency MBS fair value measurements is as follows (in thousands):

 

     Amount  

Balance at March 31, 2010

   $ 5,324   

Principal paydowns

     (1,108

Unrealized gains recognized in other comprehensive income

     864   

Unrealized losses

     0   
        

Balance at June 30, 2010

   $ 5,080   
        

 

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NOTE 7. INCOME TAXES

We have elected to be taxed as a REIT and to comply with the provisions of the Code with respect thereto. Accordingly, we will not be subject to federal or state income taxes to the extent that our distributions to stockholders satisfy the REIT requirements and certain asset, gross income and stock ownership tests are met. We believe we currently meet all REIT requirements regarding the ownership of our common stock and the distribution of our net income. Therefore, we believe that we continue to qualify as a REIT under the provisions of the Code.

NOTE 8. SERIES B CUMULATIVE CONVERTIBLE PREFERRED STOCK

The Series B Preferred Stock has a par value of $0.01 per share and a liquidation preference of $25.00 per share plus accrued and unpaid dividends (whether or not declared). The Series B Preferred Stock must be paid a dividend at a rate of 6.25% per year on the $25.00 liquidation preference before our common stock is entitled to receive any dividends. The Series B Preferred Stock is senior to the common stock and on parity with our 8.625% Series A Cumulative Preferred Stock, or Series A Preferred Stock, with respect to the payment of distributions and amounts, upon liquidation, dissolution or winding up.

The Series B Preferred Stock has no maturity date and is not redeemable. Through June 30, 2010, the Series B Preferred Stock was convertible at the then-current conversion rate of 3.2317 shares of our common stock per $25.00 liquidation preference. The conversion rate is adjusted in any fiscal quarter in which the cash dividends paid to common stockholders results in an annualized common stock dividend yield that is greater than 6.25%. The conversion ratio is also subject to adjustment upon the occurrence of certain specific events such as a change of control. The Series B Preferred Stock is convertible into shares of our common stock at the option of the holder(s) of Series B Preferred Stock at any time at the then-prevailing conversion rate. On or after January 25, 2012, we may, at our option, convert under certain circumstances each share of Series B Preferred Stock into a number of common shares at the then-prevailing conversion rate. We may exercise our Company Conversion Option only if our common stock price equals or exceeds 130% of the then-prevailing conversion price of the Series B Preferred Stock for at least twenty (20) trading days in a period of thirty (30) consecutive trading days (including the last trading day of such period) ending on the trading day immediately prior to our issuance of a press release announcing the exercise of our Company Conversion Option. The Series B Preferred Stock contains certain fundamental change provisions that allow the holder to redeem the Series B Preferred Stock for cash if certain events occur, such as a change in control. The Series B Preferred Stock generally does not have voting rights, except if dividends on the Series B Preferred Stock are in arrears for six or more quarterly periods (whether or not consecutive). Under such circumstances, the holder(s) of Series B Preferred Stock, together with the holders of Series A Preferred Stock, will be entitled to elect two additional directors to our board of directors to serve until all unpaid dividends have been paid or declared and set aside for payment. In addition, certain material and adverse changes to the terms of the Series B Preferred Stock may not be taken without the affirmative vote of at least two-thirds of the outstanding shares of Series B Preferred Stock and Series A Preferred Stock voting together as a single class. Through June 30, 2010, we have declared and set aside for payment the required dividends for the Series B Preferred Stock.

During the three months ended June 30, 2010, there were no transactions to convert shares of Series B Preferred Stock into shares of our common stock. During the three months ended June 30, 2010, we did not issue any shares of Series B Preferred Stock. At June 30, 2010, there were 1.102 million shares of Series B Preferred Stock outstanding.

NOTE 9. PUBLIC OFFERINGS AND CAPITAL STOCK

At June 30, 2010, our authorized capital included 200 million shares of common stock, of which 117,027,665 shares were issued and outstanding.

At June 30, 2010, our authorized capital included 20 million shares of $0.01 par value preferred stock, of which 5.15 million shares had been designated 8.625% Series A Cumulative Preferred Stock (liquidation preference $25.00 per share) and 3.15 million shares had been designated 6.25% Series B Cumulative Convertible Preferred Stock (liquidation preference $25.00 per share). The undesignated shares of preferred stock may be issued in one or more classes or series, with such distinctive designations, rights and preferences as determined by our board of directors.

On February 1, 2010, we announced that our board of directors had authorized a share repurchase program, permitting us to acquire 5,850,000 shares of our common stock, or approximately 5% of our outstanding common stock. The shares are to be acquired at prevailing prices through open market transactions. The manner, price, number and timing of these share repurchases are subject to market conditions and applicable SEC rules. During the three months ended June 30, 2010, we had repurchased a total of 2,547,616 shares at a weighted average price of $6.46 per share under this program. From February 1, 2010 through June 30, 2010, we had repurchased an aggregate of 3,060,616 shares at a weighted average price of $6.52 per share under this program.

On May 14, 2008, we entered into a Controlled Equity Offering Sales Agreement, or the 2008 Sales Agreement, with Cantor Fitzgerald & Co., or Cantor.

 

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During the three months ended June 30, 2010, we did not sell any shares of our common stock or preferred stock under the Program. At June 30, 2010, there were 5,101,900 shares of common stock, 1,225,000 shares of Series A Preferred Stock and 1,902,800 shares of Series B Preferred Stock, respectively, available under the 2008 Sales Agreement.

Our Dividend Reinvestment and Stock Purchase Plan allows stockholders and non-stockholders to purchase shares of our common stock and to reinvest dividends therefrom to acquire additional shares of our common stock. On December 28, 2009, we filed a shelf registration statement on Form S-3ASR with the SEC, offering up to 20 million shares of common stock for our 2009 Dividend Reinvestment and Stock Purchase Plan, or the 2009 Plan. During the three months ended June 30, 2010, we issued approximately 1.624 million shares of common stock under the 2009 Plan, resulting in proceeds to us of approximately $10.8 million. At June 30, 2010, there were approximately 15.5 million shares remaining under the 2009 Plan.

On December 28, 2009, we filed a shelf registration statement on Form S-3 with the SEC, and on February 26, 2010 we filed a pre-effective amendment with the SEC, offering up to $600 million of our capital stock. The registration statement was declared effective on March 26, 2010. At June 30, 2010, the entire amount remained available for issuance under the registration statement.

On November 7, 2005, we filed a registration statement on Form S-8 with the SEC to register an aggregate of up to 3.5 million shares of our common stock to be issued pursuant to the Anworth Mortgage Asset Corporation 2004 Equity Compensation Plan. To date, we have issued 2.778 million shares under the plan. This amount includes 1.278 million shares of unexercised stock options and restricted stock.

NOTE 10. TRANSACTIONS WITH AFFILIATES

Anworth 2002 Incentive Compensation Plan

Under our 2002 Incentive Compensation Plan, or the 2002 Incentive Plan, Lloyd McAdams, our Chief Executive Officer, Joseph E. McAdams, our Chief Investment Officer, Heather U. Baines, our Executive Vice President, and other executives are eligible to earn incentive compensation during each fiscal quarter. The 2002 Incentive Plan requires that we pay all amounts earned thereunder each quarter (subject to offset for accrued negative incentive compensation) and we will be required to pay a percentage of such amounts to certain of our executives pursuant to the terms of their employment agreements. Pursuant to their employment agreements, Lloyd McAdams, Joseph E. McAdams and Heather U. Baines are entitled to minimum percentages of all amounts paid under the 2002 Incentive Plan. Those percentages are 45%, 25% and 5%, respectively. The 2002 Incentive Plan is tied directly to our performance and is designed to incentivize key employees to maximize return on equity. The total aggregate amount of compensation that may be earned quarterly by all participants under the plan equals a percentage of net income, before incentive compensation, in excess of the amount that would produce an annualized return on average net worth equal to the ten-year U.S. Treasury Rate plus 1%, or the Threshold Return. At June 30, 2010, the Threshold Return was 4.53%.

Average net worth, as defined in the 2002 Incentive Plan which was amended by our Compensation Committee on August 3, 2009 and approved by our board of directors on October 8, 2009 (and which amendment was filed with the SEC on October 15, 2009 as an exhibit to a Current Report on Form 8-K), for any period is (i) the daily average of the cumulative net proceeds to date from all offerings of the Company’s equity securities, after deducting any underwriting discounts and commissions and other expenses and costs related to such offerings, plus (ii) the Company’s retained earnings computed by taking the average of such values at the end of each month during such period.

The 2002 Incentive Plan contains a “high water-mark” provision requiring that in any fiscal quarter in which net income is an amount less than the amount necessary to earn the Threshold Return, the Company will calculate negative incentive compensation for that fiscal quarter which will be carried forward and will offset future incentive compensation earned under the 2002 Incentive Plan with respect to participants who were participants during the fiscal quarter(s) in which negative incentive compensation was generated. At June 30, 2010, the incentive compensation accrual carry forward was a negative $9.1 million, which was reduced from a negative $10.4 million at March 31, 2010 and a negative $12.2 million at December 31, 2009. This negative carry forward may provide an incentive to management to make higher risk investments in an attempt to generate returns to overcome the negative carry forward.

The percentage of taxable net income in excess of the Threshold Return earned under the 2002 Incentive Plan by all employees is calculated based on our quarterly average net worth as defined in the 2002 Incentive Plan. The percentage rate used in this calculation is based on a blended average of the following tiered percentage rates:

 

   

25% for the first $50 million of average net worth;

 

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15% for the average net worth between $50 million and $100 million;

 

   

10% for the average net worth between $100 million and $200 million; and

 

   

5% for the average net worth in excess of $200 million.

During the three months ended June 30, 2010 and June 30, 2009, eligible employees under the 2002 Incentive Plan did not earn any incentive compensation due to the negative incentive carry forward under the Plan.

Employment Agreements

Salary, Incentive and Termination Provisions

Pursuant to the terms of their employment agreements with us, Lloyd McAdams serves as our President, Chairman and Chief Executive Officer, Joseph E. McAdams serves as our Executive Vice President and Chief Investment Officer, and Heather U. Baines serves as our Executive Vice President. Lloyd McAdams receives a $925 thousand annual base salary, Joseph E. McAdams receives a $700 thousand annual base salary and Heather U. Baines receives a $60 thousand annual base salary.

These employment agreements also have the following provisions:

 

   

the three executives are entitled to participate in the 2002 Incentive Plan and each of these individuals are provided a minimum percentage of the amounts earned under such plan. Lloyd McAdams is entitled to 45% of all amounts paid under the plan, Joseph E. McAdams is entitled to 25% of all amounts paid under the plan and Heather U. Baines is entitled to 5% of all amounts paid under the plan.

 

   

the 2002 Incentive Plan may not be amended without the consent of Lloyd McAdams and Joseph E. McAdams;

 

   

in the event any of the three executives is terminated without “cause,” or if they terminate for “good reason,” or, in the case of Lloyd McAdams or Joseph E. McAdams, their employment agreements are not renewed, then the executives would be entitled to: (1) all base salary due under the employment agreements, (2) all discretionary bonus due under their employment agreements, (3) a lump sum payment of an amount equal to three years of the executive’s then-current base salary, (4) payment of COBRA medical coverage for 18 months, (5) immediate vesting of all pension benefits, (6) all incentive compensation under the 2002 Incentive Plan to which the executives would have been entitled to under the employment agreements prorated through the termination date, and (7) all expense reimbursements and benefits due and owing the executives through the termination. In addition, under these circumstances Lloyd McAdams and Joseph E. McAdams would each be entitled to a lump sum payment equal to 150% of the greater of (i) the highest amount paid or that could be payable (in the aggregate) under the 2002 Incentive Plan during any one of the three fiscal years prior to their termination, and (ii) the highest amount paid, or that could be payable (in the aggregate), under the 2002 Incentive Plan during any of the three fiscal years following their termination. Ms. Baines would also be entitled to a lump sum payment equal to all incentive compensation that Ms. Baines would have been entitled to under the 2002 Incentive Plan during the three-year period following her termination;

 

   

the equity awards granted to each of the three executives will immediately vest upon the termination of the executive’s employment if such termination is in connection with a change in control;

 

   

Lloyd McAdams and Joseph E. McAdams are each subject to a one-year non-competition provision following termination of their employment except in the event of a change in control; and

 

   

each agreement contains an evergreen provision that permits automatic renewal for one year at the end of each term unless written notice of termination is provided by either party six months prior to the end of the current term.

Performance-Based Bonus Pool Provisions

Under the terms of their employment agreements, a long-term equity incentive structure was established for Messrs. Lloyd McAdams and Joseph E. McAdams. As a result, they are eligible to participate in a performance-based bonus pool that is funded based on the Company’s return on average equity, or ROAE. ROAE is calculated as the twelve-month net income available to common stockholders, excluding the effect of depreciation, preferred stock dividends, gains/losses on asset sales and impairment charges, divided by the average stockholder equity less goodwill and preferred stockholder equity. The Compensation Committee of our board of directors, or the Compensation Committee, evaluated various measures and factors of performance in developing this structure and, in its view, ROAE was determined to be the single best indicator of our overall performance and therefore of value creation for our stockholders. This is in part due to the fact that ROAE is a metric of our performance that has been calculated and reported on a consistent basis since our inception in 1998.

 

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As structured by the Compensation Committee, the aggregate amount of this performance-based bonus pool available for distribution can range annually based upon our ROAE in accordance with the following:

 

   

if our ROAE is 0% or less, no performance-based bonus is paid.

 

   

if our ROAE is greater than 0% but less than 8%, a bonus pool of up to $500 thousand is available in the aggregate.

 

   

if our ROAE is 8% or greater, then the bonus pool available to be paid to both executives in the aggregate equals $500 thousand plus 10% of the first $5 million of excess return and 6% of the amount of the excess return greater than $5 million.

The Compensation Committee has the discretionary right to adjust downward the amount available for distribution from the bonus pool by as much as 10% in any given year, based upon its assessment of factors including our leverage, stability of the book value of our common stock and price per share of our common stock relative to other industry participants. Of the aggregate amount available for distribution from the bonus pool, the Compensation Committee bases annual bonus allocation to each of Messrs. Lloyd McAdams and Joseph E. McAdams on its assessment of the performance of each executive.

In order to further align the performance of Messrs. Lloyd McAdams and Joseph E. McAdams with our long-term financial success and the creation of stockholder value, the Compensation Committee also determined that with respect to 2008 and each year thereafter, 25% of the annual performance-based bonus amount allocated to be distributed to an executive over $100 thousand would be paid in restricted shares of common stock (the “Restricted Shares”). In addition, neither executive will be permitted to sell or otherwise transfer any Restricted Shares during the executive’s employment with us until the value of his respective stock holdings in the company exceeds a seven and one-half times multiple of his base compensation and, once this threshold is met, only to the extent that the value of such holdings exceeds that multiple.

Prior to the end of any year, the Compensation Committee, at its discretion, may notify an executive that the executive will not participate in the pool during the following year. If this occurs, the sale or transfer restrictions on previously issued pool shares will be eliminated at that time.

The Compensation Committee, in its discretion, may provide additional compensation to each of Messrs. Lloyd McAdams and Joseph E. McAdams beyond the annual performance-based bonus awards earned under the incentive compensation structure in their employment agreements. This additional compensation may be provided in consideration of the Company’s execution of our business and strategic plans. During the three months ended June 30, 2010, no additional compensation was paid to Messrs. Lloyd McAdams and Joseph E. McAdams.

Change in Control and Arbitration Agreements

On June 27, 2006, we entered into Change in Control and Arbitration Agreements with each of Thad M. Brown, our Chief Financial Officer, Charles J. Siegel, our Senior Vice President-Finance, Bistra Pashamova, our Senior Vice President and Portfolio Manager, and Evangelos Karagiannis, our Vice President and Portfolio Manager, as well as certain of our other employees. The Change in Control and Arbitration Agreements grant these officers and employees, in the event that a change in control occurs (as defined therein), a lump sum payment equal to (i) 12 months annual base salary in effect on the date of the change in control, plus (ii) the average annual incentive compensation received for the two complete fiscal years prior to the date of the change in control, and plus (iii) the average annual bonus received for the two complete fiscal years prior to the date of the change in control, as well as other benefits. The Change in Control and Arbitration Agreements also provide for accelerated vesting of equity awards granted to these officers and employees upon a change in control.

Agreements with Pacific Income Advisers, Inc.

On June 13, 2002, we entered into a sublease with Pacific Income Advisers, Inc., or PIA, a company owned by trusts controlled by certain of our officers. Under the sublease, as amended on July 8, 2003, we lease, on a pass-through basis, 5,500 square feet of office space from PIA and pay rent at an annual rate equal to PIA’s obligation, currently $54.16 per square foot. The sublease runs through June 30, 2012 unless earlier terminated pursuant to the master lease. During the three and six months ended June 30, 2010, we paid approximately $76 thousand and $158 thousand, respectively, in rent and other operating expenses to PIA under the sublease, which is included in “Other expenses” on the consolidated statements of income. During the three and six months ended June 30, 2009, we paid $86 thousand and $166 thousand, respectively, in rent and related expenses to PIA under this sublease.

 

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At June 30, 2010, the future minimum lease commitment was as follows (in whole dollars):

 

Year

   2010    2011    2012    Total
Commitment

Commitment

   $ 153,401    $ 311,414    $ 158,012    $ 622,827

On October 14, 2002, we entered into an administrative services agreement with PIA. On July 25, 2008, we entered into a new administrative services agreement with PIA which was amended on December 29, 2008. Under the administrative services agreement, PIA provides administrative services and equipment to us including human resources, operational support and information technology, and we pay an annual fee of 7 basis points on the first $225 million of stockholders’ equity, 5 basis points on the next $450 million of stockholders’ equity and 3.5 basis points thereafter (paid quarterly in arrears) for those services. The administrative services agreement is for an initial term of one year and will renew for successive one-year terms thereafter unless either party gives notice of termination no less than 30 days before the expiration of the then-current annual term. We may also terminate the administrative services agreement upon 30 days prior written notice for any reason and immediately if there is a material breach by PIA. Included in “Other expenses” on the consolidated statements of income are fees of $84 thousand and $167 thousand, respectively, paid to PIA in connection with this agreement during the three and six months ended June 30, 2010. During the three and six months ended June 30, 2009, we paid fees of $79 thousand and $141 thousand, respectively, to PIA in connection with this agreement.

Deferred Compensation Plan

On January 15, 2003, we adopted the Anworth Mortgage Asset Corporation Deferred Compensation Plan, or the Deferred Compensation Plan. We amended the plan effective January 1, 2005 to comply with Section 409A of the Code enacted as part of the American Jobs Creation Act of 2004. The Deferred Compensation Plan permits our eligible officers to defer the payment of all or a portion of their cash compensation that otherwise would be in excess of the $1 million annual limitation on deductible compensation imposed by Section 162(m) of the Code (based on the officers’ compensation and benefit elections made prior to January 1 of the calendar year in which the compensation will be deferred). Under this limitation, compensation paid to our Chief Executive Officer and our four other highest paid officers is not deductible by us for income tax purposes to the extent the amount paid to any such officer exceeds $1 million in any calendar year, unless such compensation qualifies as performance-based compensation under Section 162(m). Our board of directors designates the eligible officers who may participate in the Deferred Compensation Plan from among the group consisting of our Chief Executive Officer and our other four highest paid officers. To date, the board has designated all of the executive officers as those who may participate in the Deferred Compensation Plan. Each eligible officer becomes a participant in the Deferred Compensation Plan by making a written election to defer the payment of cash compensation. With certain limited exceptions, the election must be filed with us before January 1 of the calendar year in which the compensation will be deferred. The election is effective for the entire calendar year and may not be terminated or modified for that calendar year. If a participant wishes to defer compensation in a subsequent calendar year, a new deferral election must be made before January 1 of that subsequent year.

Amounts deferred under the Deferred Compensation Plan are not paid to the participant as earned, but are credited to a bookkeeping account maintained by us in the name of the participant. The balance in the participant’s account is credited with earnings at a rate of return equal to the annual dividend yield on our common stock. The balance in the participant’s account is paid to the participant six months after termination of employment or upon the death of the participant or a change in control of our company. Each participant is a general unsecured creditor of our company with respect to all amounts deferred under the Deferred Compensation Plan. At June 30, 2010, the aggregate balance of the amounts previously deferred for Lloyd McAdams was $364,874.

NOTE 11. EQUITY COMPENSATION PLAN

2004 Equity Compensation Plan

At our May 27, 2004 annual stockholders’ meeting, our stockholders adopted the Anworth Mortgage Asset Corporation 2004 Equity Compensation Plan, or the Plan, which amended and restated our 1997 Stock Option and Awards Plan. The Plan authorized the grant of stock options and other stock-based awards, as of December 31, 2005, for an aggregate of up to 3,500,000 of the outstanding shares of our common stock. The Plan authorizes our board of directors, or a committee of our Board, to grant incentive stock options, as defined under section 422 of the Code, options not so qualified, restricted stock, dividend equivalent rights (DERs), phantom shares and other stock-based awards. The exercise price for any option granted under the Plan may not be less than 100% of the fair market value of the shares of common stock at the time the option is granted. At June 30, 2010, 721,616 shares remained available for future issuance under the Plan through any combination of stock options or other awards. The Plan does not provide for automatic annual increases in the aggregate share reserve or the number of shares remaining available for grant. We filed a registration statement on Form S-8 on November 7, 2005 to register an aggregate of up to 3,500,000 shares of our common stock to be issued pursuant to the Plan.

 

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In October 2005, our board of directors approved the grant of 200,780 shares of restricted stock to various of our employees under our 2004 Equity Plan. The stock price on the grant date was $7.72. The restricted stock vests 10% per year on each anniversary date for a ten-year period and shall also vest immediately upon the death of the grantee or upon the grantee reaching age 65. Each grantee shall have the right to sell 40% of the restricted stock anytime after such shares have vested. The remaining 60% of such vested restricted stock may not be sold until after termination of employment with us. We amortize the restricted stock over the vesting period, which is the lesser of ten years or the remaining number of years to age 65.

In October 2006, our board of directors approved a grant of an aggregate of 197,362 shares of performance-based restricted stock to various of our officers and employees under our 2004 Equity Plan. Such grant was made effective on October 18, 2006. The closing stock price on the effective date of the grant was $9.12. The shares will vest in equal annual installments over a three-year period provided that the annually compounded rate of return on our common stock, including dividends, exceeds 12% measured on an annual basis of the anniversary date of the grant. If the annually compounded rate of return does not exceed 12%, then the shares will vest on the anniversary date thereafter when the annually compounded rate of return exceeds 12%. If the annually compounded rate of return does not exceed 12% within ten years after the effective date of the grant, then the shares will be forfeited. The shares will fully vest within the ten-year period upon the death of a grantee. Upon vesting, each grantee shall have the right to sell 40% of the restricted stock anytime after such shares have vested. The remaining 60% of such vested restricted stock may not be sold, transferred or pledged until after termination of employment with us or upon the tenth anniversary of the effective date.

We recognize the compensation expense related to restricted stock over the ten-year vesting period. During the three months ended June 30, 2010 and June 30, 2009, we expensed approximately $51 thousand and $51 thousand, respectively, related to these restricted stock grants.

At our May 24, 2007 annual meeting of stockholders, our stockholders adopted the Anworth Mortgage Asset Corporation 2007 Dividend Equivalent Rights Plan, or the 2007 Dividend Equivalent Rights Plan. A dividend equivalent right, or DER, is a right to receive amounts equal in value to the dividend distributions paid on a share of our common stock. DERs are paid in either cash or shares of our common stock, whichever is specified by our Compensation Committee at the time of grant, at such times as dividends are paid on shares of our common stock during the period between the date a DER is issued and the date the DER expires or earlier terminates. The committee may impose such other conditions to the grant of DERs as it may deem appropriate. The maximum term for DERs under the 2007 Dividend Equivalent Rights Plan is ten years from the date of grant. There were no awards of DERs granted during 2007. On February 22, 2008, a grant of an aggregate of 300 thousand DERs under the DER Plan was issued to our employees and officers. On December 22, 2008, a grant of an aggregate of 150 thousand DERs under the DER Plan was issued to our employees and officers. On December 16, 2009, a grant of an aggregate of 50 thousand DERs under the DER Plan was issued to our employees and officers. These DERs are not attached to any stock and only have the right to receive the same cash distribution per common share distributed to our common stockholders during the term of the grant. All of these grants have a five-year term from the date of the grant. During the three months ended June 30, 2010 we paid or accrued $125 thousand as compensation related to DERs granted. During the three months ended June 30, 2009, we paid or accrued approximately $144 thousand as compensation related to DERs granted.

NOTE 12. HEDGING INSTRUMENTS

At June 30, 2010, we were a counterparty to interest rate swap agreements, which are derivative instruments as defined by ASC 815-10, with an aggregate notional amount of $2.47 billion and a weighted average maturity of 2.2 years. During the three months ended June 30, 2010, one swap agreement with a notional amount of $100 million matured. During the three months ended June 30, 2010, we entered into five swap agreements with a notional amount of $300 million and terms of up to five years. We utilize swap agreements to manage interest rate risk relating to our repurchase agreements (the hedged item) and do not anticipate entering into derivative transactions for speculative or trading purposes. In accordance with the swap agreements, we will pay a fixed-rate of interest during the term of the swap agreements (ranging from 1.788% to 5.7375%) and receive a payment that varies with the three-month LIBOR rate.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

At June 30, 2010 and December 31, 2009, our swap agreements had the following notional amounts (in thousands), remaining term (in months) and weighted average interest rates:

 

     June 30, 2010    December 31, 2009
     Notional
Amount
   Weighted
Average
Interest
Rate
    Remaining
Term in
Months
   Notional
Amount
   Weighted
Average
Interest
Rate
    Remaining
Term in
Months

Less than 12 months

   $ 925,000    4.58   7    $ 750,000    4.75   7

1 year to 2 years

     250,000    3.48      20      475,000    4.36      16

2 years to 3 years

     645,000    3.75      30      520,000    3.92      29

3 years to 4 years

     325,000    2.31      45      375,000    3.32      39

4 years to 5 years

     325,000    2.55      59      200,000    2.43      52
                                   
   $ 2,470,000    3.68   26    $ 2,320,000    4.06   23
                                   

Swap Agreements by Counterparty

 

     June 30,
2010
   December 31,
2009
     (in thousands)

Credit Suisse

   $ 695,000    $ 695,000

Deutsche Bank Securities

     575,000      825,000

Citigroup

     400,000      400,000

Nomura Securities International

     400,000      250,000

Morgan Stanley

     150,000      0

J.P. Morgan Securities Inc.

     100,000      100,000

Bank of New York

     100,000      0

LBBW Securities, LLC

     50,000      50,000
             
   $ 2,470,000    $ 2,320,000
             

For the six months ended June 30, 2010, there was an increase in unrealized losses of $7.8 million, from $81.5 million in unrealized losses at December 31, 2009 to $89.3 million in unrealized losses, on our swap agreements included in “Other comprehensive income” (this decrease consisted of unrealized losses on cash flow hedges of $49.3 million and a reclassification adjustment for interest expense included in net income of $41.5 million).

At June 30, 2010, we had liability derivatives (shown on our unaudited consolidated balance sheets) of $88.6 million.

During the three months ended June 30, 2010, there was no gain or loss recognized in earnings due to hedge ineffectiveness. We have determined that our hedges are still considered “highly effective.” There were no components of the derivative instruments’ gain or loss excluded from the assessment of hedge effectiveness. The maximum length of our swap agreements is five years. We do not anticipate any discontinuance of the swap agreements and thus do not expect to recognize any gain or loss into earnings because of this. On September 18, 2008, we terminated all of our interest rate swap agreements with Lehman Brothers Special Finance, or LBSF, as the counterparty. The notional balance of these swap agreements was $240 million. The fair value of these swap agreements at termination was approximately $(1.5) million, reflecting a realized loss. This loss is being amortized into interest expense over the remaining term of the related hedged borrowings. During the three months ended June 30, 2010, the amount amortized into interest expense was approximately $65 thousand and the remaining amount at June 30, 2010 to be amortized was approximately $638 thousand. For the three months ended June 30, 2009, the amount amortized into interest expense was approximately $154 thousand.

For more information on our accounting policies, the objectives and risk exposures relating to derivatives and hedging agreements, see the section on “Derivative Financial Instruments” in Note 1. For more information on the fair value of our swap agreements, see Note 6.

NOTE 13. COMMITMENTS AND CONTINGENCIES

(a) Lease Commitment and Administrative Services Commitment—We sublease office space and use administrative services from PIA, as more fully described in Note 10.

 

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ANWORTH MORTGAGE ASSET CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

NOTE 14. OTHER EXPENSES

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2010    2009    2010    2009
     (in thousands)    (in thousands)

Legal and accounting fees

   $ 186    $ 158    $ 289    $ 370

Printing and stockholder communications

     134      76      146      86

Directors and Officers insurance

     108      109      218      238

Software and implementation

     77      61      141      122

Administrative service fees

     84      79      167      141

Rent and related expenses

     76      86      158      166

Stock exchange and filing fees

     57      49      116      99

Custodian fees

     33      48      65      85

Sarbanes-Oxley consulting fees

     3      16      39      48

Board of directors fees and expenses

     74      122      147      188

Securities data services

     27      27      54      53

Other

     72      75      148      137
                           

Total of other expenses:

   $ 931    $ 906    $ 1,688    $ 1,733
                           

NOTE 15. SUBSEQUENT EVENTS

On July 9, 2010, we declared a Series A Preferred Stock dividend of $0.539063 per share and a Series B Preferred Stock dividend of $0.390625 per share, each of which is payable on October 15, 2010 to our holders of record of Series A Preferred Stock and Series B Preferred Stock, respectively, as of the close of business on September 30, 2010.

When we pay any cash dividend during any quarterly fiscal period to all or substantially all of our common stockholders in an amount that results in an annualized common stock dividend yield that is greater than 6.25% (the dividend yield on our Series B Preferred Stock), the conversion rate on our Series B Preferred Stock is adjusted based on a formula specified in the Series B Preferred Stock prospectus supplement. This conversion rate increased on July 12, 2010 from 3.2317 shares of our common stock to 3.2990 shares of our common stock using the following information: (1) the average of the closing price of our common stock for the ten (10) consecutive trading day period was $7.16 and (2) the annualized common stock dividend yield was 13.9665%.

 

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

As used in this Quarterly Report on Form 10-Q, “company,” “we,” “us,” “our,” and “Anworth” refer to Anworth Mortgage Asset Corporation.

You should read the following discussion and analysis in conjunction with the unaudited consolidated financial statements and related notes thereto contained in Item 1 of this Quarterly Report on Form 10-Q. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our stock. We urge you to carefully review and consider the various disclosures made by us in this Quarterly Report on Form 10-Q and in our other reports filed with the United States Securities and Exchange Commission, or the SEC, including our Annual Report on Form 10-K for the fiscal year ended December 31, 2009.

Forward Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the 1933 Act and Section 21E of the Securities Exchange Act of 1934, as amended, and, as such, may involve known and unknown risks, uncertainties and assumptions. Forward-looking statements are those that predict or describe future events or trends and that do not relate solely to historical matters. You can generally identify forward-looking statements as statements containing the words “will,” “believe,” “expect,” “anticipate,” “intend,” “estimate,” “assume” or other similar expressions. You should not rely on our forward-looking statements because the matters they describe are subject to assumptions, known and unknown risks, uncertainties and other unpredictable factors, many of which are beyond our control.

 

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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 yield curve; the availability of mortgage-backed securities for purchase; changes in the prepayment rates on the mortgage loans securing our MBS; our ability to borrow to finance our assets; our ability to use borrowings to finance our assets and, if available, the terms of any financing; 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 of 1940, as amended; risks associated with investing in real estate assets, including changes in business conditions and the general economy; and management’s ability to manage our growth. 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.

General

Our Company

We were incorporated in October 1997 and commenced operations on March 17, 1998. We are in the business of investing primarily in United States agency mortgage-backed securities, or MBS, which are obligations guaranteed by the United States government, such as Ginnie Mae, or federally sponsored enterprises such as Fannie Mae or Freddie Mac. Our principal business objective is to generate net income for distribution to stockholders based upon the spread between the interest income on our mortgage-related assets and the cost of borrowing to finance our acquisition of these assets.

We are organized for tax purposes as a real estate investment trust, or REIT. Accordingly, we generally distribute substantially all of our earnings to stockholders without paying federal or state income taxes at the corporate level on the distributed earnings. At June 30, 2010, our qualified REIT assets (real estate assets, as defined under the Internal Revenue Code of 1986, as amended, or the Code, cash, cash items and government securities) were greater than 90% of our total assets, as compared to the Code requirement that at least 75% of our total assets be qualified REIT assets. Greater than 99% of our 2009 revenue qualifies for both the 75% source of gross income test and the 95% source of gross income test under the REIT rules. At June 30, 2010, we believe we met all REIT requirements regarding the ownership of our common stock and distributions of our net income. Therefore, at June 30, 2010, we believe that we continued to qualify as a REIT under the provisions of the Code.

Credit and liquidity problems surrounding the mortgage markets and impacting the general economy have continued. This, along with other factors, created great uncertainty in the financial markets and the economic recession. General downward economic trends, reduced availability of credit, increased unemployment and concerns over the economy persist.

Although the U.S. government and other governments have taken various actions (including placing Fannie Mae and Freddie Mac in conservatorship) intended to protect financial institutions, their respective economies and their respective housing and mortgage markets, we continue to operate under very difficult market conditions. There can be no assurance that these various actions will have a beneficial impact on the global financial markets and, more specifically, the market for the securities we currently own in our portfolio. We cannot predict what, if any, impact these actions or future actions by either the U.S. government or foreign governments could have on our business, results of operations and financial condition. These events may impact the availability of financing generally in the marketplace and also may impact the market value of MBS generally, including the securities we currently own in our portfolio.

Our Portfolio

Our operations consist of the following portfolios: agency mortgage-backed securities, or Agency MBS, and non-agency mortgage-backed securities, or Non-Agency MBS. Approximately 99.9% of our total portfolio is Agency MBS.

At June 30, 2010, we had total assets of $6.26 billion. Our Agency MBS portfolio, consisting of $6.15 billion, was distributed as follows: 27% adjustable-rate Agency MBS, 62% hybrid adjustable-rate Agency MBS, 11% fixed-rate Agency MBS and less than 1% agency floating-rate collateralized mortgage obligations, or CMOs. Our Non-Agency MBS portfolio consisted of approximately $5.1 million of floating-rate CMOs. Stockholders’ equity available to common stockholders at June 30, 2010 was approximately $840 million, or $7.18 per share. The $840 million equals total stockholders’ equity of $889 million less the Series A Preferred Stock liquidating value of approximately $46.9 million and less the difference between the Series B Preferred Stock liquidating value of $27.5 million and the proceeds from its sale of $25.6 million. For the three months ended June 30, 2010, we reported net income of $25.8 million. Net income to common stockholders was $24.4 million, or net income of $0.21 per diluted share, based on a weighted average of 121.1 million fully diluted shares outstanding, which consisted of net income of $25.8 million minus payment of preferred dividends of $1.4 million.

 

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Recent Regulatory Developments

During the first quarter of 2010, Freddie Mac and Fannie Mae both announced that they would be repurchasing seriously delinquent mortgage loans from the MBS pools that they guarantee. These buyouts resulted in a higher level of principal prepayments on our MBS portfolio. Freddie Mac’s buyout program was substantially completed during the first quarter and was the primary factor causing the increase in portfolio CPR during the first quarter. Fannie Mae announced that its buyout activity would be conducted mostly during the second quarter of 2010. During the second quarter, the total of Agency MBS principal payments that we received was $1.072 billion, which compares with $449 million received during the first quarter.

In July 2010, the Dodd-Frank Financial Reform Bill (“the Wall Street Reform and Consumer Protection Act”) was passed by Congress and signed into law by President Obama. This legislation aims to restore responsibility and accountability to the U.S. financial system. It is unclear how this legislation may impact the financial environment, particularly for Agency MBS, repurchase agreements and interest rate swap agreements, as much of the Bill’s implementation has not yet been defined by the regulators.

Results of Operations

Three Months Ended June 30, 2010 Compared to June 30, 2009

For the three months ended June 30, 2010, our net income was $25.8 million. Our net income available to common stockholders was $24.4 million, or $0.21 per diluted share, based on a weighted average of 121.1 million fully diluted shares outstanding. This includes net income of $25.8 million minus the payment of preferred dividends of $1.4 million. For the three months ended June 30, 2009, our net income was $34.0 million. Our net income available to common stockholders was $32.5 million, or $0.31 per diluted share, based on a weighted average of 105.8 million fully diluted shares outstanding. This included net income of $34 million minus the payment of preferred dividends of $1.5 million.

Net interest income for the three months ended June 30, 2010 totaled $29.8 million, or 44.6% of gross income, compared to $38.1 million, or 53.3% of gross income, for the three months ended June 30, 2009. Net interest income is comprised of the interest income earned on mortgage investments (net of premium amortization expense) less interest expense from borrowings. Interest income (net of premium amortization expense) for the three months ended June 30, 2010 was $54.4 million, compared to $67.3 million for the three months ended June 30, 2009, a decrease of 19.1% due primarily to an increase in premium amortization expense, a decrease in the weighted average coupons on Agency MBS (from 5.42% at June 30, 2009 to 4.50% at June 30, 2010), partially offset by an increase in the weighted average portfolio outstanding of approximately $5.97 billion at June 30, 2010 from approximately $5.36 billion at June 30, 2009. Interest expense for the three months ended June 30, 2010 was $24.6 million, compared to $29.2 million for the three months ended June 30, 2009, a decrease of 15.8%, which resulted from a decline in short-term interest rates.

The results of our 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 MBS, the supply of, and demand for, MBS in the marketplace, and the terms and availability of financing. Our net interest income varies primarily as a result of changes in interest rates, the slope of the yield curve (the differential between long-term and short-term interest rates), borrowing costs (our interest expense) and prepayment speeds on our MBS portfolios, 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 borrowings, which are primarily comprised of repurchase agreements, to increase; (ii) the value of our MBS portfolios and, correspondingly, our stockholders’ equity to decline; (iii) coupons on our MBS to reset, although on a delayed basis, to higher interest rates; (iv) prepayments on our MBS portfolios to slow, thereby slowing the amortization of our MBS purchase premiums; and (v) the value of our interest rate swap agreements and, correspondingly, our stockholders’ equity to increase. Conversely, decreases in interest rates, in general, may, over time, cause: (i) prepayments on our MBS portfolios to increase, thereby accelerating the amortization of our MBS purchase premiums; (ii) the interest expense associated with our borrowings to decrease; (iii) the value of our MBS portfolios and, correspondingly, our stockholders’ equity to increase; (iv) the value of our interest rate swap agreements and, correspondingly, our stockholders’ equity to decrease; and (v) coupons on our MBS to reset, although on a delayed basis, to lower interest rates. In addition, our borrowing costs and credit lines are further affected by the type of collateral pledged and general conditions in the credit markets.

During the three months ended June 30, 2010, premium amortization expense increased $8.28 million, or 199%, from $4.16 million during the three months ended June 30, 2009 to $12.44 million, due primarily to an increase in prepayments and an increase in the amortization of unearned premium on securities acquired in the latter part of 2009 and in 2010 at higher premiums.

 

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The table below shows the approximate CPR of our Agency MBS and Non-Agency MBS for each of the following quarters:

 

     2010     2009  

Portfolio

   First
Quarter
    Second
Quarter
    First
Quarter
    Second
Quarter
 

Agency MBS and Non-Agency MBS

   30   48   15   17

During the three months ended June 30, 2010 and June 30, 2009, there was no gain or loss recognized in earnings due to hedge ineffectiveness. We have determined that our hedges are still considered “highly effective.” There were no components of the derivative instruments’ gain or loss excluded from the assessment of hedge effectiveness.

Total expenses were $4.0 million for the three months ended June 30, 2010, compared to $4.0 million for the three months ended June 30, 2009. Compensation costs decreased $699 thousand (due to a decrease in the accrual for bonus and incentive compensation), partially offset by the write-down of the Lehman receivable by $674 thousand and an increase in “Other expenses” (as detailed in Note 14 to the accompanying unaudited consolidated financial statements) of $25 thousand.

Six Months Ended June 30, 2010 Compared to June 30, 2009

For the six months ended June 30, 2010, our net income was $59.1 million. Our net income available to common stockholders was $56.2 million, or $0.47 per diluted share, based on a weighted average of 120.7 million fully diluted shares outstanding. This includes net income of $59.1 million minus the payment of preferred dividends of $2.9 million. For the six months ended June 30, 2009, our net income was $64.8 million. Our net income available to common stockholders was $61.8 million, or $0.61 per diluted share, based on a weighted average of 102.7 million fully diluted shares outstanding. This included net income of $64.8 million minus the payment of preferred dividends of $3 million.

Net interest income for the six months ended June 30, 2010 totaled $67.0 million, or 47.7% of gross income, compared to $72.6 million, or 50.8% of gross income, for the six months ended June 30, 2009. Interest income (net of premium amortization expense) for the six months ended June 30, 2010 was $115.6 million, compared to $134.3 million for the six months ended June 30, 2009, a decrease of 13.9% due primarily to an increase in premium amortization. Interest expense for the six months ended June 30, 2010 was $48.6 million, compared to $61.7 million for the six months ended June 30, 2009, a decrease of 21.2%, which resulted from a decline in short-term interest rates.

During the six months ended June 30, 2010, premium amortization expense increased $16.2 million, or 187%, from $8.65 million during the six months ended June 30, 2009 to $24.8 million, due primarily to an increase in prepayments and an increase in the amortization of unearned premium on securities acquired in the latter part of 2009 and in 2010 at higher premiums.

During the six months ended June 30, 2010, there was no gain or loss recognized in earnings due to hedge ineffectiveness compared to a net gain on derivative instruments of approximately $107 thousand for the six months ended June 30, 2009. We have determined that our hedges are still considered “highly effective.” There were no components of the derivative instruments’ gain or loss excluded from the assessment of hedge effectiveness.

Total expenses were $8.0 million for the six months ended June 30, 2010, compared to $7.9 million for the six months ended June 30, 2009. The increase of $67 thousand in total expenses was due primarily to the write-down of the Lehman receivable by $674 thousand, partially offset by a decrease in compensation costs of $562 thousand (due to a decrease in the accrual for bonus and incentive compensation) and a decrease in “Other expenses” (as detailed in Note 14 to the accompanying unaudited consolidated financial statements) of $45 thousand.

 

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Financial Condition

Agency MBS Portfolio

At June 30, 2010, we held agency mortgage assets whose amortized cost was approximately $6.0 billion, consisting primarily of $5.33 billion of adjustable-rate Agency MBS, $652 million of fixed-rate Agency MBS and $5 million of floating-rate CMOs. This amount represents an approximate 5% decrease from the $6.31 billion held at December 31, 2009. Of the adjustable-rate Agency MBS owned by us, 31% were adjustable-rate pass-through certificates whose coupons reset within one year. The remaining 69% consisted of hybrid adjustable-rate Agency MBS whose coupons will reset between one year and five years. Hybrid adjustable-rate Agency MBS have an initial interest rate that is fixed for a certain period, usually three to five years, and thereafter adjust annually for the remainder of the term of the loan.

The following table presents a schedule of the fair value of our Agency MBS owned at June 30, 2010 and December 31, 2009, classified by type of issuer (dollar amounts in thousands):

 

     June 30, 2010     December 31, 2009  

Agency

   Fair Value    Portfolio
Percentage
    Fair
Value
   Portfolio
Percentage
 

Fannie Mae (FNM)

   $ 5,068,416    82.4   $ 5,113,407    78.8

Freddie Mac (FHLMC)

     1,059,804    17.3        1,350,448    20.8   

Ginnie Mae (GNMA)

     20,407    0.3        21,946    0.4   
                          

Total Agency MBS:

   $ 6,148,627    100.0   $ 6,485,801    100.0
                          

The following table classifies the fair value of our Agency MBS owned at June 30, 2010 and December 31, 2009 by type of interest rate index (dollar amounts in thousands):

 

     June 30, 2010     December 31, 2009  

Index

   Fair Value    Portfolio
Percentage
    Fair Value    Portfolio
Percentage
 

One-month LIBOR

   $ 4,959    0.1   $ 5,661    0.1

Six-month LIBOR

     101,696    1.7        138,715    2.1   

One-year LIBOR

     4,880,527    79.3        4,982,800    76.8   

Six-month certificate of deposit

     1,386    0.0        1,426    0.0   

Six-month constant maturity treasury

     530    0.0        559    0.0   

One-year constant maturity treasury

     429,311    7.0        476,461    7.4   

Cost of Funds Index

     31,062    0.5        33,405    0.5   

Fixed-rate

     699,156    11.4        846,774    13.1   
                          

Total Agency MBS:

   $ 6,148,627    100.0   $ 6,485,801    100.0
                          

The fair values indicated do not include interest earned but not yet paid. With respect to our hybrid adjustable-rate Agency MBS, the fair value of these securities appears on the line associated with the index based on which the security will eventually reset once the initial fixed interest rate period has expired. The fair value of our Agency MBS is reported to us independently from dealers who are major financial institutions and are considered to be market makers for these types of instruments. For more detail on the fair value of our Agency MBS, see Note 6 to the accompanying unaudited consolidated financial statements.

 

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The weighted average coupons and average amortized costs of our Agency MBS at June 30, 2010 and December 31, 2009 were as follows:

 

     June 30,
2010
    December 31,
2009
 

Weighted Average Coupon:

    

Adjustable-rate

   3.78   4.11

Hybrid adjustable-rate

   4.59      5.35   

Fixed-rate

   5.75      5.79   

CMOs

   1.15      1.04   
            

Total Agency MBS

   4.50   5.08
            

Average Amortized Cost:

    

Adjustable-rate and hybrid adjustable-rate

   102.39   102.14

Fixed-rate

   100.47      100.40   
            

Total Agency MBS

   102.17   101.92
            

Current yield (weighted average coupon divided by average amortized cost)

   4.40   4.98

Relative to our Agency MBS portfolio at June 30, 2010, the average interest rate on outstanding repurchase agreements was 0.28% and the average days to maturity was 38 days. After adjusting for interest rate swap transactions, the average interest rate on outstanding repurchase agreements was 1.86% and the weighted average term to next rate adjustment was 396 days. Relative to our Agency MBS portfolio at December 31, 2009, the average interest rate on outstanding repurchase agreements was 0.24% and the average days to maturity was 38 days. After adjusting for interest rate swap transactions, the average interest rate on outstanding repurchase agreements was 1.88% and the weighted average term to next rate adjustment was 309 days.

At June 30, 2010 and December 31, 2009, the unamortized net premium paid for our Agency MBS was $127.8 million and $118 million, respectively.

One of the factors that impacts the reported yield on our MBS portfolio is the actual prepayment rate on the underlying mortgages. We analyze our MBS and the extent to which prepayments impact the yield. When the rate of prepayments exceeds expectations, we amortize the premiums paid on mortgage assets over a shorter time period, resulting in a reduced yield to maturity on our mortgage assets. Conversely, if actual prepayments are less than the assumed CPR, the premium would be amortized over a longer time period, resulting in a higher yield to maturity.

Non-Agency MBS Portfolio

Non-Agency MBS are securities not issued by the government or government-sponsored enterprises and are secured primarily by first-lien residential mortgage loans. At June 30, 2010, our Non-Agency MBS portfolio consisted of a fair value of $5.1 million of floating-rate CMOs with an average coupon of 0.59% which were acquired at par value. At December 31, 2009, our Non-Agency MBS portfolio consisted of a fair value of $4.8 million of floating-rate CMOs with an average coupon of 0.48%, which were acquired at par value.

At June 30, 2010, the fair value of our Non-Agency MBS portfolio increased to approximately $5.1 million from a fair value of approximately $4.8 million at December 31, 2009. The increase is due primarily to an increase in an unrealized gain of approximately $2.3 million, partially offset by principal paydowns of approximately $2.0 million.

At June 30, 2010, the two securities representing the principal balance of our Non-Agency MBS portfolio were rated CC by Standard & Poor’s and Ca by Moody’s Investor Service.

We received valuations at June 30, 2010 and December 31, 2009 for the Non-Agency MBS from an independent third party pricing service whose methodologies are based on broker-provided pricing as well as indirect observation of market activity and we consider the fair value measurement a Level 3 input at June 30, 2010 and December 31, 2009. For more detail on the fair value of our Non-Agency MBS, see Note 6 to the accompanying unaudited consolidated financial statements.

 

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The table below provides additional details regarding our Non-Agency MBS portfolio at June 30, 2010 and December 31, 2009:

 

     June 30,
2010
    December 31,
2009
 

Non-Agency MBS at fair value

   $ 5.1 million      $ 4.7 million   

Principal balance of Non-Agency MBS

   $ 39.81 million      $ 41.79 million   

Original principal balance on Non-Agency MBS

   $ 60 million      $ 60 million   

Original FICO (credit score)

     730        730   

Information on Loan Collateral of Non-Agency MBS Securitizations

    

Loan principal as percentage of original loan principal

     66.4     69.7

Weighted average original loan-to-value (LTV)

     69     69

Weighted average original LTV adjusted for negative loan amortization

     73     73

California loans(1)

     69     69

Pay-option ARM loans(1)

     100     100

2006 loan originations(1)

     99     99

3-month CPR

     15.5     13.1

Loans in foreclosure(1)

     18.2     16.5

Real estate owned (REO)(1)(2)

     3.4     3.5

Total seriously delinquent(1)(3)

     30.8     27.2

Realized losses (as percentage of original collateral balance)

     5.6     3.6

Information on Subordination Levels of Non-Agency MBS Securitizations(4)

    

Average securitization principal subordinate to Anworth-owned tranches

     3.4     6.0

Average securitization principal of Anworth-owned tranches

     16.6     16.1

Average securitization principal senior to Anworth-owned tranches

     80.0     77.9

 

(1) As a percentage of collateral loan principal.
(2) Represents the amount of collateral loan principal where the properties are now REO.
(3) Includes 90+ days delinquent plus foreclosures plus bankruptcy plus REO.
(4) Weighted average as percentage of collateral loan principal at June 30, 2010 and December 31, 2009.

Hedging

We periodically enter into derivative transactions, in the form of forward purchase commitments and interest rate swap agreements, which are intended to hedge our exposure to rising interest rates on funds borrowed to finance our investments in securities. We designate interest rate swap transactions as cash flow hedges. We also periodically enter into derivative transactions, in the form of forward purchase commitments, which are not designated as hedges. To the extent that we enter into hedging transactions to reduce our interest rate risk on indebtedness incurred to acquire or carry real estate assets, any income or gain from the disposition of those hedging transactions should be qualifying income under the REIT rules for purposes of the 95% gross income test and of the 95% gross income test have been extended to exclusion under the 75% gross income test. To qualify for this exclusion, the hedging transaction must be clearly identified as such before the close of the day on which it was acquired, originated or entered into. The transaction must hedge indebtedness incurred or to be incurred by us to acquire or carry real estate assets.

As part of our asset/liability management policy, we may enter into hedging agreements such as interest rate caps, floors or swaps. These agreements are entered into to try to reduce interest rate risk and are designed to provide us with income and capital appreciation in the event of certain changes in interest rates. We review the need for hedging agreements on a regular basis consistent with our capital investment policy. At June 30, 2010, we were a counter-party to swap

 

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agreements, which are derivative instruments as defined by ASC 815-10, with an aggregate notional amount of $2.47 billion and an average maturity of 2.2 years. We do not anticipate entering into derivative transactions for speculative or trading purposes. In accordance with the swap agreements, we pay a fixed rate of interest during the term of the swap agreements and receive a payment that varies with the three-month LIBOR rate. At June 30, 2010, there were unrealized losses of approximately $89.2 million on our swap agreements.

For more information on the amounts, policies, objectives and other qualitative data on our hedge agreements, see Notes 1, 6 and 12 to the accompanying unaudited consolidated financial statements.

Liquidity and Capital Resources

Agency MBS and Non-Agency MBS Portfolios

Our primary source of funds consists of repurchase agreements which totaled $5.1 billion at June 30, 2010. As collateral for these repurchase agreements, we pledged approximately $5.43 billion in Agency MBS. Our other significant source of funds for the three months ended June 30, 2010 consisted of payments of principal from our Agency MBS portfolio in the amount of $1.07 billion.

For the three months ended June 30, 2010, there was a net decrease in cash and cash equivalents of approximately $362 thousand. This consisted of the following components:

 

   

Net cash used in operating activities for the three months ended June 30, 2010 was approximately $48.8 million. This is comprised primarily of net income of $25.8 million, adding back the following non-cash items: the amortization of premiums and discounts of approximately $12.4 million, the amortization of restricted stock of $70 thousand and the write-down of the Lehman receivable by $674 thousand. Net cash used in operating activities also included a decrease in accrued expenses of approximately $86.2 million (due primarily to a decrease in payable for securities purchased) and an increase in prepaid expenses of approximately $7.4 million, partially offset by an increase in accrued interest payable of approximately $2.3 million and a decrease in interest receivable of approximately $3.5 million;

 

   

Net cash provided by investing activities for the three months ended June 30, 2010 was approximately $310 million which consisted of purchases of Agency MBS of approximately $693 million partially offset by $1.07 billion from principal payments on Agency MBS, $1.1 million from principal payments on Non-Agency MBS and purchases of reverse repurchase agreements of approximately $70.5 million; and

 

   

Net cash used in financing activities for the three months ended June 30, 2010 was approximately $261 million. This consisted of borrowings on repurchase agreements of approximately $7.03 billion partially offset by repayments on repurchase agreements of approximately $7.25 billion. This also included net proceeds from common stock issued of approximately $10.8 million less dividends paid of $32.1 million on common stock, dividends paid of approximately $1.4 million on preferred stock and retirement of treasury stock of approximately $16.5 million.

Relative to our Agency MBS portfolio at June 30, 2010, all of our repurchase agreements were fixed-rate term repurchase agreements with original maturities ranging from 28 days to three months. At June 30, 2010, we had borrowed funds under repurchase agreements with 15 different financial institutions. As the repurchase agreements mature, we enter into new repurchase agreements to take their place. Because we borrow money based on the fair value of our MBS and because increases in short-term interest rates or increasing market concern about the liquidity or value of our MBS can negatively impact the valuation of MBS, our borrowing ability could be reduced and lenders may initiate margin calls in the event short-term interest rates increase or the value of our MBS declines for other reasons. We had adequate cash flow, liquid assets and unpledged collateral with which to meet our margin requirements during the three months ended June 30, 2010 but there can be no assurance we will have adequate cash flow, liquid assets and unpledged collateral with which to meet our margin requirements in the future.

Our leverage on capital (including all preferred stock and junior subordinated notes) decreased from 5.5x at December 31, 2009 to 5.35x at June 30, 2010.

In the future, we expect that our primary sources of funds will continue to consist of borrowed funds under repurchase agreement transactions and monthly payments of principal and interest on our MBS portfolio. Our liquid assets generally consist of unpledged MBS, cash and cash equivalents. A large negative change in the market value of our MBS might reduce our liquidity, requiring us to sell assets with the likely result of realized losses upon sale.

 

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During the three months ended June 30, 2010, we raised approximately $10.8 million in capital under our Dividend Reinvestment and Stock Purchase Plan.

At June 30, 2010, our authorized capital included 20 million shares of $0.01 par value preferred stock, which we have classified as Series A Preferred Stock and Series B Preferred Stock. During the three months ended June 30, 2010, we did not issue any shares of Series A Preferred Stock or Series B Preferred Stock. During the three months ended June 30, 2010, there were no transactions to convert shares of Series B Preferred Stock into shares of our common stock.

During the three months ended June 30, 2010, we did not issue any shares of common stock or preferred stock under our Controlled Equity Offering Sales Agreement with Cantor Fitzgerald & Co. (as described in Note 9 to the accompanying unaudited consolidated financial statements).

On February 1, 2010, we announced that our board of directors had authorized a share repurchase program, permitting us to acquire 5,850,000 shares of our common stock, or approximately 5% of our outstanding common stock. The shares are to be acquired at prevailing prices through open market transactions. The manner, price, number and timing of these share repurchases are subject to market conditions and applicable SEC rules. During the three months ended June 30, 2010, we repurchased (as more fully described in Note 9 to the accompanying unaudited consolidated financial statements) a total of 2,547,616 shares of our common stock at a weighted average price of $6.46 per share under this program. From February 1, 2010 through June 30, 2010, we repurchased an aggregate of 3,060,616 shares at a weighted average price of $6.52 per share under this program. The shares were acquired at prevailing prices through open market transactions and were made subject to restrictions related to volume, pricing and timing subject to applicable SEC rules.

Disclosure of Contractual Obligations

There were no material changes outside the normal course of business during the three months ended June 30, 2010 to the contractual obligations identified in our Form 10-K for the fiscal year ended December 31, 2009.

Off-balance Sheet Arrangements

At June 30, 2010, we did not have any off-balance sheet arrangements.

Stockholders’ Equity

We use available-for-sale treatment for our Agency MBS and Non-Agency MBS, which are carried on our consolidated balance sheets at fair value rather than historical cost. Based upon this treatment, our total equity base at June 30, 2010 was $889 million. Common stockholders’ equity was approximately $840 million or a book value of $7.18 per share.

Under our available-for-sale accounting treatment, unrealized fluctuations in fair values of assets are assessed to determine whether they are other-than-temporary. To the extent we determine that these unrealized fluctuations are temporary, they do not impact GAAP income or taxable income but rather are reflected on our consolidated balance sheets by changing the carrying value of the assets and reflecting the change in stockholders’ equity under “Accumulated other comprehensive income, unrealized gain (loss) on available-for-sale securities.”

As a result of this mark-to-market accounting treatment, our book value and book value per share are likely to fluctuate far more than if we used historical amortized cost accounting on all of our assets. As a result, comparisons with some companies that use historical cost accounting for all of their balance sheets may not be meaningful.

Unrealized changes in the fair value of MBS have one significant and direct effect on our potential earnings and dividends: positive mark-to-market changes will increase our equity base and allow us to increase our borrowing capacity, while negative changes will tend to reduce borrowing capacity under our capital investment policy. A very large negative change in the net market value of our MBS might reduce our liquidity, requiring us to sell assets with the likely result of realized losses upon sale. “Accumulative other comprehensive income, unrealized gain” on available-for-sale Agency MBS was approximately $151 million or 2.52% of the amortized cost of our Agency MBS at June 30, 2010. This, along with “Accumulative other comprehensive loss, derivatives” of approximately $89.2 million and “Accumulated other comprehensive gain, Non-Agency MBS” of $2.8 million, constitutes the total “Accumulative other comprehensive income” of approximately $64.6 million.

Critical Accounting Policies

Management has the obligation to ensure that its policies and methodologies are in accordance with GAAP. Management has reviewed and evaluated its critical accounting policies and believes them to be in accordance with GAAP.

 

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The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions in certain circumstances that affect amounts reported in the accompanying unaudited consolidated financial statements. In preparing these unaudited consolidated financial statements, management has made its best estimates and judgments on the basis of information then readily available to it of certain amounts included in the unaudited 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 the accounting policies described below. Nevertheless, 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 materially and adversely from these estimates.

Our accounting policies are described in Note 1 to the accompanying unaudited consolidated financial statements. Management believes the more significant of our accounting policies are the following:

Revenue Recognition

The most significant source of our revenue is derived from our investments in MBS. We reflect income using the effective yield method, which, through amortization of premiums and accretion of discounts at an effective yield, recognizes periodic income over the estimated life of the investment on a constant yield basis, as adjusted for actual prepayment activity. Management believes our revenue recognition policies are appropriate to reflect the substance of the underlying transactions.

Interest income on our MBS is accrued based on the actual coupon rate and the outstanding principal amounts of the underlying mortgages. Premiums and discounts are amortized or accreted into interest income over the expected lives of the securities using the effective interest yield method, adjusted for the effects of actual prepayments and estimated prepayments based on ASC 320-10. Our policy for estimating prepayment speeds for calculating the effective yield is to evaluate historical performance, street consensus prepayment speeds and current market conditions. If our estimate of prepayments is incorrect, we may be required to make an adjustment to the amortization or accretion of premiums and discounts that would have an impact on future income.

Valuation and Classification of Investment Securities

We carry our investment securities on our consolidated balance sheets at fair value. The fair values of our Agency MBS are generally based on third party bid price indications provided by certain dealers who make markets in such securities. The fair value of our Non-Agency MBS are obtained from an independent third party pricing service whose methodologies are based on broker-provided pricing as well as indirect observation of market activity. If, in the opinion of management, one or more securities prices reported to us are not reliable or unavailable, management reviews the fair value based on characteristics of the security it receives from the issuer and available market information. The fair values reported reflect estimates and may not necessarily be indicative of the amounts we could realize in a current market exchange. We review various factors (e.g., expected cash flows, changes in interest rates, credit protection, etc.) in determining whether and to what extent an other-than-temporary impairment exists. To the extent that unrealized losses on our Agency MBS and Non-Agency MBS are attributable to changes in interest rates and not credit quality, and because we do not have the intent to sell these investments, nor is it not more likely than not that we will be required to sell these investments before recovery of their amortized cost bases, which may be at maturity, we do not consider these investments to be other-than-temporarily impaired. Losses (that are related to credit quality) on securities classified as available-for-sale, which are determined by management to be other-than-temporary in nature, are reclassified from “Accumulated other comprehensive income” to current-period income. For more detail on the fair value of our securities, see Note 6 to the accompanying unaudited consolidated financial statements.

Accounting for Derivatives and Hedging Activities

In accordance with ASC 815-10, a derivative that is designated as a hedge is recognized as an asset/liability and measured at estimated fair value. In order for our interest rate swap agreements to qualify for hedge accounting, upon entering into the swap agreement, we must anticipate that the hedge will be highly “effective,” as defined by ASC 815-10.

On the date we enter into a derivative contract, we designate the derivative as a hedge of the variability of cash flows that are to be received or paid in connection with a recognized asset or liability (a “cash flow” hedge). Changes in the fair value of a derivative that are highly effective and that are designated and qualify as a cash flow hedge, to the extent that the hedge is effective, are recorded in “Other comprehensive income” and reclassified to income when the forecasted transaction affects income (e.g., when periodic settlement interest payments are due on repurchase agreements). The swap agreements are carried on our consolidated balance sheets at their fair value based on values obtained from large financial institutions who are considered market makers for these types of instruments. Hedge ineffectiveness, if any, is recorded in current-period income.

We formally assess, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods. If it is determined that a derivative is not (or has ceased to be) highly effective as a hedge, we discontinue hedge accounting.

 

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When we discontinue hedge accounting, the gain or loss on the derivative remains in “Accumulated other comprehensive income” and is reclassified into income when the forecasted transaction affects income. In all situations in which hedge accounting is discontinued and the derivative remains outstanding, we will carry the derivative at its fair value on our consolidated balance sheets, recognizing changes in the fair value in current-period income.

For purposes of the cash flow statement, cash flows from derivative instruments are classified with the cash flows from the hedged item. For more detail on our derivative instruments, see Notes 1, 6 and 12 to the accompanying unaudited consolidated financial statements.

Income Taxes

Our financial results do not reflect provisions for current or deferred income taxes. Management believes that we have and intend to continue to operate in a manner that will allow us to be taxed as a REIT and, as a result, management does not expect to pay substantial, if any, corporate level taxes. Many of these requirements, however, are highly technical and complex. If we were to fail to meet these requirements, we would be subject to federal income tax.

Subsequent Events

On July 9, 2010, we declared a Series A Preferred Stock dividend of $0.539063 per share and a Series B Preferred Stock dividend of $0.390625 per share, each of which is payable on October 15, 2010 to our holders of record of Series A Preferred Stock and Series B Preferred Stock, respectively, as of the close of business on September 30, 2010.

When we pay any cash dividend during any quarterly fiscal period to all or substantially all of our common stockholders in an amount that results in an annualized common stock dividend yield that is greater than 6.25% (the dividend yield on our Series B Preferred Stock), the conversion rate on our Series B Preferred Stock is adjusted based on a formula specified in the Series B Preferred Stock prospectus supplement. This conversion rate increased on July 12, 2010 from 3.2317 shares of our common stock to 3.2990 shares of our common stock using the following information: (1) the average of the closing price of our common stock for the ten (10) consecutive trading day period was $7.16 and (2) the annualized common stock dividend yield was 13.9665%.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We seek to manage the interest rate, market value, liquidity, prepayment and credit risks inherent in all financial instruments in a prudent manner designed to insure our longevity while, at the same time, seeking to provide an opportunity for stockholders to realize attractive total rates of return through ownership of our common stock. While we do not seek to avoid risk completely, we do seek, to the best of our ability, to assume risk that can be quantified from historical experience, to actively manage that risk, to earn sufficient returns to justify taking those risks and to maintain capital levels consistent with the risks we undertake.

Interest Rate Risk

We primarily invest in adjustable-rate, hybrid and fixed-rate mortgage-related assets. Hybrid mortgages are ARMs that have a fixed interest rate for an initial period of time (typically three years or greater) and then convert to an adjustable-rate for the remaining loan term. Our debt obligations are generally repurchase agreements of limited duration that are periodically refinanced at current market rates.

ARM-related assets are typically subject to periodic and lifetime interest rate caps that limit the amount an ARM-related asset’s interest rate can change during any given period. ARM securities are also typically subject to a minimum interest rate payable. Our borrowings are not subject to similar restrictions. Hence, in a period of increasing interest rates, interest rates on our borrowings could increase without limitation, while the interest rates on our mortgage-related assets could be limited. This problem would be magnified to the extent we acquire mortgage-related assets that are not fully indexed. Further, some ARM-related assets may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. These factors could lower our net interest income or cause a net loss during periods of rising interest rates, which would negatively impact our liquidity, net income and our ability to make distributions to stockholders.

 

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We fund the purchase of a substantial portion of our ARM-related assets with borrowings that have interest rates based on indices and repricing terms similar to, but of shorter maturities than, the interest rate indices and repricing terms of our mortgage assets. Thus, we anticipate that in most cases the interest rate indices and repricing terms of our mortgage assets and our funding sources will not be identical, thereby creating an interest rate mismatch between assets and liabilities. During periods of changing interest rates, such interest rate mismatches could negatively impact our net interest income, dividend yield and the market price of our common stock.

Most of our adjustable-rate assets are based on the one-year constant maturity treasury rate and the one-year LIBOR rate and our debt obligations are generally based on LIBOR. These indices generally move in the same direction, but there can be no assurance that this will continue to occur.

Our ARM-related assets and borrowings reset at various different dates for the specific asset or obligation. In general, the repricing of our debt obligations occurs more quickly than on our assets. Therefore, on average, our cost of funds may rise or fall more quickly than does our earnings rate on the assets.

Further, our net income may vary somewhat as the spread between one-month interest rates and six- and twelve-month interest rates varies.

At June 30, 2010, our Agency MBS and Non-Agency MBS and the related borrowings will prospectively reprice based on the following time frames (dollar amounts in thousands):

 

     Investments(1)(2)     Borrowings  
     Amount    Percentage  of
Total
Investments
    Amount    Percentage  of
Total
Borrowings
 

Investment Type/Rate Reset Dates:

          

Fixed-rate investments

   $ 699,156    11.4   $ 0    0.0

Adjustable-Rate Investments/Obligations:

          

Less than 3 months

     412,152    6.7     4,990,000    98.0

Greater than 3 months and less than 1 year

     1,264,982    20.6        100,000    2.0   

Greater than 1 year and less than 2 years

     1,029,434    16.7        0    0.0   

Greater than 2 years and less than 3 years

     1,114,921    18.1        0    0.0   

Greater than 3 years and less than 5 years

     1,633,062    26.5        0    0.0   
                          

Total:

   $ 6,153,707    100.0   $ 5,090,000    1000.0
                          

 

(1) Based on when they contractually reprice and does not consider the effect of any prepayments.
(2) The Company assumes that if the repricing of the investment is just beyond 3 months but less than 4 months, it is included in the “Less than 3 months” category.

At December 31, 2009, our Agency MBS and Non-Agency MBS and the related borrowings will prospectively reprice based on the following time frames (dollar amounts in thousands):

 

     Investments(1)(2)     Borrowings  
     Amount    Percentage  of
Total
Investments
    Amount    Percentage  of
Total
Borrowings
 

Investment Type/Rate Reset Dates:

          

Fixed-rate investments

   $ 846,774    13.1   $ 0    0.0

Adjustable-Rate Investments/Obligations:

          

Less than 3 months

     302,345    4.7        5,359,000    100.0

Greater than 3 months and less than 1 year

     1,343,012    20.7        0    0.0   

Greater than 1 year and less than 2 years

     1,414,173    21.8        0    0.0   

Greater than 2 years and less than 3 years

     1,422,397    21.9        0    0.0   

Greater than 3 years and less than 5 years

     1,161,842    17.8        0    0.0   
                          

Total:

   $ 6,490,543    100.0   $ 5,359,000    100.0
                          

 

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(1) Based on when they contractually reprice and does not consider the effect of any prepayments.
(2) The Company assumes that if the repricing of the investment is just beyond 3 months but less than 4 months, it is included in the “Less than 3 months” category.

Market Value Risk

All of our MBS are classified as available-for-sale assets. As such, they are reflected at fair value (i.e., market value) with the periodic adjustment to fair value (that is not considered to be an other-than-temporary impairment) reflected as part of “Accumulated other comprehensive income” that is included in the equity section of our balance sheet. The market value of our assets can fluctuate due to changes in interest rates and other factors.

Liquidity Risk

Our primary liquidity risk arises from financing long-maturity MBS with short-term debt. The interest rates on our borrowings generally adjust more frequently than the interest rates on our adjustable-rate MBS. For example, at June 30, 2010, our Agency MBS and Non-Agency adjustable-rate MBS had a weighted average term to next rate adjustment of approximately 28 months while our borrowings had a weighted average term to next rate adjustment of 38 days. After adjusting for interest rate swap transactions, the weighted average term to next rate adjustment was 396 days. Accordingly, in a period of rising interest rates, our borrowing costs will usually increase faster than our interest earnings from MBS. As a result, we could experience a decrease in net income or a net loss during these periods. Our assets that are pledged to secure short-term borrowings are high-quality liquid assets. As a result, we have been able to roll over our short-term borrowings as they mature. There can be no assurance that we will always be able to roll over our short-term debt.

During the past year, there were continuing liquidity and credit concerns surrounding the mortgage markets and the general economy. While the U.S. government and other governments have taken various actions to address these concerns, there continue to be severe restrictions on the availability of financing in general and concerns about the potential impact on product availability, liquidity, interest rates and changes in the yield curve. While we have been able to meet all of our liquidity needs to date, there are still concerns in the mortgage sector about the availability of financing generally.

At June 30, 2010, we had unrestricted cash of $473 thousand and $707 million in unpledged Agency MBS and Non-Agency MBS available to meet margin calls on short-term borrowings that could be caused by asset value declines or changes in lender collateralization requirements.

Prepayment Risk

Prepayments are the full or partial repayment of principal prior to the original term to maturity of a mortgage loan and typically occur due to refinancing of mortgage loans. Prepayment rates on mortgage-related securities and mortgage loans vary from time to time and may cause changes in the amount of our net interest income. Prepayments of ARM loans usually can be expected to increase when mortgage interest rates fall below the then-current interest rates on such loans and decrease when mortgage interest rates exceed the then-current interest rate on such loans, although such effects are not entirely predictable. Prepayment rates may also be affected by the conditions in the housing and financial markets, general economic conditions and the relative interest rates on fixed-rate loans and ARM loans underlying MBS. The purchase prices of MBS are generally based upon assumptions regarding the expected amounts and rates of prepayments. Where slow prepayment assumptions are made, we may pay a premium for MBS. To the extent such assumptions differ from the actual amounts of prepayments, we could experience reduced earnings or losses. The total prepayment of any MBS purchased at a premium by us would result in the immediate write-off of any remaining capitalized premium amount and a reduction of our net interest income by such amount. In addition, in the event that we are unable to acquire new MBS to replace the prepaid MBS, our financial condition, cash flows and results of operations could be harmed.

We often purchase mortgage-related assets that have a higher interest rate than the market interest rate at the time. In exchange for this higher interest rate, we must pay a premium over par value to acquire these assets. In accordance with accounting rules, we amortize this premium over the term of the MBS. As we receive repayments of mortgage principal, we amortize the premium balances as a reduction to our income. If the mortgage loans underlying MBS were prepaid at a faster rate than we anticipate, we would amortize the premium at a faster rate. This would reduce our income.

General

Many assumptions are made to present the information in the tables below 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; therefore, the tables below and all related disclosures constitute forward-looking statements. The analyses presented utilize assumptions and estimates based on management’s judgment and experience. Furthermore, future sales, acquisitions and restructuring could materially change

 

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the interest rate risk profile for us. The tables quantify the potential changes in net income and net asset value should interest rates immediately change (are “shocked”). The results of interest rate shocks of plus and minus 100 and 200 basis points are presented. The cash flows associated with the portfolio of mortgage-related assets for each shock rate are calculated based on a variety of assumptions including prepayment speeds, time until coupon reset, yield on future acquisitions, slope of the yield curve and size of the portfolio. Assumptions made on the interest rate-sensitive liabilities, which are repurchase agreements, include anticipated interest rates (no negative rates are utilized), collateral requirements as a percent of the repurchase agreement and amount of borrowing. Assumptions made in calculating the impact on net asset value of interest rate shocks include interest rates, prepayment rates and the yield spread of mortgage-related assets relative to prevailing interest rates.

Tabular Presentation

The information presented in the tables below projects the impact of sudden changes in interest rates on Anworth’s annual Projected Net Interest Income and Projected Portfolio Value, as more fully discussed below, based on our investments in place at June 30, 2010 and includes all of our interest rate-sensitive assets, liabilities and hedges, such as interest rate swap agreements.

Changes in Projected Net Interest Income equals the change that would occur in the calculated Projected Net Interest Income for the next twelve months relative to the 0% change scenario if interest rates were to instantaneously parallel shift to and remain at the stated level for the next twelve months.

Changes in Projected Portfolio Value equals the change in the value of our assets that we carry at fair value and any change in the value of any derivative instruments or hedges, such as interest rate swap agreements. We acquire interest rate-sensitive assets and fund them with interest rate-sensitive liabilities. We generally plan to retain such assets and the associated interest rate risk to maturity.

 

Change in Interest Rates

   Percentage Change in
Projected  Net Interest Income
    Percentage Change in
Projected  Portfolio Value
 

-2%

   -55.3   -1.6

-1%

   -27.3   -0.3

0%

   0 %   0 %

1%

   -9.9   -1.3

2%

   -23.2   -3.5

When interest rates are shocked, prepayment assumptions are adjusted based on management’s best estimate of the effects of changes in interest rates on prepayment speeds. For example, under current market conditions, a 100 basis point decline in interest rates is estimated to result in a 61% increase in the prepayment rate of our Agency MBS and Non-Agency MBS portfolios. The base interest rate scenario assumes interest rates at June 30, 2010. Actual results could differ significantly from those estimated in the tables. The above table includes the effect of interest rate swap agreements. At June 30, 2010, the aggregate notional amount of the interest rate swap agreements was $2.47 billion and the weighted average maturity was 2.2 years.

The information presented in the table below projects the impact of sudden changes in interest rates on Anworth’s annual Projected Net Income and Projected Portfolio Value compared to the base case used in the table above and excludes the effect of the interest rate swap agreements.

 

Change in Interest Rates

   Percentage Change in
Projected Net Interest Income
    Percentage Change in
Projected Portfolio Value
 

-2%

   24.6   0.1

-1%

   48.5   0.5

0%

   0 %   0 %

1%

   38.3   -2.1

2%

   4.6   -5.1

 

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Item 4. Controls and Procedures

Disclosure Controls and Procedures

We maintain disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules, regulations and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness in design and operation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective in the timely and accurate recording, processing, summarizing and reporting of information required to be disclosed by us in our reports filed or submitted under the Exchange Act within the time periods specified in the SEC’s rules, regulations and forms. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has concluded that our disclosure controls and procedures are also effective to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings.

We are not a party to any material pending legal proceedings.

 

Item 1A. Risk Factors.

There are no material changes to the risk factors as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2009 as modified and supplemented by the risk factors disclosed in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2010. The materialization of any risks and uncertainties identified in our Forward Looking Statements contained in this report together with those previously disclosed in the Form 10-K an our Quarterly Report on Form 10-Q for the quarter ended March 31, 2010 or those that are presently unforeseen could result in material and adverse effects on our financial condition, results of operations and cash flows. See Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Forward Looking Statements” in this Quarterly Report on Form 10-Q.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

The table below summarizes the Company’s monthly repurchases of equity securities during the three months ended June 30, 2010:

 

Period

   Total Number
of Shares
Purchased
   Average
Price Paid per
Share
   Total Number
of Shares
Purchased as
Part of Publicly
Announced
Plans or
Programs (1)
   Maximum
Number of
Shares
That
May Yet Be
Purchased
Under the
Plans or
Programs

Shares purchased in prior quarter

   513,000       513,000    5,337,000
               

Month #1 (April 1-30)

   0    $ 0.00    0    5,337,000

Month #2 (May 1-31)

   2,416,216      6.45    2,929,216    2,920,784

Month #3 (June 1-30)

   131,400      6.75    3,060,616    2,789,384
                   

Total shares purchased this quarter

   2,547,616    $ 6.46       2,789,384
               

 

(1) On February 1, 2010, we announced that our board of directors had authorized a share repurchase program, permitting us to acquire 5,850,000 shares of our common stock, or approximately 5% of our outstanding common stock. The shares are to be acquired at prevailing prices through open market transactions. The manner, price, number and timing of these share repurchases are subject to market conditions and applicable SEC rules.

 

Item 3. Defaults Upon Senior Securities.

None.

 

Item 4. Reserved.

 

Item 5. Other Information.

(a) Additional Disclosures. None.

 

  (b) Stockholder Nominations. There have been no material changes to the procedures by which stockholders may recommend nominees to our board of directors during the quarter ended June 30, 2010. Please see the discussion of our procedures in our most recent proxy statement.

 

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Item 6. Exhibits.

The following exhibits are either filed herewith or incorporated herein by reference:

 

Exhibit

Number

 

Description

  1.1   Controlled Equity Offering Sales Agreement dated May 14, 2008 between Anworth Mortgage Asset Corporation and Cantor Fitzgerald & Co. (incorporated by reference from our Current Report on Form 8-K filed with the SEC on May 15, 2008)
  3.1   Amended Articles of Incorporation of Anworth (incorporated by reference from our Registration Statement on Form S-11, Registration No. 333-38641, which became effective under the Securities Act of 1933 on March 12, 1998)
  3.2   Amended Bylaws of Anworth (incorporated by reference from our Current Report on Form 8-K filed with the SEC on March 13, 2009)
  3.3   Articles of Amendment to Amended Articles of Incorporation (incorporated by reference from our Definitive Proxy Statement filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, as filed with the SEC on May 14, 2003)
  3.4   Articles Supplementary for Series A Cumulative Preferred Stock (incorporated by reference from our Current Report on Form 8-K filed with the SEC on November 3, 2004)
  3.5   Articles Supplementary for Series A Cumulative Preferred Stock (incorporated by reference from our Current Report on Form 8-K filed with the SEC on January 21, 2005)
  3.6   Articles Supplementary for Series B Cumulative Convertible Preferred Stock (incorporated by reference from our Current Report on Form 8-K filed with the SEC on January 30, 2007)
  3.7   Articles Supplementary for Series B Cumulative Convertible Preferred Stock (incorporated by reference from our Current Report on Form 8-K filed with the SEC on May 21, 2007)
  3.8   Articles of Amendment to Amended Articles of Incorporation (incorporated by reference from our Current Report on Form 8-K filed with the SEC on May 28, 2008)
  4.1   Specimen Common Stock Certificate (incorporated by reference from our Registration Statement on Form S-11, Registration No. 333-38641, which became effective under the Securities Act of 1933 on March 12, 1998)
  4.2   Specimen Series A Cumulative Preferred Stock Certificate (incorporated by reference from our Current Report on Form 8-K filed with the SEC on November 3, 2004)
  4.3   Specimen Series B Cumulative Convertible Preferred Stock Certificate (incorporated by reference from our Current Report on Form 8-K filed with the SEC on January 30, 2007)
  4.4   Specimen Anworth Capital Trust I Floating Rate Preferred Stock Certificate (liquidation amount $1,000 per Preferred Security) (incorporated by reference from our Current Report on Form 8-K filed with the SEC on March 16, 2005)
  4.5   Specimen Anworth Capital Trust I Floating Rate Common Stock Certificate (liquidation amount $1,000 per Common Security) (incorporated by reference from our Current Report on Form 8-K filed with the SEC on March 16, 2005)
  4.6   Specimen Anworth Floating Rate Junior Subordinated Note Due 2035 (incorporated by reference from our Current Report on Form 8-K filed with the SEC on March 16, 2005)
  4.7   Junior Subordinated Indenture dated as of March 15, 2005, between Anworth and JPMorgan Chase Bank (incorporated by reference from our Current Report on Form 8-K filed with the SEC on March 16, 2005)
10.1   2002 Incentive Compensation Plan (incorporated by reference from our Definitive Proxy Statement filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, as filed with the SEC on May 17, 2002), as amended by Amendment No. 1 to 2002 Incentive Compensation Plan (incorporated by reference from our Current Report on Form 8-K filed with the SEC on October 15, 2009)
10.2*   2004 Equity Compensation Plan (incorporated by reference from our Definitive Proxy Statement filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, as filed with the SEC on April 26, 2004)
10.3   2007 Dividend Equivalent Rights Plan (incorporated by reference from our Definitive Proxy Statement filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, as filed with the SEC on April 26, 2007)

 

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Exhibit

Number

 

Description

10.4*   2009 Dividend Reinvestment and Stock Purchase Plan (incorporated by reference from our Registration Statement on Form S-3ASR, Registration No. 333-164047, which became effective under the Act on December 28, 2009)
10.5*   Employment Agreement dated January 1, 2002, between the Manager and Lloyd McAdams (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed with the SEC on August 14, 2002) as amended by Addenda dated April 18, 2002 (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed with the SEC on August 14, 2002), May 28, 2004 (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, as filed with the SEC on August 9, 2004), June 27, 2006 (incorporated by reference from our Current Report on Form 8-K filed with the SEC on June 28, 2006), February 22, 2008 (incorporated by reference from our Current Report on Form 8-K filed with the SEC on February 27, 2008) , December 30, 2008 (incorporated by reference from our Current Report on Form 8-K filed with the SEC on January 2, 2009) and October 14, 2009 (incorporated by reference from our Current Report on Form 8-K, filed with the SEC on October 15, 2009).
10.6*   Employment Agreement dated January 1, 2002, between the Manager and Heather U. Baines (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed with the SEC on August 14, 2002) as amended by Addenda dated April 18, 2002 (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed with the SEC on August 14, 2002), June 27, 2006 (incorporated by reference from our Current Report on Form 8-K filed with the SEC on June 28, 2006) and February 13, 2008 (incorporated by reference from our Current Report on Form 8-K filed with the SEC on February 15, 2008) and October 14, 2009 (incorporated by reference from our Current Report on Form 8-K, filed with the SEC on October 15, 2009).
10.7*   Employment Agreement dated January 1, 2002, between the Manager and Joseph E. McAdams (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed with the SEC on August 14, 2002) as amended by Addenda dated April 18, 2002 (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed with the SEC on August 14, 2002), June 13, 2002 (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed with the SEC on August 14, 2002), May 28, 2004 (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, as filed with the SEC on August 9, 2004), June 27, 2006 (incorporated by reference from our Current Report on Form 8-K filed with the SEC on June 28, 2006), February 13, 2008 (incorporated by reference from our Current Report on Form 8-K filed with the SEC on February 15, 2008), February 22, 2008 (incorporated by reference from our Current Report on Form 8-K filed with the SEC on February 27, 2008) , December 30, 2008 (incorporated by reference from our Current Report on Form 8-K filed with the SEC on January 2, 2009) and October 14, 2009 (incorporated by reference from our Current Report on Form 8-K, filed with the SEC on October 15, 2009).
10.8   Sublease dated June 13, 2002, between Anworth and PIA (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, as filed with the SEC on August 14, 2002) as amended by Amendment to Sublease dated July 8, 2003 (incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended June 30, 2003, as filed with the SEC on August 8, 2003)
10.9   Deferred Compensation Plan (incorporated by reference from our Annual Report on Form 10-K for the year ended December 31, 2002, as filed with the SEC on March 26, 2003)
10.10*   Purchase Agreement dated as of March 15, 2005, by and among Anworth, Anworth Capital Trust I, TABERNA Preferred Funding I, Ltd., and Merrill Lynch International (incorporated by reference from our Current Report on Form 8-K filed with the SEC on March 16, 2005)
10.11   Second Amended and Restated Trust Agreement dated as of September 26, 2005 by and among Anworth, JPMorgan Chase Bank, National Association, Chase Bank USA, National Association, Lloyd McAdams, Joseph McAdams, Thad Brown and the several Holders, as defined therein. (incorporated by reference from our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, as filed with the SEC on March 16, 2006)
10.12*   Change in Control and Arbitration Agreement dated June 27, 2006, between Anworth and Thad M. Brown (incorporated by reference from our Current Report on Form 8-K filed with the SEC on June 28, 2006)
10.13*   Change in Control and Arbitration Agreement dated June 27, 2006, between Anworth and Charles J. Siegel (incorporated by reference from our Current Report on Form 8-K filed with the SEC on June 28, 2006)

 

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Exhibit

Number

 

Description

10.14   Change in Control and Arbitration Agreement dated June 27, 2006, between Anworth and Evangelos Karagiannis (incorporated by reference from our Current Report on Form 8-K filed with the SEC on June 28, 2006)
10.15*   Change in Control and Arbitration Agreement dated June 27, 2006, between Anworth and Bistra Pashamova (incorporated by reference from our Current Report on Form 8-K filed with the SEC on June 28, 2006)
10.16   Administrative Services Agreement dated December 29, 2008, between Anworth and PIA (incorporated by reference from our Annual Report on Form 10-K for the fiscal year ended December 31, 2008, as filed with the SEC on March 12, 2009)
31.1   Certification of the Principal Executive Officer, as required by Rule 13a-14(a) of the Securities Exchange Act of 1934
31.2   Certification of the Principal Financial Officer, as required by Rule 13a-14(a) of the Securities Exchange Act of 1934
32.1   Certifications of the Principal Executive Officer provided pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2   Certifications of the Principal Financial Officer provided pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101**   XBRL Instance Document
101**   XBRL Taxonomy Extension Schema Document
101**   XBRL Taxonomy Extension Calculation Linkbase Document
101**   XBRL Taxonomy Definition Linkbase Document
101**   XBRL Taxonomy Extension Labels Linkbase Document
101**   XBRL Taxonomy Extension Presentation Linkbase Document

 

* Represents a management contract or compensatory plan, contract or arrangement in which any director or any of the named executives participates.
** XBRL (Extensible Business Reporting Language) information is furnished and not filed or a part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

  ANWORTH MORTGAGE ASSET CORPORATION
Dated: August 4, 2010  

/S/    JOSEPH LLOYD MCADAMS        

  Joseph Lloyd McAdams
  Chairman of the Board, President and Chief Executive Officer
  (Chief Executive Officer)
Dated: August 4, 2010  

/S/    THAD M. BROWN        

  Thad M. Brown
  Chief Financial Officer
  (Chief Financial Officer and Principal Accounting Officer)

 

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