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Annaly Capital Management 10-K 2011
a6624738.htm
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

 (MARK ONE)

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

FOR THE FISCAL YEAR ENDED:  DECEMBER 31, 2010

OR

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

FOR THE TRANSITION PERIOD FROM                                       TO       

COMMISSION FILE NUMBER:  1-13447

ANNALY CAPITAL MANAGEMENT, INC.
(Exact Name of Registrant as Specified in its Charter)


MARYLAND
22-3479661
(State or other jurisdiction of incorporation of organization)
(I.R.S. Employer Identification Number)
   
1211 Avenue of the Americas, Suite 2902
 
New York, New York
10036
(Address of Principal Executive Offices)
(Zip Code)

(212) 696-0100
(Registrant’s telephone number, including area code)
 
 
Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class
Name of Each Exchange on Which Registered
   
Common Stock, par value $.01 per share
New York Stock Exchange
   
7.875% Series A Cumulative Redeemable Preferred Stock
New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

None.

Indicate by check mark whether the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes x No o

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes o     No x

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  Noo
 
 
 

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


Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   o

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

Large accelerated filer  x     Accelerated filer o       Non-accelerated filer  o     Smaller reporting company o

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

At June 30, 2010, the aggregate market value of the voting stock held by non-affiliates of the Registrant was $9,536,990,800.

The number of shares of the Registrant’s Common Stock outstanding on February 24, 2011 was 804,165,257.

Documents Incorporated by Reference
 
The registrant intends to file a definitive proxy statement pursuant to Regulation 14A within 120 days of the end of the fiscal year ended December 31, 2010.  Portions of such proxy statement are incorporated by reference into Part III of this Form 10-K.
 
 
 

 
 
ANNALY CAPITAL MANAGEMENT, INC.
2010 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
 
PART I
   
PAGE
1
     
17
     
33
     
33
     
33
     
 
     
PART II
     
34
     
37
     
38
     
55
     
57
     
57
     
57
     
58
     
PART III
     
58
     
58
     
58
     
58
     
58
     
PART IV
     
59
     
59
     
F-1
     
II-1
 
 
 

 
 
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain statements contained in this annual report, and certain statements contained in our future filings with the Securities and Exchange Commission (the SEC or the Commission), in our press releases or in our other public or shareholder communications may not be based on historical facts and are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.  Forward-looking statements, which are based on various assumptions (some of which are beyond our control), may be identified by reference to a future period or periods or by the use of forward-looking terminology, such as “may,” “will,” “believe,” “expect,” “anticipate,” “continue,” or similar terms or variations on those terms or the negative of those terms.  Actual results could differ materially from those set forth in forward-looking statements due to a variety of factors, including, but not limited to:
 
 
·
changes in interest rates,
 
 
·
changes in the yield curve,
 
 
·
changes in prepayment rates,
 
 
·
the availability of mortgage-backed securities and other securities for purchase,
 
 
·
the availability of financing and, if available, the terms of any financing,
 
 
·
changes in the market value of our assets,
 
 
·
changes in business conditions and the general economy,
 
 
·
our ability to consummate any contemplated investment opportunities,
 
 
·
risks associated with the investment advisory business of our wholly owned subsidiaries, including:
 
 
o
the removal by clients of assets managed,
 
 
o
their regulatory requirements, and
 
 
o
competition in the investment advisory business,
 
 
·
risks associated with the broker-dealer business of our subsidiary,
 
 
·
changes in government regulations affecting our business, and
 
 
·
our ability to maintain our qualification as a REIT for federal income tax purposes.
 
No forward-looking statements can be guaranteed and actual future results may vary materially and we caution you not to place undue reliance on these forward-looking statements.  For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, please see the information under the caption “Risk Factors” described in this Form 10-K.  We do not undertake, and specifically disclaim any obligation, to publicly release the result of any revisions which may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.
 
 
 

 
 
PART I

All references to “we,” “us,” or “our” mean Annaly Capital Management, Inc. and all entities owned by us, except where it is made clear that the term means only the parent company.  The following defines certain of the commonly used terms in this annual report on Form 10-K:  Agency mortgage-backed securities refers to residential mortgage-backed securities that are issued or guaranteed by a federally chartered corporation, such as Fannie Mae or Freddie Mac, or an agency of the U.S. Government, such as Ginnie Mae; Investment Securities refers to Agency mortgage-backed securities, Agency debentures, corporate debt securities and reverse repurchase agreement loans; and Interest Earning Assets refers to Investment Securities, securities borrowed and U.S. Treasury Securities.

THE COMPANY
 
Background

We own, manage, and finance a portfolio of real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations (or CMOs), Agency callable debentures, and other securities representing interests in or obligations backed by pools of mortgage loans.  Our principal business objective is to generate net income for distribution to our stockholders from the spread between the interest income on our Interest Earning Assets and the cost of borrowings to finance our acquisition of Interest Earning Assets and from dividends we receive from our subsidiaries.  Our wholly-owned subsidiaries offer diversified real estate, asset management and other financial services.  We are a Maryland corporation that commenced operations on February 18, 1997.  We are self-advised and self-managed.  We acquired Fixed Income Discount Advisory Company (or FIDAC) on June 4, 2004 and Merganser Capital Management, Inc. (or Merganser) on October 31, 2008.  FIDAC and Merganser manage a number of investment vehicles and separate accounts for which they earn fee income.  Our subsidiary, RCap Securities Inc. (or RCap), operates as a broker-dealer, and was granted membership in the Financial Industry Regulatory Authority (or FINRA) in January 2009.
 
We have elected and believe that we are organized and have operated in a manner that qualifies us to be taxed as a real estate investment trust (or REIT) under the Internal Revenue Code of 1986, as amended (or the Code).  If we qualify for taxation as a REIT, we generally will not be subject to federal income tax on our taxable income that is distributed to our stockholders.  Therefore, substantially all of our assets, other than FIDAC, Merganser and RCap, which are our taxable REIT subsidiaries, consist of qualified REIT real estate assets (of the type described in Section 856(c)(5)(B) of the Code).  We have financed our purchases of Agency mortgage-backed securities and Agency debentures with the net proceeds of equity offerings and borrowings under repurchase agreements whose interest rates adjust based on changes in short-term market interest rates.

Assets

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

The remainder of our assets, comprising not more than 25% of our total assets, may consist of other qualified REIT real estate assets which are unrated or rated less than high quality, but which are at least “investment grade” (rated “BBB” or better by Standard & Poor’s Corporation (or S&P) or the equivalent by another nationally recognized rating agency) or, if not rated, we determine them to be of comparable credit quality to an investment which is rated “BBB” or better.  In addition, we may directly or indirectly invest part of this remaining 25% of our assets in other types of securities, including but without limitation, unrated debt, equity or derivative securities, to the extent consistent with our REIT qualification requirements.  The derivative securities in which we invest may include securities representing the right to receive interest only or a disproportionately large amount of interest, as well as inverse floaters, which may have imbedded leverage as part of their structural characteristics.
 
 
1

 
 
We may acquire mortgage-backed securities backed by single-family residential mortgage loans as well as securities backed by loans on multi-family, commercial or other real estate related properties.  To date, substantially all of the mortgage-backed securities that we have acquired have been backed by single-family residential mortgage loans.

To date, substantially all of the mortgage-backed securities that we have acquired have been Agency mortgage-backed securities which, although not rated, carry an implied “AAA” rating.  Agency mortgage-backed securities consist of agency pass-through certificates and CMOs issued or guaranteed by an Agency.  Pass-through certificates provide for a pass-through of the monthly interest and principal payments made by the borrowers on the underlying mortgage loans.  CMOs divide a pool of mortgage loans into multiple tranches with different principal and interest payment characteristics.

At December 31, 2010, approximately 13% of our Investment Securities were adjustable-rate pass-through certificates, approximately 86% of our Investment Securities were fixed-rate pass-through certificates, CMOs or fixed-rate corporate loans, and approximately 1% of our Investment Securities were CMO floaters or floating-rate corporate loans.  Our adjustable-rate pass-through certificates are backed by adjustable-rate mortgage loans and have coupon rates which adjust over time, subject to interest rate caps and lag periods, in conjunction with changes in short-term interest rates.  Our fixed-rate pass-through certificates are backed by fixed-rate mortgage loans and have coupon rates which do not adjust over time.  CMO floaters are tranches of mortgage-backed securities where the interest rate adjusts in conjunction with changes in short-term interest rates.  CMO floaters may be backed by fixed-rate mortgage loans or, less often, by adjustable-rate mortgage loans.  In this Form 10-K, except where the context indicates otherwise, we use the term “adjustable-rate interest-earning assets” to refer to adjustable-rate pass-through certificates, CMO floaters, Agency debentures and corporate debt.  At December 31, 2010, the weighted average yield on our portfolio of earning assets was 3.80% and the weighted average term to next rate adjustment on adjustable rate securities was 39 months.

We may also invest in Agency debentures, which consist of debentures issued by the Federal Home Loan Bank (FHLB), Freddie Mac and Freddie Mac. We intend to continue to invest in adjustable-rate pass-through certificates, fixed-rate mortgage-backed securities, CMO floaters, and Agency debentures.  We may also invest on a limited basis in derivative securities which include securities representing the right to receive interest only or a disproportionately large amount of interest as well as inverse floaters, which may have imbedded leverage as part of their structural characteristics.  We have not and will not invest in real estate mortgage investment conduit (REMIC) residuals and other CMO residuals.

Borrowings
 
We attempt to structure our collateralized borrowings to have interest rate adjustment indices and interest rate adjustment periods that, on an aggregate basis, correspond generally to the interest rate adjustment indices and periods of our adjustable-rate interest-earning assets.  However, periodic rate adjustments on our collateralized borrowings are generally more frequent than rate adjustments on our Investment Securities.  At December 31, 2010, the weighted average cost of funds for all of our collateralized borrowings was 1.84%, with the effect of swaps, the weighted average original term to maturity was 253 days, and the weighted average term to next rate adjustment of these collateralized borrowings was 127 days.

We generally expect to maintain a ratio of debt-to-equity of between 8:1 and 12:1, although the ratio may vary, as it currently does because of market conditions, from this range from time to time based upon various factors, including our management’s opinion of the level of risk of our assets and liabilities, our liquidity position, our level of unused borrowing capacity and over-collateralization levels required by lenders when we pledge assets to secure borrowings.  For purposes of calculating this ratio, our equity is equal to the value of our investment portfolio on a mark-to-market basis, less the book value of our obligations under repurchase agreements and other collateralized borrowings and convertible senior notes.  At December 31, 2010, our ratio of debt-to-equity was 6.7:1.

During the quarter ended March 31, 2010, we issued $600.0 million in aggregate principal amount of our 4% convertible senior notes due 2015 (Convertible Senior Notes) for net proceeds following underwriting expenses of approximately $582.0 million.  Interest on the notes is paid semi-annually at a rate of 4% per year and the notes will mature on February 15, 2015 unless earlier repurchased or converted.  As of December 1, 2010 the notes were convertible into shares of common stock at a conversion rate of 54.1089 shares of common stock per $1,000 principal amount of notes, which is equivalent to an initial conversion price of approximately $18.4812 per share of common stock, subject to adjustment in certain circumstances.
 
 
2

 
 
Hedging
 
To the extent consistent with our election to qualify as a REIT, we enter into hedging transactions to attempt to protect our Agency mortgage-backed securities and Agency debentures and related borrowings against the effects of major interest rate changes.  This hedging is used to mitigate declines in the market value of our Agency mortgage-backed securities and Agency debentures during periods of increasing or decreasing interest rates and to limit or cap the interest rates on our borrowings.  These transactions are entered into solely for the purpose of hedging interest rate or prepayment risk and not for speculative purposes.  In connection with our interest rate risk management strategy, we hedge a portion of our interest rate risk by entering into derivative financial instrument contracts.  As of December 31, 2010, we had $27.1 billion in interest rate swaps, which in effect modify the cash flows on repurchase agreements.
 
Our Subsidiaries
 
FIDAC, an investment advisor registered with the SEC, is a fixed-income investment management company specializing in managing fixed income investments in residential mortgage-backed securities, commercial mortgage-backed securities and collateralized debt obligations for various investment vehicles and separate accounts.  FIDAC also has experience in managing and structuring debt financing associated with various asset classes and serves as a liquidation agent of collateralized debt obligations.  FIDAC commenced active investment management operations in 1994.  At December 31, 2010, FIDAC was the adviser or sub-adviser for investment vehicles and separate accounts.  The team managing Annaly perform the same roles at FIDAC.
 
Merganser, an investment advisor registered with the SEC, has expertise in a variety of fixed income strategies and focuses on managing each portfolio based on each client’s specific investment principles.  Merganser serves a diverse group of clients in a variety of disciplines nationwide including pension, public, operating, Taft-Hartley and endowment funds as well as defined contribution plans. Merganser’s investment team maintains a careful balance of risk management and performance by employing fundamental security analysis and by trading in an environment supported by state-of-the-art technology, infrastructure and operations.
 
RCap operates as a broker-dealer and was granted membership in the Financial Industry Regulatory Authority (or FINRA) in January 2009.
 
Compliance with REIT and Investment Company Requirements
 
We constantly monitor our investments and the income from these investments and, to the extent we enter into hedging transactions, we monitor income from our hedging transactions as well, so as to ensure at all times that we maintain our qualification as a REIT and our exemption from registration under the Investment Company Act of 1940, as amended.
 
Executive Officers of the Company
 
The following table sets forth certain information as of February 24, 2011 concerning our executive officers:
 
Name
Age
Position held with the Company
     
Michael A.J. Farrell
59
Chairman of the Board, Chief Executive Officer and President
     
Wellington J. Denahan-Norris
47
Vice Chairman of the Board, Chief Investment Officer and Chief Operating Officer
     
Kathryn F. Fagan
44
Chief Financial Officer and Treasurer
 
 
3

 
 
R. Nicholas Singh
51
Chief Legal Officer, Secretary and Chief Compliance Officer
     
James P. Fortescue
37
Managing Director, Head of Liabilities and Chief of Staff
     
Kristopher Konrad
36
Managing Director and  Head Portfolio Manager
     
Rose-Marie Lyght
37
Managing Director and Chief Investment Officer of FIDAC
     
Jeremy Diamond
47
Managing Director and Head of Research and Corporate Communications
     
Ronald Kazel
43
Managing Director and Head of Asset Management Group
     
Matthew Lambiase
44
Managing Director and Co-Head of Business Development
     
Kevin Keyes
43
Managing Director and Chief Strategy Officer
 
Mr. Farrell and Ms. Denahan-Norris have had years of experience in the investment banking and investment management industries where, in various capacities, they have each managed portfolios of mortgage-backed securities, arranged collateralized borrowings and utilized hedging techniques to mitigate interest rate and other risk within fixed-income portfolios. Ms. Fagan is a certified public accountant and, prior to becoming our Chief Financial Officer and Treasurer, served as Chief Financial Officer and Controller of a publicly owned savings and loan association. Mr. Singh joined Annaly in February 2005. Mr. Fortescue joined Annaly in 1997. Mr. Konrad joined Annaly in 1997. Ms. Lyght joined Annaly in April 1999. Mr. Diamond joined Annaly in March 2002. Mr. Kazel joined Annaly in December 2001. Mr. Lambiase joined Annaly in 2004. Mr. Keyes joined Annaly in September 2009. Prior to that he was a Managing Director at Merrill Lynch. We and our subsidiaries had 114 full-time employees at December 31, 2010.
 
Distributions
 
  To maintain our qualification as a REIT, we must distribute substantially all of our taxable income to our stockholders each year.  We have done this in the past and intend to continue to do so in the future.  We also have declared and paid regular quarterly dividends in the past and intend to do so in the future.  We have adopted a dividend reinvestment plan to enable holders of common stock to reinvest dividends automatically in additional shares of common stock.

BUSINESS STRATEGY

General>

           Our principal business objective is to generate income for distribution to our stockholders, primarily from the net cash flows on our Investment Securities.  Our net cash flows result primarily from the difference between the interest income on our Investment Securities and borrowing costs of our repurchase agreements, and from dividends we receive from our subsidiaries.  To achieve our business objective and generate dividend yields, our strategy is:

 
§
to acquire Investment Securities that we believe:

 
-
we have the necessary expertise to evaluate and manage;

-      we can readily finance;

 
-
are consistent with our balance sheet guidelines and risk management objectives; and

-      provide attractive investment returns in a range of scenarios;
 
 
4

 
 
 
§
to finance purchases of mortgage-backed securities with the proceeds of equity and debt offerings and, to the extent permitted by our capital investment policy, to utilize leverage to increase potential returns to stockholders through borrowings;

 
§
to attempt to structure our borrowings to have interest rate adjustment indices and interest rate adjustment periods that, on an aggregate basis, generally correspond to the interest rate adjustment indices and interest rate adjustment periods of our adjustable-rate mortgage-backed securities;

 
§
to seek to minimize prepayment risk by structuring a diversified portfolio with a variety of prepayment characteristics and through other means; and

 
§
to issue new equity or debt and increase the size of our balance sheet when opportunities in the market for mortgage-backed securities are likely to allow growth in earnings per share.

We believe we are able to obtain cost efficiencies through our facilities-sharing arrangement with FIDAC and RCap and by virtue of our management’s experience in managing portfolios of mortgage-backed securities and arranging collateralized borrowings.  We will strive to become even more cost-efficient over time by:

 
§
seeking to raise additional capital from time to time in order to increase our ability to invest in mortgage-backed securities;

 
§
striving to lower our effective borrowing costs by seeking direct funding with collateralized lenders, rather than using financial intermediaries, and investigating the possibility of using commercial paper and medium term note programs;

 
§
improving the efficiency of our balance sheet structure by investigating the issuance of uncollateralized subordinated debt, preferred stock and other forms of capital; and

 
§
utilizing information technology in our business, including improving our ability to monitor the performance of our Investment Securities and to lower our operating costs.

Mortgage-Backed Securities

General

To date, substantially all of the mortgage-backed securities that we have acquired have been Agency mortgage-backed securities which, although not rated, carry an implied “AAA” rating.  Agency mortgage-backed securities are mortgage-backed securities where a government agency or federally chartered corporation, such as Freddie Mac, Fannie Mae or Ginnie Mae, guarantees payments of principal or interest on the securities.  Agency mortgage-backed securities consist of agency pass-through certificates and CMOs issued or guaranteed by an agency.

Even though to date we have only acquired mortgage-backed securities with an implied “AAA” rating, under our capital investment policy, we have the ability to acquire securities of lower quality.  Under our policy, at least 75% of our total assets must be high quality mortgage-backed securities and short-term investments.  High quality securities are securities (1) that are rated within one of the two highest rating categories by at least one of the nationally recognized rating agencies, (2) that are unrated but are guaranteed by the United States government or an agency of the United States government, or (3) that are unrated or whose ratings have not been updated but that our management determines are of comparable quality to rated high quality mortgage-backed securities.

Under our capital investment policy, the remainder of our assets, comprising not more than 25% of total assets, may consist of mortgage-backed securities and other qualified REIT real estate assets which are unrated or rated less than high quality, but which are at least “investment grade” (rated “BBB” or better by S&P or the equivalent by another nationally recognized rating organization) or, if not rated, we determine them to be of comparable credit quality to an investment which is rated “BBB” or better.  In addition, we may directly or indirectly invest part of this remaining 25% of our assets in other types of securities, including without limitation, unrated debt, equity or derivative securities, to the extent consistent with our REIT qualification requirements.  The derivative securities in which we invest may include securities representing the right to receive interest only or a disproportionately large amount of interest, as well as inverse floaters, which may have imbedded leverage as part of their structural characteristics. We intend to structure our portfolio to maintain a minimum weighted average rating (including our deemed comparable ratings for unrated mortgage-backed securities) of our mortgage-backed securities of at least single “A” under the S&P rating system and at the comparable level under the other rating systems.
 
 
5

 
 
Our allocation of investments among the permitted investment types may vary from time-to-time based on the evaluation by our board of directors of economic and market trends and our perception of the relative values available from these types of investments, except that in no event will our investments that are not high quality exceed 25% of our total assets.

We intend to acquire only those mortgage-backed securities that we believe we have the necessary expertise to evaluate and manage, that are consistent with our balance sheet guidelines and risk management objectives and that we believe we can readily finance.  Since we generally hold the mortgage-backed securities we acquire until maturity, we generally do not seek to acquire assets whose investment returns are attractive in only a limited range of scenarios.  We believe that future interest rates and mortgage prepayment rates are very difficult to predict. Therefore, we seek to acquire mortgage-backed securities which we believe will provide acceptable returns over a broad range of interest rate and prepayment scenarios.

At December 31, 2010, our mortgage-backed securities consisted of pass-through certificates and CMOs issued or guaranteed by Freddie Mac, Fannie Mae or Ginnie Mae.  We have not, and will not, invest in REMIC residuals and other CMO residuals.

Description of Mortgage-Backed Securities>

The mortgage-backed securities that we acquire provide funds for mortgage loans made primarily to residential homeowners.  Our securities generally represent interests in pools of mortgage loans made by savings and loan institutions, mortgage bankers, commercial banks and other mortgage lenders.  These pools of mortgage loans are assembled for sale to investors (like us) by various government, government-related and private organizations.

Mortgage-backed securities differ from other forms of traditional debt securities, which normally provide for periodic payments of interest in fixed amounts with principal payments at maturity or on specified call dates.  Instead, mortgage-backed securities provide for a monthly payment, which consists of both interest and principal.  In effect, these payments are a “pass-through” of the monthly interest and principal payments made by the individual borrower on the mortgage loans, net of any fees paid to the issuer or guarantor of the securities.  Additional payments result from prepayments of principal upon the sale, refinancing or foreclosure of the underlying residential property, net of fees or costs which may be incurred.  Some mortgage-backed securities, such as securities issued by Ginnie Mae, are described as “modified pass-through”. These securities entitle the holder to receive all interest and principal payments owed on the mortgage pool, net of certain fees, regardless of whether the mortgagors actually make mortgage payments when due.

The investment characteristics of pass-through mortgage-backed securities differ from those of traditional fixed-income securities.  The major differences include the payment of interest and principal on the mortgage-backed securities on a more frequent schedule, as described above, and the possibility that principal may be prepaid at any time due to prepayments on the underlying mortgage loans or other assets.  These differences can result in significantly greater price and yield volatility than is the case with traditional fixed-income securities.

Various factors affect the rate at which mortgage prepayments occur, including changes in interest rates, general economic conditions, the age of the mortgage loan, the location of the property and other social and demographic conditions.  Generally prepayments on mortgage-backed securities increase during periods of falling mortgage interest rates and decrease during periods of rising mortgage interest rates.  We may reinvest prepayments at a yield that is higher or lower than the yield on the prepaid investment, thus affecting the weighted average yield of our investments.

To the extent mortgage-backed securities are purchased at a premium, faster than expected prepayments result in a faster than expected amortization of the premium paid. Conversely, if these securities were purchased at a discount, faster than expected prepayments accelerate our recognition of income.
 
 
6

 
 
CMOs may allow for shifting of prepayment risk from slower-paying tranches to faster-paying tranches.  This is in contrast to mortgage pass-through certificates where all investors share equally in all payments, including all prepayments, on the underlying mortgages.

Freddie Mac Certificates>

Freddie Mac is a privately-owned government-sponsored enterprise created pursuant to an Act of Congress on July 24, 1970.  The principal activity of Freddie Mac currently consists of the purchase of mortgage loans or participation interests in mortgage loans and the resale of the loans and participations in the form of guaranteed mortgage-backed securities.  Freddie Mac guarantees to each holder of Freddie Mac certificates the timely payment of interest at the applicable pass-through rate and ultimate collection of all principal on the holder’s pro rata share of the unpaid principal balance of the related mortgage loans, but does not guarantee the timely payment of scheduled principal of the underlying mortgage loans.  The obligations of Freddie Mac under its guarantees are solely those of Freddie Mac and are not backed by the full faith and credit of the United States.  If Freddie Mac were unable to satisfy these obligations, distributions to holders of Freddie Mac certificates would consist solely of payments and other recoveries on the underlying mortgage loans and, accordingly, defaults and delinquencies on the underlying mortgage loans would adversely affect monthly distributions to holders of Freddie Mac certificates.

Freddie Mac certificates may be backed by pools of single-family mortgage loans or multi-family mortgage loans.  These underlying mortgage loans may have original terms to maturity of up to 40 years.  Freddie Mac certificates may be issued under cash programs (composed of mortgage loans purchased from a number of sellers) or guarantor programs (composed of mortgage loans acquired from one seller in exchange for certificates representing interests in the mortgage loans purchased).

Freddie Mac certificates may pay interest at a fixed rate or an adjustable rate.  The interest rate paid on adjustable-rate Freddie Mac certificates (Freddie Mac ARMs) adjusts periodically within 60 days prior to the month in which the interest rates on the underlying mortgage loans adjust.  The interest rates paid on certificates issued under Freddie Mac’s standard ARM programs adjust in relation to the Treasury index.  Other specified indices used in Freddie Mac ARM programs include the 11th District Cost of Funds Index published by the Federal Home Loan Bank of San Francisco, LIBOR and other indices.  Interest rates paid on fully-indexed Freddie Mac ARM certificates equal the applicable index rate plus a specified number of basis points.  The majority of the series of Freddie Mac ARM certificates issued to date have evidenced pools of mortgage loans with monthly, semi-annual or annual interest adjustments.  Adjustments in the interest rates paid are generally limited to an annual increase or decrease of either 100 or 200 basis points and to a lifetime cap of 500 or 600 basis points over the initial interest rate.  Certain Freddie Mac programs include mortgage loans which allow the borrower to convert the adjustable mortgage interest rate to a fixed rate.  Adjustable-rate mortgages which are converted into fixed-rate mortgage loans are repurchased by Freddie Mac or by the seller of the loan to Freddie Mac at the unpaid principal balance of the loan plus accrued interest to the due date of the last adjustable rate interest payment.

Fannie Mae Certificates>

Fannie Mae is a privately-owned, federally-chartered corporation organized and existing under the Federal National Mortgage Association Charter Act.  Fannie Mae provides funds to the mortgage market primarily by purchasing home mortgage loans from local lenders, thereby replenishing their funds for additional lending.  Fannie Mae guarantees to the registered holder of a Fannie Mae certificate that it will distribute amounts representing scheduled principal and interest on the mortgage loans in the pool underlying the Fannie Mae certificate, whether or not received, and the full principal amount of any such mortgage loan foreclosed or otherwise finally liquidated, whether or not the principal amount is actually received.  The obligations of Fannie Mae under its guarantees are solely those of Fannie Mae and are not backed by the full faith and credit of the United States.  If Fannie Mae were unable to satisfy its obligations, distributions to holders of Fannie Mae certificates would consist solely of payments and other recoveries on the underlying mortgage loans and, accordingly, defaults and delinquencies on the underlying mortgage loans would adversely affect monthly distributions to holders of Fannie Mae.
 
 
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Fannie Mae certificates may be backed by pools of single-family or multi-family mortgage loans.  The original term to maturity of any such mortgage loan generally does not exceed 40 years.  Fannie Mae certificates may pay interest at a fixed rate or an adjustable rate.  Each series of Fannie Mae ARM certificates bears an initial interest rate and margin tied to an index based on all loans in the related pool, less a fixed percentage representing servicing compensation and Fannie Mae’s guarantee fee.  The specified index used in different series has included the Treasury Index, the 11th District Cost of Funds Index published by the Federal Home Loan Bank of San Francisco, LIBOR and other indices.  Interest rates paid on fully-indexed Fannie Mae ARM certificates equal the applicable index rate plus a specified number of basis points.  The majority of series of Fannie Mae ARM certificates issued to date have evidenced pools of mortgage loans with monthly, semi-annual or annual interest rate adjustments.  Adjustments in the interest rates paid are generally limited to an annual increase or decrease of either 100 or 200 basis points and to a lifetime cap of 500 or 600 basis points over the initial interest rate.  Certain Fannie Mae programs include mortgage loans which allow the borrower to convert the adjustable mortgage interest rate of the ARM to a fixed rate.  Adjustable-rate mortgages which are converted into fixed-rate mortgage loans are repurchased by Fannie Mae or by the seller of the loans to Fannie Mae at the unpaid principal of the loan plus accrued interest to the due date of the last adjustable rate interest payment.  Adjustments to the interest rates on Fannie Mae ARM certificates are typically subject to lifetime caps and periodic rate or payment caps.

Ginnie Mae Certificates>

Ginnie Mae is a wholly owned corporate instrumentality of the United States within the Department of Housing and Urban Development (HUD).  The National Housing Act of 1934 authorizes Ginnie Mae to guarantee the timely payment of the principal and interest on certificates which represent an interest in a pool of mortgages insured by the Federal Housing Administration (FHA) or partially guaranteed by the Department of Veterans Affairs and other loans eligible for inclusion in mortgage pools underlying Ginnie Mae certificates.  Section 306(g) of the Housing Act provides that the full faith and credit of the United States is pledged to the payment of all amounts which may be required to be paid under any guaranty by Ginnie Mae.

At present, most Ginnie Mae certificates are backed by single-family mortgage loans.  The interest rate paid on Ginnie Mae certificates may be a fixed rate or an adjustable rate.  The interest rate on Ginnie Mae certificates issued under Ginnie Mae’s standard ARM program adjusts annually in relation to the Treasury index.  Adjustments in the interest rate are generally limited to an annual increase or decrease of 100 basis points and to a lifetime cap of 500 basis points over the initial coupon rate.

Single-Family and Multi-Family Privately-Issued Certificates

Single-family and multi-family privately-issued certificates are pass-through certificates that are not issued by one of the agencies and that are backed by a pool of conventional single-family or multi-family mortgage loans.  These certificates are issued by originators of, investors in, and other owners of mortgage loans, including savings and loan associations, savings banks, commercial banks, mortgage banks, investment banks and special purpose “conduit” subsidiaries of these institutions.

While agency pass-through certificates are backed by the express obligation or guarantee of one of the agencies, as described above, privately-issued certificates are generally covered by one or more forms of private (i.e., non-governmental) credit enhancements.  These credit enhancements provide an extra layer of loss coverage in the event that losses are incurred upon foreclosure sales or other liquidations of underlying mortgaged properties in amounts that exceed the equity holder’s equity interest in the property.  Forms of credit enhancements include limited issuer guarantees, reserve funds, private mortgage guaranty pool insurance, over-collateralization and subordination.

Subordination is a form of credit enhancement frequently used and involves the issuance of classes of senior and subordinated mortgage-backed securities.  These classes are structured into a hierarchy to allocate losses on the underlying mortgage loans and also for defining priority of rights to payment of principal and interest.  Typically, one or more classes of senior securities are created which are rated in one of the two highest rating levels by one or more nationally recognized rating agencies and which are supported by one or more classes of mezzanine securities and subordinated securities that bear losses on the underlying loans prior to the classes of senior securities. Mezzanine securities, as used in this Form 10-K, refers to classes that are rated below the two highest levels, but no lower than a single “B” rating under the S&P rating system (or comparable level under other rating systems) and are supported by one or more classes of subordinated securities which bear realized losses prior to the classes of mezzanine securities. Subordinated securities, as used in this Form 10-K, refers to any class that bears the “first loss” from losses from underlying mortgage loans or that is rated below a single “B” level (or, if unrated, we deem it to be below that level).  In some cases, only classes of senior securities and subordinated securities are issued.  By adjusting the priority of interest and principal payments on each class of a given series of senior-subordinated mortgage-backed securities, issuers are able to create classes of mortgage-backed securities with varying degrees of credit exposure, prepayment exposure and potential total return, tailored to meet the needs of sophisticated institutional investors.
 
 
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Collateralized Mortgage Obligations and Multi-Class Pass-Through Securities>

We may also invest in CMOs and multi-class pass-through securities.  CMOs are debt obligations issued by special purpose entities that are secured by mortgage loans or mortgage-backed certificates, including, in many cases, certificates issued by government and government-related guarantors, including, Ginnie Mae, Fannie Mae and Freddie Mac, together with certain funds and other collateral.  Multi-class pass-through securities are equity interests in a trust composed of mortgage loans or other mortgage-backed securities.  Payments of principal and interest on underlying collateral provide the funds to pay debt service on the CMO or make scheduled distributions on the multi-class pass-through securities.  CMOs and multi-class pass-through securities may be issued by agencies or instrumentalities of the U.S. Government or by private organizations.  The discussion of CMOs in the following paragraphs is similarly applicable to multi-class pass-through securities.

In a CMO, a series of bonds or certificates is issued in multiple classes.  Each class of CMOs, often referred to as a “tranche,” is issued at a specific coupon rate (which, as discussed below, may be an adjustable rate subject to a cap) and has a stated maturity or final distribution date.  Principal prepayments on collateral underlying a CMO may cause it to be retired substantially earlier than the stated maturity or final distribution date.  Interest is paid or accrues on all classes of a CMO on a monthly, quarterly or semi-annual basis.  The principal and interest on underlying mortgages may be allocated among the several classes of a series of a CMO in many ways.  In a common structure, payments of principal, including any principal prepayments, on the underlying mortgages are applied to the classes of the series of a CMO in the order of their respective stated maturities or final distribution dates, so that no payment of principal will be made on any class of a CMO until all other classes having an earlier stated maturity or final distribution date have been paid in full.

Other types of CMO issues include classes such as parallel pay CMOs, some of which, such as planned amortization class CMOs (or PAC bonds), provide protection against prepayment uncertainty.  Parallel pay CMOs are structured to provide payments of principal on certain payment dates to more than one class.  These simultaneous payments are taken into account in calculating the stated maturity date or final distribution date of each class which, as with other CMO structures, must be retired by its stated maturity date or final distribution date but may be retired earlier.  PAC bonds generally require payment of a specified amount of principal on each payment date so long as prepayment speeds on the underlying collateral fall within a specified range.

Other types of CMO issues include targeted amortization class CMOs (or TAC bonds), which are similar to PAC bonds.  While PAC bonds maintain their amortization schedule within a specified range of prepayment speeds, TAC bonds are generally targeted to a narrow range of prepayment speeds or a specified prepayment speed.  TAC bonds can provide protection against prepayment uncertainty since cash flows generated from higher prepayments of the underlying mortgage-related assets are applied to the various other pass-through tranches so as to allow the TAC bonds to maintain their amortization schedule.

A CMO may be subject to the issuer’s right to redeem the CMO prior to its stated maturity date, which may diminish the anticipated return on our investment.  Privately-issued CMOs are supported by private credit enhancements similar to those used for privately-issued certificates and are often issued as senior-subordinated mortgage-backed securities.  We will only acquire CMOs or multi-class pass-through certificates that constitute debt obligations or beneficial ownership in grantor trusts holding mortgage loans, or regular interests in REMICs, or that otherwise constitute qualified REIT real estate assets under the Internal Revenue Code (provided that we have obtained a favorable opinion of our tax advisor or a ruling from the IRS to that effect).
 
Adjustable-Rate Mortgage Pass-Through Certificates and Floating Rate Mortgage-Backed Securities
 
Some of the mortgage pass-through certificates we acquire are adjustable-rate mortgage pass-through certificates.  This means that their interest rates may vary over time based upon changes in an objective index, such as:
 
 
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·
LIBOR or the London Interbank Offered Rate.  The interest rate that banks in London offer for deposits in London of U.S. dollars.
 
 
·
Treasury Index.  A monthly or weekly average yield of benchmark U.S. Treasury securities, as published by the Federal Reserve Board.
 
 
·
CD Rate.  The weekly average of secondary market interest rates on six-month negotiable certificates of deposit, as published by the Federal Reserve Board.
 
These indices generally reflect short-term interest rates.  The underlying mortgages for adjustable-rate mortgage pass-through certificates are adjustable-rate mortgage loans (or ARMs).

We also acquire CMO floaters.  One or more tranches of a CMO may have coupon rates that reset periodically at a specified increment over an index such as LIBOR.  These adjustable-rate tranches are sometimes known as CMO floaters and may be backed by fixed or adjustable-rate mortgages.

There are two main categories of indices for adjustable-rate mortgage pass-through certificates and floaters:  (1) those based on U.S. Treasury securities, and (2) those derived from calculated measures such as a cost of funds index or a moving average of mortgage rates.  Commonly utilized indices include the one-year Treasury note rate, the three-month Treasury bill rate, the six-month Treasury bill rate, rates on long-term Treasury securities, the 11th District Federal Home Loan Bank Costs of Funds Index, the National Median Cost of Funds Index, one-month or three-month LIBOR, the prime rate of a specific bank, or commercial paper rates.  Some indices, such as the one-year Treasury rate, closely mirror changes in market interest rate levels.  Others, such as the 11th District Home Loan Bank Cost of Funds Index, tend to lag changes in market interest rate levels.  We seek to diversify our investments in adjustable-rate mortgage pass-through certificates and floaters among a variety of indices and reset periods so that we are not at any one time unduly exposed to the risk of interest rate fluctuations.  In selecting adjustable-rate mortgage pass-through certificates and floaters for investment, we will also consider the liquidity of the market for the different mortgage-backed securities.

We believe that adjustable-rate mortgage pass-through certificates and floaters are particularly well-suited to our investment objective of high current income, consistent with modest volatility of net asset value, because the value of adjustable-rate mortgage pass-through certificates and floaters generally remains relatively stable as compared to traditional fixed-rate debt securities paying comparable rates of interest.  While the value of adjustable-rate mortgage pass-through certificates and floaters, like other debt securities, generally varies inversely with changes in market interest rates (increasing in value during periods of declining interest rates and decreasing in value during periods of increasing interest rates), the value of adjustable-rate mortgage pass-through certificates and floaters should generally be more resistant to price swings than other debt securities because the interest rates on these securities move with market interest rates.

Adjustable-rate mortgage pass-through certificates and floaters typically have caps, which limit the maximum amount by which the interest rate may be increased or decreased at periodic intervals or over the life of the security.  To the extent that interest rates rise faster than the allowable caps on the adjustable-rate mortgage pass-through certificates and floaters, these securities will behave more like fixed-rate securities.  Consequently, interest rate increases in excess of caps can be expected to cause these securities to behave more like traditional debt securities than adjustable-rate interest-earning assets and, accordingly, to decline in value to a greater extent than would be the case in the absence of these caps.

Adjustable-rate mortgage pass-through certificates and floaters, like other mortgage-backed securities, differ from conventional bonds in that principal is to be paid back over the life of the security rather than at maturity.  As a result, we receive monthly scheduled payments of principal and interest on these securities and may receive unscheduled principal payments representing prepayments on the underlying mortgages.  When we reinvest the payments and any unscheduled prepayments we receive, we may receive a rate of interest on the reinvestment which is lower than the rate on the existing security.  For this reason, adjustable-rate mortgage pass-through certificates and floaters are less effective than longer-term debt securities as a means of “locking in” longer-term interest rates.  Accordingly, adjustable-rate mortgage pass-through certificates and floaters, while generally having less risk of price decline during periods of rapidly rising interest rates than fixed-rate mortgage-backed securities of comparable maturities, have less potential for capital appreciation than fixed-rate securities during periods of declining interest rates.
 
 
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As in the case of fixed-rate mortgage-backed securities, to the extent these securities are purchased at a premium, faster than expected prepayments would accelerate our amortization of the premium.  Conversely, if these securities were purchased at a discount, faster than expected prepayments would accelerate our recognition of income.

As in the case of fixed-rate CMOs, floating-rate CMOs may allow for shifting of prepayment risk from slower-paying tranches to faster-paying tranches.  This is in contrast to mortgage pass-through certificates where all investors share equally in all payments, including all prepayments, on the underlying mortgages.

Other Floating Rate Instruments>

We may also invest in structured floating-rate notes issued or guaranteed by government agencies, such as Fannie Mae and Freddie Mac.  These instruments are typically structured to reflect an interest rate arbitrage (i.e., the difference between the agency’s cost of funds and the income stream from specified assets of the agency) and their reset formulas may provide more attractive returns than other floating rate instruments. The indices used to determine resets are the same as those described above.
 
Mortgage Loans>

As of December 31, 2010, we have not invested directly in mortgage loans, but we may from time-to-time invest a small percentage of our assets directly in single-family, multi-family or commercial mortgage loans.  We expect that the majority of these mortgage loans would be ARM pass-through certificates.  The interest rate on an ARM pass-through certificate is typically tied to an index (such as LIBOR or the interest rate on Treasury bills), and is adjustable periodically at specified intervals.  These mortgage loans are typically subject to lifetime interest rate caps and periodic interest rate or payment caps.  The acquisition of mortgage loans generally involves credit risk.  We may obtain credit enhancement to mitigate this risk; however, there can be no assurances that we will be able to obtain credit enhancement or that credit enhancement would mitigate the credit risk of the underlying mortgage loans.

Capital Investment Policy>

Asset Acquisitions

Our capital investment policy provides that at least 75% of our total assets will be comprised of high quality mortgage-backed securities and short-term investments.  The remainder of our assets (comprising not more than 25% of total assets), may consist of mortgage-backed securities and other qualified REIT real estate assets which are unrated or rated less than high quality but which are at least “investment grade” (rated “BBB” or better) or, if not rated, are determined by us to be of comparable credit quality to an investment which is rated “BBB” or better.  In addition, we may directly or indirectly invest part of this remaining 25% of our assets in other types of securities, including without limitation, unrated debt, equity or derivative securities, to the extent consistent with our REIT qualification requirements.  The derivative securities in which we invest may include securities representing the right to receive interest only or a disproportionately large amount of interest, as well as inverse floaters, which may have imbedded leverage as part of their structural characteristics.

Our capital investment policy requires that we structure our portfolio to maintain a minimum weighted average rating (including our deemed comparable ratings for unrated mortgage-backed securities) of our mortgage-backed securities of at least single “A” under the S&P rating system and at the comparable level under the other rating systems.  To date, substantially all of the mortgage-backed securities we have acquired have been pass-through certificates or CMOs issued or guaranteed by Freddie Mac, Fannie Mae or Ginnie Mae which, although not rated, have an implied “AAA” rating.

We intend to acquire only those mortgage-backed securities that we believe we have the necessary expertise to evaluate and manage, that we can readily finance and that are consistent with our balance sheet guidelines and risk management objectives.  Since we expect to hold our mortgage-backed securities until maturity, we generally do not seek to acquire assets whose investment returns are only attractive in a limited range of scenarios.  We believe that future interest rates and mortgage prepayment rates are very difficult to predict and, as a result, we seek to acquire mortgage-backed securities which we believe provide acceptable returns over a broad range of interest rate and prepayment scenarios.
 
 
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Among the asset choices available to us, our policy is to acquire those mortgage-backed securities which we believe generate the highest returns on capital invested, after consideration of the following:

 
§
the amount and nature of anticipated cash flows from the asset;

 
§
our ability to pledge the asset to secure collateralized borrowings;

 
§
the increase in our capital requirement determined by our capital investment policy resulting from the purchase and financing of the asset; and

 
§
the costs of financing, hedging and managing the asset.

Prior to acquisition, we assess potential returns on capital employed over the life of the asset and in a variety of interest rate, yield spread, financing cost, credit loss and prepayment scenarios.

We also give consideration to balance sheet management and risk diversification issues.  We deem a specific asset which we are evaluating for potential acquisition as more or less valuable to the extent it serves to increase or decrease certain interest rate or prepayment risks which may exist in the balance sheet, to diversify or concentrate credit risk, and to meet the cash flow and liquidity objectives our management may establish for our balance sheet from time-to-time.  Accordingly, an important part of the asset evaluation process is a simulation, using risk management models, of the addition of a potential asset and our associated borrowings and hedges to the balance sheet and an assessment of the impact this potential asset acquisition would have on the risks in and returns generated by our balance sheet as a whole over a variety of scenarios.

We believe that adjustable-rate mortgage pass-through certificates and floaters are particularly well-suited to our investment objective of high current income, consistent with modest volatility of net asset value, because the value of adjustable-rate mortgage pass-through certificates and floaters generally remains relatively stable as compared to traditional fixed-rate debt securities paying comparable rates of interest.  We have, however, purchased a significant amount of fixed-rate mortgage-backed securities and may continue to do so in the future if, in our view, the potential returns on capital invested, after hedging and all other costs, would exceed the returns available from other assets or if the purchase of these assets would serve to reduce or diversify the risks of our balance sheet.

We may purchase the stock of mortgage REITs or similar companies when we believe that these purchases would yield attractive returns on capital employed.    We do not, however, presently intend to invest in the securities of other issuers for the purpose of exercising control or to underwrite securities of other issuers.

We may acquire newly issued mortgage-backed securities, and also may seek to expand our capital base in order to further increase our ability to acquire new assets, when the potential returns from new investments appears attractive relative to the return expectations of stockholders.  We may in the future acquire mortgage-backed securities by offering our debt or equity securities in exchange for the mortgage-backed securities.

We generally intend to hold mortgage-backed securities for extended periods.  In addition, the REIT provisions of the Internal Revenue Code limit in certain respects our ability to sell mortgage-backed securities.  We may decide however to sell assets from time to time, for a number of reasons, including our desire to dispose of an asset as to which credit risk concerns have arisen, to reduce interest rate risk, to substitute one type of mortgage-backed security for another, to improve yield or to maintain compliance with the 55% requirement of Section 3(c)(5)(C) of the Investment Company Act, or generally to re-structure the balance sheet when we deem advisable.  Our board of directors has not adopted any policy that would restrict management’s authority to determine the timing of sales or the selection of mortgage-backed securities to be sold.

We do not invest in REMIC residuals or other CMO residuals.

As a requirement for maintaining REIT status, we will distribute to stockholders aggregate dividends equaling at least 90% of our REIT taxable income (determined without regard to the deduction for dividends paid and by excluding any net capital gain) for each taxable year.  We will make additional distributions of capital when the return expectations of the stockholders appear to exceed returns potentially available to us through making new investments in mortgage-backed securities.  Subject to the limitations of applicable securities and state corporation laws, we can distribute capital by making purchases of our own capital stock or through paying down or repurchasing any outstanding uncollateralized debt obligations.
 
 
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Our asset acquisition strategy may change over time as market conditions change and as we evolve.

Credit Risk Management

                Although we do not expect to encounter credit risk in our Agency mortgage-backed securities and Agency debentures, we face credit risk on the portions of our portfolio which are not mortgage-backed securities and Agency debentures.  In addition, our use of repurchase agreements and interest rate swaps creates exposure to credit risk relating to potential losses that could be recognized if the counterparties to these instruments fail to perform their obligations under the contracts.  In the event of a default by the counterparty, we could have difficulty obtaining our Agency mortgage-backed securities pledged as collateral for swaps.  We review credit risk and other risk of loss associated with each investment and determine the appropriate allocation of capital to apply to the investment under our capital investment policy.  Our management will monitor the overall portfolio risk and determine appropriate levels of provision for loss.

Capital and Leverage

We expect generally to maintain a debt-to-equity ratio of between 8:1 and 12:1, although the ratio may vary, as it currently does because of market conditions, from this range from time to time based upon various factors, including our management’s opinion of the level of risk of our assets and liabilities, our liquidity position, our level of unused borrowing capacity and over-collateralization levels required by lenders when we pledge assets to secure borrowings.  For purposes of calculating this ratio, our equity (or capital base) is equal to the value of our investment portfolio on a mark-to-market basis less the book value of our obligations under repurchase agreements and other collateralized borrowings.  For the calculation of this ratio, equity includes the Series B Cumulative Convertible Preferred Stock, which is not included in equity under Generally Accepted Accounting Principles.

Our goal is to strike a balance between the under-utilization of leverage, which reduces potential returns to stockholders, and the over-utilization of leverage, which could reduce our ability to meet our obligations during adverse market conditions.  Our capital investment policy limits our ability to acquire additional assets during times when our debt-to-equity ratio exceeds 12:1.  At December 31, 2010, our ratio of debt-to-equity was 6.7:1.  Our capital base represents the approximate liquidation value of our investments and approximates the market value of assets that we can pledge or sell to meet over-collateralization requirements for our borrowings.  The unpledged portion of our capital base is available for us to pledge or sell as necessary to maintain over-collateralization levels for our borrowings.
 
We are prohibited from acquiring additional assets during periods when our capital base is less than the minimum amount required under our capital investment policy, except as may be necessary to maintain REIT status or our exemption from the Investment Company Act of 1940, as amended (or the Investment Company Act).  In addition, when our capital base falls below our risk-managed capital requirement, our management is required to submit to our board of directors a plan for bringing our capital base into compliance with our capital investment policy guidelines.  We anticipate that in most circumstances we can achieve this goal without overt management action through the natural process of mortgage principal repayments.  We anticipate that our capital base is likely to exceed our risk-managed capital requirement during periods following new equity offerings and during periods of falling interest rates and that our capital base could fall below the risk-managed capital requirement during periods of rising interest rates.
 
The first component of our capital requirement is the current aggregate over-collateralization amount or “haircut” the lenders require us to hold as capital.  The haircut for each mortgage-backed security is determined by our lenders based on the risk characteristics and liquidity of the asset.  Should the market value of our pledged assets decline, we will be required to deliver additional collateral to our lenders to maintain a constant over-collateralization level on our borrowings.
 
 
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The second component of our capital requirement is the “excess capital cushion.”  This is an amount of capital in excess of the haircuts required by our lenders.  We maintain the excess capital cushion to meet the demands of our lenders for additional collateral should the market value of our mortgage-backed securities decline.  The aggregate excess capital cushion equals the sum of liquidity cushion amounts assigned under our capital investment policy to each of our mortgage-backed securities.  We assign excess capital cushions to each mortgage-backed security based on our assessment of the mortgage-backed security’s market price volatility, credit risk, liquidity and attractiveness for use as collateral by lenders.  The process of assigning excess capital cushions relies on our management’s ability to identify and weigh the relative importance of these and other factors.  In assigning excess capital cushions, we also give consideration to hedges associated with the mortgage-backed security and any effect such hedges may have on reducing net market price volatility, concentration or diversification of credit and other risks in the balance sheet as a whole and the net cash flows that we can expect from the interaction of the various components of our balance sheet.
 
Our capital investment policy stipulates that at least 25% of the capital base maintained to satisfy the excess capital cushion must be invested in AAA-rated adjustable-rate mortgage-backed securities or assets with similar or better liquidity characteristics.
 
A substantial portion of our borrowings are short-term or variable-rate borrowings.  Our borrowings are implemented primarily through repurchase agreements, but in the future may also be obtained through loan agreements, lines of credit, dollar-roll agreements (an agreement to sell a security for delivery on a specified future date and a simultaneous agreement to repurchase the same or a substantially similar security on a specified future date) and other credit facilities with institutional lenders and issuance of debt securities such as commercial paper, medium-term notes, CMOs and senior or subordinated notes.  We enter into financing transactions only with institutions that we believe are sound credit risks and follow other internal policies designed to limit our credit and other exposure to financing institutions.
 
We expect to continue to use repurchase agreements as our principal financing device to leverage our mortgage-backed securities portfolio.  We anticipate that, upon repayment of each borrowing under a repurchase agreement, we will use the collateral immediately for borrowing under a new repurchase agreement.  We have not at the present time entered into any commitment agreements under which the lender would be required to enter into new repurchase agreements during a specified period of time, nor do we presently plan to have liquidity facilities with commercial banks. We may, however, enter into such commitment agreements in the future.  We enter into repurchase agreements primarily with national broker-dealers, commercial banks and other lenders which typically offer this type of financing.  We enter into collateralized borrowings only with financial institutions meeting credit standards approved by our board of directors, and we monitor the financial condition of these institutions on a regular basis.
 
A repurchase agreement, although structured as a sale and repurchase obligation, acts as a financing under which we effectively pledge our mortgage-backed securities as collateral to secure a short-term loan.  Generally, the other party to the agreement makes the loan in an amount equal to a percentage of the market value of the pledged collateral.  At the maturity of the repurchase agreement, we are required to repay the loan and correspondingly receive back our collateral.  While used as collateral, the mortgage-backed securities continue to pay principal and interest which are for our benefit.  In the event of our insolvency or bankruptcy, certain repurchase agreements may qualify for special treatment under the Bankruptcy Code, the effect of which, among other things, would be to allow the creditor under the agreement to avoid the automatic stay provisions of the Bankruptcy Code and to foreclose on the collateral without delay.  In the event of the insolvency or bankruptcy of a lender during the term of a repurchase agreement, the lender may be permitted, under applicable insolvency laws, to repudiate the contract, and our claim against the lender for damages may be treated simply as an unsecured creditor.  In addition, if the lender is a broker or dealer subject to the Securities Investor Protection Act of 1970, or an insured depository institution subject to the Federal Deposit Insurance Act, our ability to exercise our rights to recover our securities under a repurchase agreement or to be compensated for any damages resulting from the lender’s insolvency may be further limited by those statutes.  These claims would be subject to significant delay and, if and when received, may be substantially less than the damages we actually incur.
 
Substantially all of our collateralized borrowing agreements require us to deposit additional collateral in the event the market value of existing collateral declines, which may require us to sell assets to reduce our borrowings.  We have designed our liquidity management policy to maintain a cushion of equity sufficient to provide required liquidity to respond to the effects under our borrowing arrangements of interest rate movements and changes in market value of our mortgage-backed securities, as described above.  However, a major disruption of the repurchase or other market that we rely on for short-term borrowings would have a material adverse effect on us unless we were able to arrange alternative sources of financing on comparable terms.
 
 
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Our articles of incorporation and bylaws do not limit our ability to incur borrowings, whether secured or unsecured.  

Interest Rate Risk Management

To the extent consistent with our election to qualify as a REIT, we follow an interest rate risk management program intended to protect our portfolio of mortgage-backed securities and related debt against the effects of major interest rate changes.  Specifically, our interest rate risk management program is formulated with the intent to offset the potential adverse effects resulting from rate adjustment limitations on our mortgage-backed securities and the differences between interest rate adjustment indices and interest rate adjustment periods of our adjustable-rate mortgage-backed securities and related borrowings.
 
Our interest rate risk management program encompasses a number of procedures, including the following:
 
 
§
we attempt to structure our borrowings to have interest rate adjustment indices and interest rate adjustment periods that, on an aggregate basis, generally correspond to the interest rate adjustment indices and interest rate adjustment periods of our adjustable-rate mortgage-backed securities; and

 
§
we attempt to structure our borrowing agreements relating to adjustable-rate mortgage-backed securities to have a range of different maturities and interest rate adjustment periods (although substantially all will be less than one year).

We adjust the average maturity adjustment periods of our borrowings on an ongoing basis by changing the mix of maturities and interest rate adjustment periods as borrowings come due and are renewed.  Through use of these procedures, we attempt to minimize the differences between the interest rate adjustment periods of our mortgage-backed securities and related borrowings that may occur.

 We enter into interest rate swaps.  We may from time-to-time enter into interest rate collars, interest rate caps or floors, and purchase interest-only mortgage-backed securities and similar instruments to attempt to mitigate the risk of the cost of our variable rate liabilities increasing at a faster rate than the earnings on our assets during a period of rising interest rates or to mitigate prepayment risk.  We may hedge as much of the interest rate risk as our management determines is in our best interests, given the cost of the hedging transactions and the need to maintain our status as a REIT.  This determination may result in our electing to bear a level of interest rate or prepayment risk that could otherwise be hedged when management believes, based on all relevant facts, that bearing the risk is advisable.

We seek to build a balance sheet and undertake an interest rate risk management program which is likely to generate positive earnings and maintain an equity liquidation value sufficient to maintain operations given a variety of potentially adverse circumstances.  Accordingly, our interest rate risk management program addresses both income preservation, as discussed above, and capital preservation concerns.  For capital preservation, we monitor our “duration.”  This is the expected percentage change in market value of our assets that would be caused by a 1% change in short and long-term interest rates.  To monitor weighted average duration and the related risks of fluctuations in the liquidation value of our equity, we model the impact of various economic scenarios on the market value of our mortgage-backed securities and liabilities.  At December 31, 2010, we estimate that the duration of our assets was 3.41 years and giving effect to the swap transactions, our weighted average duration was 0.74 years.  We believe that our interest rate risk management program will allow us to maintain operations throughout a wide variety of potentially adverse circumstances.  Nevertheless, in order to further preserve our capital base (and lower our duration) during periods when we believe a trend of rapidly rising interest rates has been established, we may decide to increase hedging activities or to sell assets.  Each of these actions may lower our earnings and dividends in the short term to further our objective of maintaining attractive levels of earnings and dividends over the long term.

We may elect to conduct a portion of our hedging operations through one or more subsidiary corporations, each of which we would elect to treat as a “taxable REIT subsidiary.” To comply with the asset tests applicable to us as a REIT, we could own 100% of the voting stock of such subsidiary, provided that the value of the stock that we own in all such taxable REIT subsidiaries does not exceed 25% of the value of our total assets at the close of any calendar quarter. A taxable subsidiary, such as FIDAC, Merganser, and RCap, would not elect REIT status and would distribute any net profit after taxes to us. Any dividend income we receive from the taxable subsidiaries (combined with all other income generated from our assets, other than qualified REIT real estate assets) must not exceed 25% of our gross income.
 
 
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We believe that we have developed a cost-effective asset/liability management program to provide a level of protection against interest rate and prepayment risks.  However, no strategy can completely insulate us from interest rate changes and prepayment risks.  Further, as noted above, the federal income tax requirements that we must satisfy to qualify as a REIT limit our ability to hedge our interest rate and prepayment risks.  We monitor carefully, and may have to limit, our asset/liability management program to assure that we do not realize excessive hedging income, or hold hedging assets having excess value in relation to total assets, which could result in our disqualification as a REIT, the payment of a penalty tax for failure to satisfy certain REIT tests under the Internal Revenue Code, provided the failure was for reasonable cause.  In addition, asset/liability management involves transaction costs which increase dramatically as the period covered by the hedging protection increases.  Therefore, we may be unable to hedge effectively our interest rate and prepayment risks.

Prepayment Risk Management

We seek to minimize the effects of faster or slower than anticipated prepayment rates through structuring a diversified portfolio with a variety of prepayment characteristics, investing in mortgage-backed securities with prepayment prohibitions and penalties, investing in certain mortgage-backed security structures which have prepayment protections, and balancing assets purchased at a premium with assets purchased at a discount.  We monitor prepayment risk through periodic review of the impact of a variety of prepayment scenarios on our revenues, net earnings, dividends, cash flow and net balance sheet market value.

Future Revisions in Policies and Strategies>

Our board of directors has established the investment policies and operating policies and strategies set forth in this Form 10-K.  The board of directors has the power to modify or waive these policies and strategies without the consent of the stockholders to the extent that the board of directors determines that the modification or waiver is in the best interests of our stockholders.  Among other factors, developments in the market which affect our policies and strategies or which change our assessment of the market may cause our board of directors to revise our policies and strategies.

Potential Acquisitions, Strategic Alliances and Other Investments>

From time-to-time we have explored possible transactions to enhance our operations and growth, including entering into new businesses, acquisitions of other businesses or assets, investments in other entities, joint venture arrangements, or strategic alliances. We entered into the broker-dealer business during the first quarter of January 2009, through our subsidiary RCap, which was granted membership in FINRA in January 2009.  On October 31, 2008 we consummated our acquisition of Merganser which is a registered investment advisor.  We own approximately 45.0 million shares of common stock of Chimera Investment Corporation, or Chimera.  Chimera is a publicly traded, specialty finance company that acquires, manages, and finances, directly or through its subsidiaries, residential mortgage loans, residential mortgage-backed securities, real estate related securities and various other asset classes.  Chimera is externally managed by FIDAC and has elected and qualifies to be taxed as a REIT for federal income tax purposes.  We own approximately 4.5 million shares of common stock of CreXus Investment Corp., or CreXus.  CreXus is a publicly traded, specialty finance company that acquires, manages, and finances, directly or through its subsidiaries, commercial mortgage loans and other commercial real estate debt, commercial mortgage-backed securities, or CMBS, and other commercial real estate-related assets.  CreXus is externally managed by FIDAC and has elected and qualifies to be taxed as a REIT for federal income tax purposes.
 
We may, from time-to-time, continue to explore possible new businesses, acquisitions, investments, joint venture arrangements and strategic alliances which may enhance our operations and assist our and our subsidiaries’ growth.  These transactions could be material to our financial condition and results of operations. The process of integrating an acquired company or business, will likely create, unforeseen operating difficulties and expenditures.  Our failure to address these risks or other problems encountered in connection with our past or future acquisitions and investments could cause us to fail to realize the anticipated benefits of such acquisitions or investments, incur unanticipated liabilities, and harm our business generally.  Future acquisitions could also result in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities, or amortization expenses, or write-offs of goodwill, any of which could harm our financial condition.  Also, the anticipated benefit of many of our acquisitions or investments may not materialize. 
 
 
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Dividend Reinvestment and Share Purchase Plan

We have adopted a dividend reinvestment and share purchase plan.  Under the dividend reinvestment feature of the plan, existing shareholders can reinvest their dividends in additional shares of our common stock.  Under the share purchase feature of the plan, new and existing shareholders can purchase shares of our common stock.  We have an effective shelf registration statement on Form S-3 which registered 100,000,000 shares that could be issued under the plan.  We still sell shares covered by this registration statement under the plan.

Legal Proceedings>

From time-to-time, we are involved in various claims and legal actions arising in the ordinary course of business.  In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on our consolidated financial statements.

Employees

As of December 31, 2010, we and our subsidiaries had 114 full time employees.  None of our employees are subject to any collective bargaining agreements.  We believe we have good relations with our employees.

Available Information>

Our investor relations website is www.annaly.com.  We make available on this website under “SEC filings,” free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after we electronically file or furnish such materials to the SEC.
 
COMPETITION

We believe that our principal competition in the acquisition and holding of the types of mortgage-backed securities we purchase are financial institutions such as banks, savings and loans, life insurance companies, institutional investors such as mutual funds and pension funds, and certain other mortgage REITs.  Some of our competitors have greater financial resources and access to capital than we do.  Our competitors, as well as additional competitors which may emerge in the future, may increase the competition for the acquisition of mortgage-backed securities, which in turn may result in higher prices and lower yields on assets.

ITEM 1A.      RISK FACTORS
 
An investment in our stock involves a number of risks.  Before making an investment decision, you should carefully consider all of the risks described in this Form 10-K.  If any of the risks discussed in this Form 10-K actually occur, our business, financial condition and results of operations could be materially adversely affected.  If this were to occur, the trading price of our stock could decline significantly and you may lose all or part of your investment.

Risks Associated with Recent Adverse Developments in the Mortgage Finance and Credit Markets

Volatile market conditions for mortgages and mortgage-related assets as well as the broader financial markets have resulted in a significant contraction in liquidity for mortgages and mortgage-related assets, which may adversely affect the value of the assets in which we invest.
 
 
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Our results of operations are materially affected by conditions in the markets for mortgages and mortgage-related assets, including Agency mortgage-backed securities, as well as the broader financial markets and the economy generally.  Beginning in the summer of 2007, significant adverse changes in financial market conditions resulted in a deleveraging of the entire global financial system and the forced sale of large quantities of mortgage-related and other financial assets.  Concerns over economic recession, geopolitical issues, unemployment, the availability and cost of financing, the mortgage market and a declining real estate market contributed to increased volatility and diminished expectations for the economy and markets.  As a result of these conditions, many traditional mortgage investors suffered severe losses in their residential mortgage portfolios and several major market participants failed or have been impaired, resulting in a significant contraction in market liquidity for mortgage-related assets.  This illiquidity negatively affected both the terms and availability of financing for all mortgage-related assets.  Further increased volatility and deterioration in the markets for mortgages and mortgage-related assets as well as the broader financial markets may adversely affect the performance and market value of our Agency mortgage-backed securities.  If these conditions persist, institutions from which we seek financing for our investments may tighten their lending standards or become insolvent, which could make it more difficult for us to obtain financing on favorable terms or at all.  Our profitability may be adversely affected if we are unable to obtain cost-effective financing for our investments.  Continued adverse developments in the broader residential mortgage market may adversely affect the value of the assets in which we invest.

Since the summer of 2007, the residential mortgage market in the United States experienced a variety of difficulties and changed economic conditions, including defaults, credit losses and liquidity concerns. Certain commercial banks, investment banks and insurance companies have announced extensive losses from exposure to the residential mortgage market. These losses have reduced financial industry capital, leading to reduced liquidity for some institutions. These factors have impacted investor perception of the risk associated with Agency mortgage-backed securities in which we invest. As a result, values for Agency mortgage-backed securities in which we invest have experienced a certain amount of volatility. Further increased volatility and deterioration in the broader residential mortgage and Agency mortgage-backed securities markets may adversely affect the performance and market value of our investments. Any decline in the value of our investments, or perceived market uncertainty about their value, would likely make it difficult for us to obtain financing on favorable terms or at all, or maintain our compliance with terms of any financing arrangements already in place.

The Agency mortgage-backed securities in which we invest are classified for accounting purposes as available-for-sale.  All assets classified as available-for-sale are reported at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity.  As a result, a decline in fair values may reduce the book value of our assets.  Moreover, if the decline in fair value of an available-for-sale security is other-than-temporarily impaired, such decline will reduce earnings.  If market conditions result in a decline in the fair value of our Agency mortgage-backed securities, our financial position and results of operations could be adversely affected.

The potential limit or wind down of the role Fannie Mae and Freddie Mac play in the mortgage-backed securities market may adversely affect our business, operations and financial condition.
 
On February 11, 2011, the U.S Department of the Treasury (or Treasury) issued a White Paper titled “Reforming America's Housing Finance Market” (or the White Paper) that lays out, among other things, proposals to limit or potentially wind down the role that Fannie Mae and Freddie Mac play in the mortgage market.  Any such proposals,  if enacted, may have broad adverse implications for the economy, the mortgage-backed securities market and our business, operations and financial condition.  We expect such proposals to be the subject of significant discussion and it is not yet possible to determine whether or when such proposals may be enacted, what form any final legislation or policies might take and how proposals, legislation or policies emanating from the White Paper may impact the economy, the mortgage-backed securities market and our business, operations and financial condition.  We are evaluating, and will continue to evaluate, the potential impact of the proposals set forth in the White Paper.
 
The conservatorship of Fannie Mae and Freddie Mac, their reliance upon the U.S. Government for solvency, and related efforts that may significantly affect Fannie Mae and Freddie Mac and their relationship with the U.S. Government, may adversely affect our business, operations and financial condition.
 
Due to increased market concerns about Fannie Mae and Freddie Mac’s ability to withstand future credit losses associated with securities held in their investment portfolios, and on which they provide guarantees, without the direct support of the U.S. Government Congress passed the Housing and Economic Recovery Act of 2008, or the HERA.  Among other things, the HERA established the Federal Housing Finance Agency, or FHFA, which has broad regulatory powers over Fannie Mae and Freddie Mac.  On September 6, 2008, the FHFA placed Fannie Mae and Freddie Mac into conservatorship and, together with the Treasury, established a program designed to boost investor confidence in Fannie Mae’s and Freddie Mac’s debt and mortgage-backed securities.  As the conservator of Fannie Mae and Freddie Mac, the FHFA controls and directs their operations and may (1) take over the assets of and operate Fannie Mae and Freddie Mac with all the powers of their shareholders, directors and officers of Fannie Mae and Freddie Mac and conduct all business of Fannie Mae and Freddie Mac; (2) collect all obligations and money due to Fannie Mae and Freddie Mac; (3) perform all functions of Fannie Mae and Freddie Mac which are consistent with the conservator’s appointment; (4) preserve and conserve the assets and property of Fannie Mae and Freddie Mac; and (5) contract for assistance in fulfilling any function, activity, action or duty of the conservator.
 
 
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In addition to FHFA becoming the conservator of Fannie Mae and Freddie Mac, the Treasury and Fannie Mae and Freddie Mac have entered into Preferred Stock Purchase Agreements (or PSPAs) pursuant to which the Treasury has ensured that each of Fannie Mae and Freddie Mac maintains a positive net worth. On December 24, 2009, the Treasury amended the terms of the PSPAs to remove the $200 billion per institution limit established under the PSPAs until the end of 2012.  The Treasury also amended the PSPAs with respect to the requirements for Fannie Mae and Freddie Mac to reduce their portfolios.
 
In addition, in 2008 the Federal Reserve established a program to purchase $100 billion in direct obligations of Fannie Mae, Freddie Mac and the Federal Home Loan Bank and $500 billion in Agency mortgage-backed securities.  These targets were increased in March 2009 to $200 billion and $1.25 trillion of Agency debentures and Agency mortgage-backed securities, respectively. The Federal Reserve stated that its actions were intended to reduce the cost and increase the availability of credit for the purchase of houses, and were meant to support housing markets and foster improved conditions in financial markets more generally.  The Federal Reserve completed this program in March 2010.
 
The problems faced by Fannie Mae and Freddie Mac resulting in their placement into federal conservatorship and receipt of significant U.S. Government support have sparked debate among some federal policy makers regarding the continued role of the U.S. Government in providing liquidity for mortgage loans and mortgage-backed securities.  With Fannie Mae’s and Freddie Mac’s future under debate, the nature of their guarantee obligations could be considerably limited relative to historical measurements.  Any changes to the nature of their guarantee obligations could redefine what constitutes an Agency mortgage-backed security and could have broad adverse implications for the market and our business, operations and financial condition.  If Fannie Mae or Freddie Mac are eliminated, or their structures change radically (i.e., limitation or removal of the guarantee obligation), we may be unable to acquire additional Agency mortgage-backed securities.  A reduction in the supply of Agency mortgage-backed securities could negatively affect the pricing of Agency mortgage-backed securities by reducing the spread between the interest we earn on our portfolio of Agency mortgage-backed securities and our cost of financing that portfolio.
 
Although the Treasury previously committed capital to Fannie Mae and Freddie Mac through 2012, and in the White Paper the Treasury committed to providing sufficient capital to enable Fannie Mae and Freddie Mac to meet their current and future guarantee obligations, there can be no assurance that these actions will be adequate for their needs. If these actions are inadequate, Fannie Mae and Freddie Mac could continue to suffer losses and could fail to honor their guarantees and other obligations.  Furthermore, the current credit support provided by the Treasury to Fannie Mae and Freddie Mac, and any additional credit support it may provide in the future, could have the effect of lowering the interest rates we expect to receive from mortgage-backed securities, and tightening the spread between the interest we earn on our mortgage-backed securities and the cost of financing those assets.
 
In addition, our existing Agency mortgage-backed securities could be materially and adversely impacted.  We rely on our Agency mortgage-backed securities as collateral for our financings under our repurchase agreements.  Any decline in their value, or perceived market uncertainty about their value, would make it more difficult for us to obtain financing on acceptable terms or at all, or to maintain our compliance with the terms of any financing transactions.
 
Future policies that change the relationship between Fannie Mae and Freddie Mac and the U.S. Government, including those that result in their winding down, nationalization, privatization, or elimination, may create market uncertainty and have the effect of reducing the actual or perceived credit quality of securities issued or guaranteed by Fannie Mae or Freddie Mac.  As a result, such policies could increase the risk of loss on investments in Agency mortgage-backed securities guaranteed by Fannie Mae and/or Freddie Mac.  It also is possible that such policies could adversely impact the market for such securities and spreads at which they trade.  All of the foregoing could materially and adversely affect our business, operations and financial condition.
 
Mortgage loan modification programs, future legislative action and changes in the requirements necessary to qualify for refinancing a mortgage with Fannie Mae, Freddie Mac or Ginnie Mae may adversely affect the value of, and the returns on, the assets in which we invest.
 
 
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The U.S. government, through the Federal Housing Administration, or FHA, and the FDIC, has implemented programs designed to provide homeowners with assistance in avoiding residential mortgage loan foreclosures including the Hope for Homeowners Act of 2008, which allows certain distressed borrowers to refinance their mortgages into FHA-insured loans.  The programs may also involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans or the rate of interest payable on the loans, or to extend the payment terms of the loans.  Members of the U.S. Congress have indicated support for additional legislative relief for homeowners, including an amendment of the bankruptcy laws to permit the modification of mortgage loans in bankruptcy proceedings.  These loan modification programs, future legislative or regulatory actions, including amendments to the bankruptcy laws, that result in the modification of outstanding mortgage loans, as well as changes in the requirements necessary to qualify for refinancing a mortgage with Fannie Mae, Freddie Mac or Ginnie Mae may adversely affect the value of, and the returns on, our Agency mortgage-backed securities and Agency debentures.  Depending on whether or not we purchased an instrument at a premium or discount, the yield we receive may be positively or negatively impacted by any modification.

The U.S. Government's pressing for refinancing of certain loans may affect prepayment rates for mortgage loans in Mortgage-Backed Securities.

In addition to the increased pressure upon residential mortgage loan investors and servicers to engage in loss mitigation activities, the U.S. Government is pressing for refinancing of certain loans, and this encouragement may affect prepayment rates for mortgage loans in Agency mortgage-backed securities.  To the extent these and other economic stabilization or stimulus efforts are successful in increasing prepayment speeds for residential mortgage loans, such as those in Agency mortgage-backed securities, that could potentially harm our income and operating results, particularly in connection with loans or Agency mortgage-backed securities purchased at a premium or our interest-only securities.

There can be no assurance that the actions of the U.S. Government, the Federal Reserve, the Treasury and other governmental and regulatory bodies for the purpose of stabilizing the financial markets will achieve the intended effect, that our business will benefit from these actions or that further government or market developments will not adversely impact us.

In response to the financial issues affecting the banking system and the financial markets and going concern threats to investment banks and other financial institutions, the U.S. Government, the Federal Reserve, the Treasury and other governmental and regulatory bodies have taken action to attempt to stabilize the financial markets.

There can be no assurance that the actions of the U.S. Government will have a beneficial impact on the financial markets, including on current levels of volatility.  To the extent the market does not respond favorably to these initiatives or these initiatives do not function as intended, our business may not receive the anticipated positive impact from the legislation.  There can also be no assurance that we will be eligible to participate in any programs established by the U.S. Government, if we are eligible, that we will be able to utilize them successfully or at all.  In addition, because the programs are designed, in part, to provide liquidity to restart the market for certain of our targeted assets, the establishment of these programs may result in increased competition for attractive opportunities in our targeted assets.  It is also possible that our competitors may utilize the programs which would provide them with attractive debt and equity capital funding from the U.S. Government. In addition, the U.S. Government, the Federal Reserve, the Treasury and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis.  We cannot predict whether or when such actions may occur, and such actions could have a dramatic impact on our business, results of operations and financial condition.

We operate in a highly competitive market for investment opportunities and competition may limit our ability to acquire desirable investments in our target assets and could also affect the pricing of these securities.
 
 
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We operate in a highly competitive market for investment opportunities.  Our profitability depends, in large part, on our ability to acquire our target assets at attractive prices. In acquiring our target assets, we will compete with a variety of institutional investors, including other REITs, specialty finance companies, public and private funds (including other funds managed by FIDAC), commercial and investment banks, commercial finance and insurance companies and other financial institutions.  Many of our competitors are substantially larger and have considerably greater financial, technical, marketing and other resources than we do.  Several other REITs have recently raised, or are expected to raise, significant amounts of capital, and may have investment objectives that overlap with ours, which may create additional competition for investment opportunities.  Some competitors may have a lower cost of funds and access to funding sources that may not be available to us, such as funding from the U.S. Government, if we are not eligible to participate in programs established by the U.S. Government.  Many of our competitors are not subject to the operating constraints associated with REIT tax compliance or maintenance of an exemption from the Investment Company Act.  In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships than us.  Furthermore, competition for investments in our target assets may lead to the price of such assets increasing, which may further limit our ability to generate desired returns.  We cannot assure you that the competitive pressures we face will not have a material adverse effect on our business, financial condition and results of operations.  Also, as a result of this competition, desirable investments in our target assets may be limited in the future and we may not be able to take advantage of attractive investment opportunities from time to time, as we can provide no assurance that we will be able to identify and make investments that are consistent with our investment objectives.
 
Risks Related to Our Business

An increase in the interest payments on our borrowings relative to the interest we earn on our Investment Securities may adversely affect our profitability.

We earn money based upon the spread between the interest payments we earn on our Investment Securities and the interest payments we must make on our borrowings.  If the interest payments on our borrowings increase relative to the interest we earn on our Investment Securities, our profitability may be adversely affected.  The interest payments on our borrowings may increase relative to the interest we earn on our adjustable-rate interest-earning assets for various reasons discussed in this section.
 
 
·
Differences in timing of interest rate adjustments on our Investment Securities and our borrowings may adversely affect our profitability
 
We rely primarily on short-term borrowings to acquire Investment Securities with long-term maturities.  Accordingly, if short-term interest rates increase, this may adversely affect our profitability.
 
Some of the Investment Securities we acquire are adjustable-rate interest-earning assets.  This means that their interest rates may vary over time based upon changes in an objective index, such as:
 
 
·
LIBOR.  The interest rate that banks in London offer for deposits in London of U.S. dollars.
 
 
·
Treasury Rate.  A monthly or weekly average yield of benchmark U.S. Treasury securities, as published by the Federal Reserve Board.
 
 
·
CD Rate.  The weekly average of secondary market interest rates on six-month negotiable certificates of deposit, as published by the Federal Reserve Board.
 
These indices generally reflect short-term interest rates.  On December 31, 2010, approximately 13% of our Investment Securities were adjustable-rate interest-earning assets.
 
The interest rates on our borrowings similarly vary with changes in an objective index.  Nevertheless, the interest rates on our borrowings generally adjust more frequently than the interest rates on our adjustable-rate interest-earning assets.  For example, on December 31, 2010, our adjustable-rate interest-earning assets had a weighted average term to next rate adjustment of 39 months, while our borrowings had a weighted average term of 127 days.  Accordingly, in a period of rising interest rates, we could experience a decrease in net income or a net loss because the interest rates on our borrowings adjust faster than the interest rates on our adjustable-rate interest-earning assets.
 
 
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·
Interest rate caps on our Agency mortgage-backed securities and Agency debentures may adversely affect our profitability
 
Our adjustable-rate interest-earning assets are typically subject to periodic and lifetime interest rate caps. Periodic interest rate caps limit the amount an interest rate can increase during any given period.  Lifetime interest rate caps limit the amount an interest rate can increase through maturity of Agency mortgage-backed securities and Agency debentures.  Our borrowings are not subject to similar restrictions.  Accordingly, in a period of rapidly increasing interest rates, we could experience a decrease in net income or experience a net loss because the interest rates on our borrowings could increase without limitation while the interest rates on our adjustable-rate interest-earning assets would be limited by caps.
 
 
·
Because we acquire fixed-rate securities, an increase in interest rates may adversely affect our profitability
 
In a period of rising interest rates, our interest payments could increase while the interest we earn on our fixed-rate mortgage-backed securities would not change.  This would adversely affect our profitability.  On December 31, 2010, approximately 86% of our Investment Securities were fixed-rate investments.
 
An increase in prepayment rates may adversely affect our profitability.

The Agency mortgage-backed securities we acquire are backed by pools of mortgage loans.  We receive payments, generally, from the payments that are made on these underlying mortgage loans.  When borrowers prepay their mortgage loans at rates that are faster-than-expected, this results in prepayments on mortgage-backed securities that are faster than expected.  These faster than expected prepayments may adversely affect our profitability.  We often purchase mortgage-backed securities 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 the market value to acquire the security.  In accordance with accounting rules, we amortize this premium over the term of the mortgage-backed security.  If the mortgage-backed security is prepaid in whole or in part prior to its maturity date, however, we must expense all or a part of the remaining unamortized portion of the premium that was prepaid at the time of the prepayment.  This adversely affects our profitability.
 
Prepayment rates generally increase when interest rates fall and decrease when interest rates rise, but changes in prepayment rates are difficult to predict.  Prepayment rates also may be affected by conditions in the housing and financial markets, general economic conditions and the relative interest rates on fixed-rate and adjustable-rate mortgage loans.
 
We often purchase mortgage-backed securities that have a higher coupon rate than the prevailing market interest rates.  In exchange for a higher coupon rate, we typically pay a premium over par value to acquire these mortgage-backed securities.  In accordance with generally accepted accounting principles (or GAAP), we amortize the premiums on our mortgage-backed securities over the life of the related mortgage-backed securities.  If the mortgage loans securing these mortgage-backed securities prepay at a more rapid rate than anticipated, we will have to amortize our premiums on an accelerated basis which may adversely affect our profitability.  Defaults on mortgage loans underlying Agency mortgage-backed securities typically have the same effect as prepayments because of the underlying Agency guarantee.  Fannie Mae and Freddie Mac significantly increased their purchases of delinquent loans from the pools of mortgages collateralizing their Agency mortgage-backed securities beginning in March 2010. As of December 31, 2010, we had net purchase premiums of $2.3 billion, or 3.0% of current par value, on our Agency mortgage-backed securities, Agency debentures, and corporate debt.
 
We may seek to reduce prepayment risk by acquiring mortgage-backed securities at a discount.  If a discounted security is prepaid in whole or in part prior to its maturity date, we will earn income equal to the amount of the remaining discount.  This will improve our profitability if the discounted securities are prepaid faster than expected.
 
We also can acquire mortgage-backed securities that are less affected by prepayments.  For example, we can acquire CMOs, a type of mortgage-backed security.  CMOs divide a pool of mortgage loans into multiple tranches that allow for shifting of prepayment risks from slower-paying tranches to faster-paying tranches.  This is in contrast to pass-through or pay-through mortgage-backed securities, where all investors share equally in all payments, including all prepayments.  As discussed below, the Investment Company Act of 1940 imposes restrictions on our purchase of CMOs.  As of December 31, 2010, approximately 19% of our Investment Securities were CMOs and approximately 81% of our Investment Securities were pass-through or pay-through securities.
 
 
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While we seek to minimize prepayment risk to the extent practical, in selecting investments we must balance prepayment risk against other risks and the potential returns of each investment.  No strategy can completely insulate us from prepayment risk.
 
An increase in interest rates may adversely affect our book value.

Increases in interest rates may negatively affect the market value of our investment securities.  Our fixed-rate securities, generally, are more negatively affected by these increases.  In accordance with accounting rules, we reduce our book value by the amount of any decrease in the market value of our investment securities.
 
Failure to procure funding on favorable terms, or at all, would adversely affect our results and may, in turn, negatively affect the market price of shares of our common stock.

The current dislocation and weakness in the broader mortgage markets could adversely affect one or more of our potential lenders and could cause one or more of our potential lenders to be unwilling or unable to provide us with financing.  This could potentially increase our financing costs and reduce our liquidity.  If one or more major market participants fails or otherwise experiences a major liquidity crisis, as was the case for Bear Stearns & Co. in March 2008 and Lehman Brothers Holdings Inc. in September 2008, it could negatively impact the marketability of all fixed income securities, including Agency RMBS, and this could negatively impact the value of the securities we acquire, thus reducing our net book value.  Furthermore, if any of our potential lenders or any of our lenders are unwilling or unable to provide us with financing, we could be forced to sell our assets at an inopportune time when prices are depressed.

Our strategy involves significant leverage.

We incur this leverage by borrowing against a substantial portion of the market value of our investment securities.  By incurring this leverage, we can enhance our returns.  Nevertheless, this leverage, which is fundamental to our investment strategy, also creates significant risks.
 
 
·
Our leverage may cause substantial losses
 
Because of our significant leverage, we may incur substantial losses if our borrowing costs increase.  Our borrowing costs may increase for any of the following reasons:
 
 
·
short-term interest rates increase;
 
 
·
the market value of our Investment Securities decreases;
 
 
·
interest rate volatility increases; or
 
 
·
the availability of financing in the market decreases.
 
 
·
Our leverage may cause margin calls and defaults and force us to sell assets under adverse market conditions
 
Because of our leverage, a decline in the value of our investment securities may result in our lenders initiating margin calls.  A margin call means that the lender requires us to pledge additional collateral to re-establish the ratio of the value of the collateral to the amount of the borrowing.  Our fixed-rate mortgage-backed securities generally are more susceptible to margin calls as increases in interest rates tend to more negatively affect the market value of fixed-rate securities.
 
 
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If we are unable to satisfy margin calls, our lenders may foreclose on our collateral. This could force us to sell our investment securities under adverse market conditions. Additionally, in the event of our bankruptcy, our borrowings, which are generally made under repurchase agreements, may qualify for special treatment under the Bankruptcy Code. This special treatment would allow the lenders under these agreements to avoid the automatic stay provisions of the Bankruptcy Code and to liquidate the collateral under these agreements without delay.
 
 
·
Liquidation of collateral may jeopardize our REIT status
 
To continue to qualify as a REIT, we must comply with requirements regarding our assets and our sources of income.  If we are compelled to liquidate our Agency mortgage-backed securities and Agency debentures, we may be unable to comply with these requirements, ultimately jeopardizing our status as a REIT and our failure to qualify as a REIT will have adverse tax consequences.
 
 
·
We may exceed our target leverage ratios
 
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1.  However, we are not required to stay within this leverage ratio.  If we exceed this ratio, the adverse impact on our financial condition and results of operations from the types of risks described in this section would likely be more severe.
 
 
·
We may not be able to achieve our optimal leverage
 
We use leverage as a strategy to increase the return to our investors.  However, we may not be able to achieve our desired leverage for any of the following reasons:
 
 
·
we determine that the leverage would expose us to excessive risk;
 
 
·
our lenders do not make funding available to us at acceptable rates; or
 
 
·
our lenders require that we provide additional collateral to cover our borrowings.
 
 
·
We may incur increased borrowing costs which would adversely affect our profitability
 
Currently, all of our collateralized borrowings are in the form of repurchase agreements.  If the interest rates on these repurchase agreements increase, it would adversely affect our profitability.
 
Our borrowing costs under repurchase agreements generally correspond to short-term interest rates such as LIBOR or a short-term Treasury index, plus or minus a margin.  The margins on these borrowings over or under short-term interest rates may vary depending upon:
 
 
·
the movement of interest rates;
 
 
·
the availability of financing in the market; or
 
 
·
the value and liquidity of our Investment Securities.
 
If we are unable to renew our borrowings at favorable rates, our profitability may be adversely affected.

Since we rely primarily on short-term borrowings, our ability to achieve our investment objectives depends not only on our ability to borrow money in sufficient amounts and on favorable terms, but also on our ability to renew or replace on a continuous basis our maturing short-term borrowings.  If we are not able to renew or replace maturing borrowings, we would have to sell our assets under possibly adverse market conditions.
 
If a counterparty to our repurchase transactions defaults on its obligation to resell the underlying security back to us at the end of the transaction term, or if the value of the underlying security has declined as of the end of that term, or if we default on our obligations under the repurchase agreement, we will lose money on our repurchase transactions.
 
 
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 When we engage in repurchase transactions, we generally sell securities to lenders (repurchase agreement counterparties) and receive cash from these lenders.  The lenders are obligated to resell the same securities back to us at the end of the term of the transaction.  Because the cash we receive from the lender when we initially sell the securities to the lender is less than the value of those securities (this difference is the haircut), if the lender defaults on its obligation to resell the same securities back to us, we may incur a loss on the transaction equal to the amount of the haircut (assuming there was no change in the value of the securities).  We would also lose money on a repurchase transaction if the value of the underlying securities has declined as of the end of the transaction term, as we would have to repurchase the securities for their initial value but would receive securities worth less than that amount.  Further, if we default on one of our obligations under a repurchase transaction, the lender can terminate the transaction and cease entering into any other repurchase transactions with us.  Repurchase agreements generally contain cross-default provisions, so that if a default occurs under any one agreement, the lenders under our other agreements could also declare a default.  Any losses we incur on our repurchase transactions could adversely affect our earnings and thus our cash available for distribution to shareholders.
 
Any repurchase agreements that we use to finance our assets may require us to provide additional collateral or pay down debt.

 Our repurchase agreements involve the risk that the market value of the securities pledged or sold by us to the repurchase agreement counterparty may decline in value, in which case the counterparty may require us to provide additional collateral or to repay all or a portion of the funds advanced.  We may not have additional collateral or the funds available to repay our debt at that time, which would likely result in defaults unless we are able to raise the funds from alternative sources, which we may not be able to achieve on favorable terms or at all.  Posting additional collateral would reduce our liquidity and limit our ability to leverage our assets.  If we cannot meet these requirements, the counterparty could accelerate its indebtedness, increase the interest rate on advanced funds and terminate our ability to borrow funds from them, which could materially and adversely affect our financial condition and ability to implement our investment strategy.  In addition, in the event that the counterparty files for bankruptcy or becomes insolvent, our securities may become subject to bankruptcy or insolvency proceedings, thus depriving us, at least temporarily, of the benefit of these assets.  Such an event could restrict our access to bank credit facilities and increase its cost of capital. Repurchase agreement counterparties may also require us to maintain a certain amount of cash or set aside assets sufficient to maintain a specified liquidity position that would enhance our ability to satisfy its collateral obligations.  As a result, we may not be able to leverage our assets as fully as we would choose, which could reduce our return on assets.  In the event that we are unable to meet these collateral obligations, our financial condition and prospects could deteriorate rapidly.
 
Our hedging strategies expose us to risks.

Our policies permit us to enter into interest rate swaps, caps and floors and other derivative transactions to help us mitigate our interest rate and prepayment risks described above.  We have used interest rate swaps and interest rate caps to provide a level of protection against interest rate risks, but no hedging strategy can protect us completely.  Interest rate hedging may fail to protect or could adversely affect us because, among other things: interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates; available interest rate hedges may not correspond directly with the interest rate risk for which protection is sought; and the duration of the hedge may not match the duration of the related liability.

 
·
Our hedging strategies may not be successful in mitigating the risks associated with interest rates
 
We cannot assure you that our use of derivatives will offset the risks related to changes in interest rates. It is likely that there will be periods in the future during which we will incur losses on our derivative financial instruments that will not be fully offset by gains on our portfolio.  The derivative financial instruments we select may not have the effect of reducing our interest rate risk.  In addition, the nature and timing of hedging transactions may influence the effectiveness of these strategies.  Poorly designed strategies or improperly executed transactions could significantly increase our risk and lead to material losses.  In addition, hedging strategies involve transaction and other costs.  Our hedging strategy and the derivatives that we use may not adequately offset the risk of interest rate volatility or that our hedging transactions may not result in losses.
 
 
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·
Our use of derivatives may expose us to counterparty risks

We enter into interest rate swap and cap agreements to hedge risks associated with movements in interest rates.  If a swap counterparty cannot perform under the terms of an interest rate swap, we would not receive payments due under that agreement, we may lose any unrealized gain associated with the interest rate swap, and the hedged liability would cease to be hedged by the interest rate swap.  We may also be at risk for any collateral we have pledged to secure our obligations under the interest rate swap if the counterparty become insolvent or file for bankruptcy.  Similarly, if a cap counterparty fails to perform under the terms of the cap agreement, in addition to not receiving payments due under that agreement that would off-sets our interest expense, we would also incur a loss for all remaining unamortized premium paid for that agreement.
 
We may face risks of investing in inverse floating rate securities.

We may invest in inverse floaters.  The returns on inverse floaters are inversely related to changes in an interest rate.  Generally, income on inverse floaters will decrease when interest rates increase and increase when interest rates decrease.  Investments in inverse floaters may subject us to the risks of reduced or eliminated interest payments and losses of principal.  In addition, certain indexed securities and inverse floaters may increase or decrease in value at a greater rate than the underlying interest rate, which effectively leverages our investment in such securities.  As a result, the market value of such securities will generally be more volatile than that of fixed rate securities.

Our investment strategy may involve credit risk.

We may incur losses if there are payment defaults under our Investment Securities.
 
To date, substantially all of our mortgage-backed securities have been agency certificates and Agency debentures which, although not rated, carry an implied “AAA” rating. Agency certificates are mortgage pass-through certificates where Freddie Mac, Fannie Mae or Ginnie Mae guarantees payments of principal and interest on the certificates. Agency debentures are debt instruments issued by Freddie Mac, Fannie Mae, or the FHLB.
 
Even though our Agency mortgage-backed securities and Agency debentures acquired thus far have been “AAA”, pursuant to our capital investment policy, we have the ability to acquire securities of lower credit quality.  Under our policy:
 
 
·
75% of our total assets must be high quality mortgage-backed securities and short-term investments.  High quality securities are securities (1) that are rated within one of the two highest rating categories by at least one of the nationally recognized rating agencies, (2) that are unrated but are guaranteed by the United States government or an agency of the United States government, or (3) that are unrated or whose ratings have not been updated but that our management determines are of comparable quality to high quality rated mortgage-backed securities;
 
 
·
the remaining 25% of total assets, may consist of mortgage-backed securities and other qualified REIT real estate assets which are unrated or rated less than high quality, but which are at least “investment grade” (rated “BBB” or better by Standard & Poor’s Corporation (or S&P) or the equivalent by another nationally recognized rating agency) or, if not rated, we determine them to be of comparable credit quality to an investment which is rated “BBB” or better.  In addition, we may directly or indirectly invest part of this remaining 25% of our assets in other types of securities, including without limitation, unrated debt, equity or derivative securities, to the extent consistent with our REIT qualification requirements.  The derivative securities in which we invest may include securities representing the right to receive interest only or a disproportionately large amount of interest, as well as inverse floaters, which may have imbedded leverage as part of their structural characteristics; and
 
 
·
we seek to structure our portfolio to maintain a minimum weighted average rating (including our deemed comparable ratings for unrated mortgage-backed securities) of our mortgage-backed securities of at least single “A” under the S&P rating system and at the comparable level under the other rating systems.
 
 
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If we acquire securities of lower credit quality, we may incur losses if there are defaults under those securities or if the rating agencies downgrade the credit quality of those securities.
 
We have not established a minimum dividend payment level.

We intend to pay quarterly dividends and to make distributions to our stockholders in amounts such that all or substantially all of our taxable income in each year (subject to certain adjustments) is distributed.  This enables us to qualify for the tax benefits accorded to a REIT under the Code.  We have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected for the reasons described in this section.  All distributions will be made at the discretion of our board of directors and will depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our board of directors may deem relevant from time to time.
 
Because of competition, we may not be able to acquire mortgage-backed securities at favorable yields.

Our net income depends, in large part, on our ability to acquire mortgage-backed securities at favorable spreads over our borrowing costs.  In acquiring mortgage-backed securities, we compete with other REITs, investment banking firms, savings and loan associations, banks, insurance companies, mutual funds, other lenders and other entities that purchase mortgage-backed securities, many of which have greater financial resources than us.  As a result, in the future, we may not be able to acquire sufficient mortgage-backed securities at favorable spreads over our borrowing costs.
 
We are dependent on our key personnel
 
We are dependent on the efforts of our key officers and employees, including Michael A. J. Farrell, our Chairman of the board of directors, Chief Executive Officer and President, Wellington J. Denahan-Norris, our Vice Chairman, Chief Operating Officer and Chief Investment Officer, and Kathryn F. Fagan, our Chief Financial Officer and Treasurer.  The loss of any of their services could have an adverse effect on our operations. Although we have employment agreements with each of them, we cannot assure you they will remain employed with us.
 
We and our shareholders are subject to certain tax risks

 
·
Our failure to qualify as a REIT would have adverse tax consequences
 
We believe that since 1997 we have qualified for taxation as a REIT for federal income tax purposes.  We plan to continue to meet the requirements for taxation as a REIT.  The determination that we are a REIT requires an analysis of various factual matters and circumstances that may not be totally within our control.  For example, to qualify as a REIT, at least 75% of our gross income must come from real estate sources and 95% of our gross income must come from real estate sources and certain other sources that are itemized in the REIT tax laws.  We are also required to distribute to stockholders at least 90% of our REIT taxable income (determined without regard to the deduction for dividends paid and by excluding any net capital gain).  Even a technical or inadvertent mistake could jeopardize our REIT status.  Furthermore, Congress and the Internal Revenue Service (or IRS) might make changes to the tax laws and regulations, and the courts might issue new rulings that make it more difficult or impossible for us to remain qualified as a REIT.
 
If we fail to qualify as a REIT, we would be subject to federal income tax at regular corporate rates.  Also, unless the IRS granted us relief under certain statutory provisions, we would remain disqualified as a REIT for four years following the year we first fail to qualify.  If we fail to qualify as a REIT, we would have to pay significant income taxes and would therefore have less money available for investments or for distributions to our stockholders.  This would likely have a significant adverse effect on the value of our securities.  In addition, the tax law would no longer require us to make distributions to our stockholders.
 
A REIT that fails the quarterly asset tests for one or more quarters will not lose its REIT status as a result of such failure if either (i) the failure is regarded as a de minimis failure under standards set out in the Internal Revenue Code, or (ii) the failure is greater than a de minimis failure but is attributable to reasonable cause and not willful neglect.  In the case of a greater than de minimis failure, however, the REIT must pay a tax and must remedy the failure within 6 months of the close of the quarter in which the failure was identified.  In addition, the Internal Revenue Code provides relief for failures of other tests imposed as a condition of REIT qualification, as long as the failures are attributable to reasonable cause and not willful neglect.  A REIT would be required to pay a penalty of $50,000, however, in the case of each failure.
 
 
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·
We have certain distribution requirements
 
As a REIT, we must distribute at least 90% of our REIT taxable income (determined without regard to the deduction for dividends paid and by excluding any net capital gain).  The required distribution limits the amount we have available for other business purposes, including amounts to fund our growth.  Also, it is possible that because of the differences between the time we actually receive revenue or pay expenses and the period we report those items for distribution purposes, we may have to borrow funds on a short-term basis to meet the 90% distribution requirement.
 
 
·
We are also subject to other tax liabilities
 
Even if we qualify as a REIT, we may be subject to certain federal, state and local taxes on our income and property.  Any of these taxes would reduce our operating cash flow.
 
 
·
Limits on ownership of our common stock could have adverse consequences to you and could limit your opportunity to receive a premium on our stock
 
To maintain our qualification as a REIT for federal income tax purposes, not more than 50% in value of the outstanding shares of our capital stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the federal tax laws to include certain entities).  Primarily to facilitate maintenance of our qualification as a REIT for federal income tax purposes, our charter will prohibit ownership, directly or by the attribution provisions of the federal tax laws, by any person of more than 9.8% of the lesser of the number or value of the issued and outstanding shares of our common stock and will prohibit ownership, directly or by the attribution provisions of the federal tax laws, by any person of more than 9.8% of the lesser of the number or value of the issued and outstanding shares of any class or series of our preferred stock.  Our board of directors, in its sole and absolute discretion, may waive or modify the ownership limit with respect to one or more persons who would not be treated as “individuals” for purposes of the federal tax laws if it is satisfied, based upon information required to be provided by the party seeking the waiver and upon an opinion of counsel satisfactory to the board of directors, that ownership in excess of this limit will not otherwise jeopardize our status as a REIT for federal income tax purposes.
 
The ownership limit may have the effect of delaying, deferring or preventing a change in control and, therefore, could adversely affect our shareholders’ ability to realize a premium over the then-prevailing market price for our common stock in connection with a change in control.
 
 
·
A REIT cannot invest more than 25% of its total assets in the stock or securities of one or more taxable REIT subsidiaries; therefore, our taxable subsidiaries cannot constitute more than 25% of our total assets
 
A taxable REIT subsidiary is a corporation, other than a REIT or a qualified REIT subsidiary, in which a REIT owns stock and which elects taxable REIT subsidiary status.  The term also includes a corporate subsidiary in which the taxable REIT subsidiary owns more than a 35% interest.  A REIT may own up to 100% of the stock of one or more taxable REIT subsidiaries.  A taxable REIT subsidiary may earn income that would not be qualifying income if earned directly by the parent REIT.  Overall, at the close of any calendar quarter, no more than 25% of the value of a REIT’s assets may consist of stock or securities of one or more taxable REIT subsidiaries.
 
The stock and securities of our taxable REIT subsidiaries are expected to represent less than 25% of the value of our total assets. Furthermore, we intend to monitor the value of our investments in the stock and securities of our taxable REIT subsidiaries to ensure compliance with the above-described 25% limitation. We cannot assure you, however, that we will always be able to comply with the 25% limitation so as to maintain REIT status.
 
 
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·
Taxable REIT subsidiaries are subject to tax at the regular corporate rates, are not required to distribute dividends, and the amount of dividends a taxable REIT subsidiary can pay to its parent REIT may be limited by REIT gross income tests
 
A taxable REIT subsidiary must pay income tax at regular corporate rates on any income that it earns.  Our taxable REIT subsidiaries will pay corporate income tax on their taxable income, and their after-tax net income will be available for distribution to us.  Such income, however, is not required to be distributed.
 
Moreover, the annual gross income tests that must be satisfied to ensure REIT qualification may limit the amount of dividends that we can receive from our taxable REIT subsidiaries and still maintain our REIT status.  Generally, not more than 25% of our gross income can be derived from non-real estate related sources, such as dividends from a taxable REIT subsidiary.  If, for any taxable year, the dividends we received from our taxable REIT subsidiaries, when added to our other items of non-real estate related income, represented more than 25% of our total gross income for the year, we could be denied REIT status, unless we were able to demonstrate, among other things, that our failure of the gross income test was due to reasonable cause and not willful neglect.
 
The limitations imposed by the REIT gross income tests may impede our ability to distribute assets from our taxable REIT subsidiaries to us in the form of dividends.  Certain asset transfers may, therefore, have to be structured as purchase and sale transactions upon which our taxable REIT subsidiaries recognize taxable gain.
 
 
·
If interest accrues on indebtedness owed by a taxable REIT subsidiary to its parent REIT at a rate in excess of a commercially reasonable rate, or if transactions between a REIT and a taxable REIT subsidiary are entered into on other than arm’s-length terms, the REIT may be subject to a penalty tax
 
If interest accrues on an indebtedness owed by a taxable REIT subsidiary to its parent REIT at a rate in excess of a commercially reasonable rate, the REIT is subject to tax at a rate of 100% on the excess of (i) interest payments made by a taxable REIT subsidiary to its parent REIT over (ii) the amount of interest that would have been payable had interest accrued on the indebtedness at a commercially reasonable rate.  A tax at a rate of 100% is also imposed on any transaction between a taxable REIT subsidiary and its parent REIT to the extent the transaction gives rise to deductions to the taxable REIT subsidiary that are in excess of the deductions that would have been allowable had the transaction been entered into on arm’s-length terms.  We will scrutinize all of our transactions with our taxable REIT subsidiaries in an effort to ensure that we do not become subject to these taxes.  We may not be able to avoid application of these taxes.
 
Risks of Ownership of Our Common Stock
 
We may change our policies without stockholder approval.
 
Our board of directors and management determine all of our policies, including our investment, financing and distribution policies. They may amend or revise these policies at any time without a vote of our stockholders. Policy changes could adversely affect our financial condition, results of operations, the market price of our common stock or our ability to pay dividends or distributions.
 
Our governing documents and Maryland law impose limitations on the acquisition of our common stock and changes in control that could make it more difficult for a third party to acquire us.
 
Maryland Business Combination Act
 
The Maryland General Corporation Law establishes special requirements for “business combinations” between a Maryland corporation and “interested stockholders” unless exemptions are applicable.  An interested stockholder is any person who beneficially owns 10% or more of the voting power of our then-outstanding voting stock.  Among other things, the law prohibits for a period of five years a merger and other similar transactions between us and an interested stockholder unless the board of directors approved the transaction prior to the party’s becoming an interested stockholder.  The five-year period runs from the most recent date on which the interested stockholder became an interested stockholder.  The law also requires a super majority stockholder vote for such transactions after the end of the five-year period.  This means that the transaction must be approved by at least:
 
 
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·
80% of the votes entitled to be cast by holders of outstanding voting shares; and
 
 
·
two-thirds of the votes entitled to be cast by holders of outstanding voting shares other than shares held by the interested stockholder or an affiliate of the interested stockholder with whom the business combination is to be effected.
 
As permitted by the Maryland General Corporation Law, we have elected not to be governed by the Maryland business combination statute.  We made this election by opting out of this statute in our articles of incorporation.  If, however, we amend our articles of incorporation to opt back in to the statute, the business combination statute could have the effect of discouraging offers to acquire us and of increasing the difficulty of consummating any such offers, even if our acquisition would be in our stockholders’ best interests.
 
Maryland Control Share Acquisition Act
 
Maryland law provides that “control shares” of a Maryland corporation acquired in a “control share acquisition” have no voting rights except to the extent approved by a vote of the stockholders.  Two-thirds of the shares eligible to vote must vote in favor of granting the “control shares” voting rights.  “Control shares” are shares of stock that, taken together with all other shares of stock the acquirer previously acquired, would entitle the acquirer to exercise voting power in electing directors within one of the following ranges of voting power:
 
 
·
one-tenth or more but less than one third of all voting power;
 
 
·
one-third or more but less than a majority of all voting power; or
 
 
·
a majority or more of all voting power.
 
Control shares do not include shares of stock the acquiring person is entitled to vote as a result of having previously obtained stockholder approval.  A “control share acquisition” means the acquisition of control shares, subject to certain exceptions.
 
If a person who has made (or proposes to make) a control share acquisition satisfies certain conditions (including agreeing to pay expenses), he may compel our board of directors to call a special meeting of stockholders to consider the voting rights of the shares.  If such a person makes no request for a meeting, we have the option to present the question at any stockholders’ meeting.
 
If voting rights are not approved at a meeting of stockholders then, subject to certain conditions and limitations, we may redeem any or all of the control shares (except those for which voting rights have previously been approved) for fair value.  We will determine the fair value of the shares, without regard to voting rights, as of the date of either:
 
 
·
the last control share acquisition; or
 
 
·
the meeting where stockholders considered and did not approve voting rights of the control shares.
 
If voting rights for control shares are approved at a stockholders’ meeting and the acquirer becomes entitled to vote a majority of the shares of stock entitled to vote, all other stockholders may obtain rights as objecting stockholders and, thereunder, exercise appraisal rights.  This means that you would be able to force us to redeem your stock for fair value.  Under Maryland law, the fair value may not be less than the highest price per share paid in the control share acquisition.  Furthermore, certain limitations otherwise applicable to the exercise of dissenters’ rights would not apply in the context of a control share acquisition.  The control share acquisition statute would not apply to shares acquired in a merger, consolidation or share exchange if we were a party to the transaction.  The control share acquisition statute could have the effect of discouraging offers to acquire us and of increasing the difficulty of consummating any such offers, even if our acquisition would be in our stockholders’ best interests.
 
 
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The market price and trading volume of our shares of common stock may be volatile and issuances of large amounts of shares of our common stock could cause the market price of our common stock to decline.
 
As of February 24, 2011, 804,165,257 shares of our common stock were outstanding. If we issue a significant number of shares of common stock or securities convertible into common stock in a short period of time, there could be a dilution of the existing common stock and a decrease in the market price of the common stock.
 
The market price of our shares of common stock may be highly volatile and could be subject to wide fluctuations. In addition, the trading volume in our shares of common stock may fluctuate and cause significant price variations to occur. We cannot assure you that the market price of our shares of common stock will not fluctuate or decline significantly in the future. Some of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of our shares of common stock include those set forth under “Special Note Regarding Forward-Looking Statements” as well as:
 
·
actual or anticipated variations in our quarterly operating results or business prospects;
   
·
changes in our earnings estimates or publication of research reports about us or the real estate industry;
   
·
an inability to meet or exceed securities analysts' estimates or expectations;
   
·
increases in market interest rates;
   
·
hedging or arbitrage trading activity in our shares of common stock;
   
·
capital commitments;
   
·
changes in market valuations of similar companies;
   
·
adverse market reaction to any increased indebtedness we incur in the future;
   
·
additions or departures of management personnel;
   
·
actions by institutional shareholders;
   
·
speculation in the press or investment community;
   
·
changes in our distribution policy;
   
·
general market and economic conditions; and
   
·
future sales of our shares of common stock or securities convertible into, or exchangeable or exercisable for, our shares of common stock.
 
Holders of our shares of common stock will be subject to the risk of volatile market prices and wide fluctuations in the market price of our shares of common stock.  In addition, many of the factors listed above are beyond our control. These factors may cause the market price of our shares of common stock to decline, regardless of our financial condition, results of operations, business or prospects. It is impossible to assure you that the market prices of our shares of common stock will not fall in the future.
 
The repurchase right in our Convertible Senior Notes triggered by a fundamental change could discourage a potential acquiror.
 
 
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If we undergo certain fundamental changes, such as the acquisition of 50% of the voting power of all shares of our common equity entitled to vote generally in the election of directors, holders of our Convertible Senior Notes may require us to repurchase all or a portion of their notes at a price equal to 100% of the principal amount of the notes to be purchased plus any accrued and unpaid interest up to, but excluding, the repurchase date.  We will pay for all notes so repurchased with shares of our common stock using a price per share equal to the average daily volume-weighted average price of our common stock for the 20 consecutive trading days ending on the trading day immediately prior to the occurrence of the fundamental change.  The issuance of these shares of common stock upon certain fundamental changes could discourage a potential acquiror.
 
Broad market fluctuations could negatively impact the market price of our shares of common stock.
 
The stock market has experienced extreme price and volume fluctuations that have affected the market price of many companies in industries similar or related to ours and that have been unrelated to these companies' operating performance. These broad market fluctuations could reduce the market price of our shares of common stock. Furthermore, our operating results and prospects may be below the expectations of public market analysts and investors or may be lower than those of companies with comparable market capitalizations, which could lead to a material decline in the market price of our shares of common stock.
 
Regulatory Risks
 
Loss of Investment Company Act exemption would adversely affect us.
 
We intend to conduct our business so as not to become regulated as an investment company under the Investment Company Act.  If we fail to qualify for this exemption, our ability to use leverage would be substantially reduced, and we would be unable to conduct our business as described in this Form 10-K.
 
We currently rely on the exemption from registration provided by Section 3(c)(5)(C) of the Investment Company Act.  Section 3(c)(5)(C) as interpreted by the staff of the SEC, requires us to invest at least 55% of our assets in “mortgages and other liens on and interest in real estate” (or Qualifying Real Estate Assets) and at least 80% of our assets in Qualifying Real Estate Assets plus real estate related assets.  The assets that we acquire, therefore, are limited by the provisions of the Investment Company Act and the rules and regulations promulgated under the Investment Company Act.  If the SEC determines that any of these securities are not qualifying interests in real estate or real estate related assets, adopts a contrary interpretation with respect to these securities or otherwise believes we do not satisfy the above exceptions, we could be required to restructure our activities or sell certain of our assets.  We may be required at times to adopt less efficient methods of financing certain of our mortgage assets and we may be precluded from acquiring certain types of higher yielding mortgage assets.  The net effect of these factors will be to lower our net interest income.  If we fail to qualify for exemption from registration as an investment company, our ability to use leverage would be substantially reduced, and we would not be able to conduct our business as described.  Our business will be materially and adversely affected if we fail to qualify for this exemption.
 
Compliance with proposed and recently enacted changes in securities laws and regulations increases our costs.
 
The Sarbanes-Oxley Act of 2002 and rules and regulations promulgated by the SEC and the New York Stock Exchange have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices.  We believe that these rules and regulations will make it more costly for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage.  These rules and regulations could also make it more difficult for us to attract and retain qualified members of management and our board of directors, particularly to serve on our audit committee.
 
The Dodd-Frank Act contains many regulatory changes and calls for future rulemaking that may affect our business, including, but not limited to resolutions involving derivatives, risk-retention in securitizations and short-term financings. We are evaluating, and will continue to evaluate the potential impact of regulatory change under the Dodd-Frank Act.
 
 
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ITEM 1B.   UNRESOLVED STAFF COMMENTS
 
None.
 
ITEM 2.     PROPERTIES

Our executive and administrative office is located at 1211 Avenue of the Americas, Suite 2902 New York, New York 10036, telephone 212-696-0100.  This office is leased under a non-cancelable lease expiring December 31, 2015.

ITEM 3.     LEGAL PROCEEDINGS

From time to time, we are involved in various claims and legal actions arising in the ordinary course of business.  In the opinion of management, the ultimate disposition of these matters will not have a material effect on our consolidated financial statements.

ITEM 4.     (REMOVED AND RESERVED)
 
 
33

 

PART II

ITEM 5.         
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock began trading publicly on October 8, 1997 and is traded on the New York Stock Exchange under the trading symbol “NLY.”  As of February 16, 2011, we had 717,915,257 shares of common stock issued and outstanding which were held by approximately 473,679 beneficial holders.

The following table sets forth, for the periods indicated, the high, low, and closing sales prices per share of our common stock as reported on the New York Stock Exchange composite tape and the cash dividends declared per share of our common stock.
 
 
Stock Prices
 
         
 
High
Low
Close
 
         
First Quarter ended March 31, 2010
$18.75
$16.96
$17.18
 
Second Quarter ended June 30, 2010
$18.10
$14.09
$17.15
 
Third Quarter ended September 30, 2010
$18.54
$16.73
$17.60
 
Fourth Quarter ended December 31, 2010
$18.37
$17.25
$17.92
 
         
 
High
Low
Close
 
         
First Quarter ended March 31, 2009
$16.29
$12.07
$13.87
 
Second Quarter ended June 30, 2009
$15.56
$13.21
$15.14
 
Third Quarter ended September 30, 2009
$19.74
$14.96
$18.14
 
Fourth Quarter ended December 31, 2009
$18.99
$16.74
$17.35
 
         
         
 
Common Dividends
 
 
Declared Per Share
 
         
First Quarter ended March 31, 2010
 
$0.65
   
Second Quarter ended June 30, 2010
 
$0.68
   
Third Quarter ended September 30, 2010
 
$0.68
   
Fourth Quarter ended December 31, 2010
 
$0.64
   
         
First Quarter ended March 31, 2009
 
$0.50
   
Second Quarter ended June 30, 2009
 
$0.60
   
Third Quarter ended September 30, 2009
 
$0.69
   
Fourth Quarter ended December 31, 2009
 
$0.75
   
 
We intend to pay quarterly dividends and to distribute to our stockholders all or substantially all of our taxable income in each year (subject to certain adjustments).  This will enable us to qualify for the tax benefits accorded to a REIT under the Code.  We have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected for the reasons described under the caption “Risk Factors.”  All distributions will be made at the discretion of our board of directors and will depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our board of directors may deem relevant from time to time.  No dividends can be paid on our common stock unless we have paid full cumulative dividends on our preferred stock.  From the date of issuance of our preferred stock through December 31, 2010, we have paid full cumulative dividends on our preferred stock.
 
 
34

 
 
SHARE PERFORMANCE GRAPH
 
The following graph and table set forth certain information comparing the yearly percentage change in cumulative total return on our common stock to the cumulative total return of the Standard & Poor’s Composite 500 stock Index or S&P 500 Index, and the Bloomberg REIT Mortgage Index, or BBG REIT index, an industry index of mortgage REITs.  The comparison is for the period from December 31, 2005 to December 31, 2010 and assumes the reinvestment of dividends.  The graph and table assume that $100 was invested in our common stock and the two other indices on December 31, 2005.  Upon written request we will provide stockholders with a list of the REITs included in the BBG REIT Index.
 
Graph
 
 
 
12/31/2005
12/31/2006
12/31/2007
12/31/2008
12/31/2009
12/31/2010
Annaly Capital Management, Inc.
100
130
174
172
206
232
S&P 500 Index
100
115
121
79
98
111
BBG Reit Index
100
117
74
55
61
67

The information in the share performance graph and table has been obtained from sources believed to be reliable, but neither its accuracy nor its completeness can be guaranteed.  The historical information set forth above is not necessarily indicative of future performance.  Accordingly, we do not make or endorse any predictions as to future share performance.
 
 
35

 
 
EQUITY COMPENSATION PLAN INFORMATION

On May 27, 2010, at our 2010 Annual Meeting of Stockholders, our stockholders approved the 2010 Equity Incentive Plan.  The 2010 Equity Incentive Plan authorizes the Compensation Committee of the board of directors to grant options, stock appreciation rights, dividend equivalent rights, or other share-based award, including restricted shares up to an aggregate of 25,000,000 shares, subject to adjustments as provided in the 2010 Equity Incentive Plan.  On June 28, 2010, we granted to each non-management director of the Company options to purchase 1,250 shares of our common stock under the 2010 Equity Incentive Plan.  The stock options were issued at the current market price on the date of grant and immediately vested with a contractual term of 5 years.  The grant date fair value is calculated using the Black-Scholes option valuation model.
 
We had previously adopted a long term stock incentive plan for executive officers, key employees and nonemployee directors (the Incentive Plan).  The Incentive Plan authorizes the Compensation Committee of the board of directors to grant awards, including incentive stock options as defined under Section 422 of the Code (ISOs) and options not so qualified (NQSOs).  The Incentive Plan authorizes the granting of options or other awards for an aggregate of the greater of 500,000 shares or 9.5% of the outstanding shares of our common stock up to a ceiling of 8,932,921 shares.  No further awards will be made under the Incentive Plan, although existing awards will remain effective.  Stock options were issued at the current market price on the date of grant, subject to an immediate or four year vesting in four equal installments with a contractual term of 5 or 10 years.  The grant date fair value is calculated using the Black-Scholes option valuation model.  For a description of our Incentive Plan, see Note 14 to the Financial Statements.
 
The following table provides information as of December 31, 2010 concerning shares of our common stock authorized for issuance under the 2010 Incentive Plan and Incentive Plan (the Incentive Plans).

 
 
 
 
Plan Category
 
 
 
Number of securities to be issued upon exercise of outstanding options, warrants and rights
 
 
 
Weighted-average exercise price of outstanding options, warrants and rights
 
Number of securities remaining available for future issuance under the Incentive Plans (excluding previously issued)
Equity compensation plans approved by security holders
 
 
6,891,975
 
 
$15.33
 
 
25,181,850
Equity compensation plans not approved by security holders
 
 
-
 
 
-
 
 
-
Total
 
6,891,975
 
$15.33
 
25,181,850
 
 
36

 
 
ITEM 6.                SELECTED FINANCIAL DATA

The following selected financial data are derived from our audited financial statements for the years ended December 31, 2010, 2009, 2008, 2007, and 2006.  The selected financial data should be read in conjunction with the more detailed information contained in the Financial Statements and Notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Form 10-K.

  SELECTED FINANCIAL DATA>
(dollars in thousands, except for per share data)
 
Statement of Operations Data
    For the Year Ended December 31, 2010      For the Year Ended December 31, 2009       For the Year Ended December 31, 2008     For the Year Ended December 31, 2007     For the Year Ended December 31, 2006  
Interest income:
                                       
     Investment securities
  $ 2,676,307     $ 2,922,499     $ 3,115,428     $ 2,355,447     $ 1,221,882  
     Securities loaned
    3,997       103       -       -       -  
     U.S. Treasury Securities
    2,830       -       -       -       -  
       Total interest income
    2,683,134       2,922,602       3,115,428       2,355,447       1,221,882  
Interest expense:
                                       
     Repurchase agreements
    397,971       575,867       1,560,976       1,892,372       1,043,898  
     Interest rate swaps
    735,107       719,803       327,936       34,093       11,115  
     Convertible Senior Notes
    24,228       -       -       -       -  
     Securities borrowed
    3,377       92       -       -       -  
     U.S. Treasury Securities sold, not yet purchased
    2,649       -       -       -       -  
       Total interest expense
    1,163,332       1,295,762       1,888,912       1,926,465       1,055,013  
                                         
Net interest income
    1,519,802       1,626,840       1,226,516       428,982       166,869  
                                         
Other (loss) income:
                                       
     Investment advisory and service fees
    58,073       48,952       27,891       22,028       22,351  
     Gain (loss) on sale of Mortgage-Backed Securities and Agency debentures
    181,791       99,128       10,713       19,062       (3,862 )
     Gain on termination of interest rate swaps
    -       -       -       2,096       10,674  
     Income from trading securities
    -       -       9,695       19,147       3,994  
     Dividend income
    31,038       17,184       2,713       91       -  
     Loss on other-than-temporarily impaired securities
    -       -       (31,834 )     (1,189 )     (52,348 )
     Loss on receivable from Prime Broker
    -       (13,613 )     -       -       -  
     Unrealized gain (loss) on interest rate swaps
    (318,832 )     349,521       (768,268 )     -       -  
     Net loss on trading securities
    (2,351 )     -       -       -       -  
     Income from underwriting
    2,095       -       -       -       -  
       Total other (loss) income
    (48,186 )     501,172       (749,090 )     61,235       (19,191 )
                                         
Expenses:
                                       
     Distribution fees
    360       1,756       1,589       3,647       3,444  
     General and administrative expenses
    171,487       130,152       103,622       62,666       40,063  
      Total Expenses
    171,847       131,908       105,211       66,313       43,507  
                                         
     Impairment of intangible for customer relationships
    -       -       -       -       2,493  
                                         
Income before income (loss) on equity method
   investment, income taxes and noncontrolling interest
      1,299,769         1,996,104         372,215         423,904         101,678  
                                         
Income (loss) on equity method investment
    2,945       (252 )     -       -       -  
                                         
Income taxes
    (35,434 )     (34,381 )     (25,977 )     ( 8,870 )     (7,538 )
                                         
Income before noncontrolling interest
    1,267,280       1,961,471       346,238       415,034       94,140  
                                         
Noncontrolling interest
    -       -       58       650       324  
                                         
Net income
    1,267,280       1,961,471       346,180       414,384       93,816  
                                         
Dividends on preferred stock
    18,033       18,501       21,177       21,493       19,557  
                                         
Net income available to common shareholders
  $ 1,249,247     $ 1,942,970     $ 325,003     $ 392,891     $ 74,259  
                                         
Total assets
  $ 83,026,590     $ 69,376,190     $ 57,597,615     $ 54,002,514     $ 30,715,980  
6.00% Series B Cumulative Convertible Preferred Stock
  $ 40,032     $ 63,114     $ 96,042     $ 111,466     $ 111,466  
Basic net income per average common share
  $ 2.12     $ 3.55     $ 0.64     $ 1.32     $ 0.44  
Diluted net income per average common share
  $ 2.04     $ 3.52     $ 0.64     $ 1.31     $ 0.44  
Dividends declared per common share
  $ 2.65     $ 2.54     $ 2.08     $ 1.04     $ 0.57  
 
 
37

 
 
ITEM 7.      MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
Overview

We own, manage, and finance a portfolio of real estate related investments, including mortgage pass-through certificates, CMOs, Agency callable debentures, and other securities representing interests in or obligations backed by pools of mortgage loans.  Our principal business objective is to generate net income for distribution to our stockholders from the spread between the interest income on our interest-earning assets and the costs of borrowing to finance our acquisition of interest-earning assets and from dividends we receive from our subsidiaries.  Our wholly-owned subsidiaries offer diversified real estate, asset management and other financial services.  FIDAC and Merganser are our wholly-owned taxable REIT subsidiaries that are registered investment advisors that generate advisory and service fee income.  RCap is our wholly-owned broker dealer taxable REIT subsidiary which generates fee income.  We also own an investment fund.
 
We are primarily engaged in the business of investing, on a leveraged basis, in mortgage pass-through certificates, CMOs and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans issued or guaranteed by Freddie Mac, Fannie Mae and Ginnie Mae.  We also invest in Federal Home Loan Bank (or FHLB), Freddie Mac and Fannie Mae debentures.

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

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

We may acquire Agency mortgage-backed securities backed by single-family residential mortgage loans as well as securities backed by loans on multi-family, commercial or other real estate related properties.  To date, substantially all of the Agency mortgage-backed securities that we have acquired have been backed by single-family residential mortgage loans.

We have elected to be taxed as a REIT for federal income tax purposes.  Pursuant to the current federal tax regulations, one of the requirements of maintaining our status as a REIT is that we must distribute at least 90% of our REIT taxable income (determined without regard to the deduction for dividends paid and by excluding any net capital gain) to our stockholders, subject to certain adjustments.

The results of our operations are affected by various factors, many of which are beyond our control.  Our results of operations primarily depend on, among other things, our net interest income, the market value of our assets and the supply of and demand for such assets.  Our net interest income, which reflects the amortization of purchase premiums and accretion of discounts, varies primarily as a result of changes in interest rates, borrowing costs and prepayment speeds, the behavior of which involves various risks and uncertainties.  Prepayment speeds, as reflected by the Constant Prepayment Rate, or CPR, and interest rates vary according to the type of investment, conditions in financial markets, competition and other factors, none of which can be predicted with any certainty.  In general, as prepayment speeds on our Agency mortgage-backed securities portfolio increase, related purchase premium amortization increases, thereby reducing the net yield on such assets.  The CPR on our Agency mortgage-backed securities portfolio averaged 27%, 19% and 13% for the years ended December 31, 2010, 2009 and 2008, respectively.  Since changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our ability to effectively manage interest rate risks and prepayment risks while maintaining our status as a REIT.
 
 
38

 
 
  The table below provides quarterly information regarding our average balances, interest income, yield on assets, average repurchase agreement balances, interest expense, cost of funds, net interest income and net interest rate spreads for the quarterly periods presented.
 
   
Average
 Investment Securities
Held (1)
 
Total
Interest
Income
 
Yield on Average Investment Securities
   
Average
Balance of Repurchase Agreements
 
Interest Expense
 
Average Cost of Funds
   
Net Interest Income
 
Net Interest Rate Spread
 
(ratios for the quarters have been annualized, dollars in thousands)
 
   
Quarter Ended
  December 31, 2010
  $ 74,749,528   $ 682,087   3.65 %   $ 67,448,046   $ 304,013   1.80 %   $ 378,074   1.85 %
Quarter Ended
  September 30, 2010
  $ 69,242,085   $ 702,976   4.06 %   $ 62,034,137   $ 302,568   1.95 %   $ 400,408   2.11 %
Quarter Ended
  June 30, 2010
  $ 61,952,037   $ 643,682   4.16 %   $ 56,190,308   $ 280,242   2.00 %   $ 363,440   2.16 %
Quarter Ended
  March 31, 2010
  $ 61,983,900   $ 654,389   4.22 %   $ 55,298,875   $ 276,509   2.00 %   $ 377,880   2.22 %
(1) Does not reflect unrealized gains/(losses).

The following table presents the CPR experienced on our Agency mortgage-backed securities portfolio, on an annualized basis, for the quarterly periods presented.

Quarter Ended
 
CPR
December 31, 2010
23%
September 30, 2010
20%
June 30, 2010
32%
March 31, 2010
34%

We believe that the CPR in future periods will depend, in part, on changes in and the level of market interest rates across the yield curve, with higher CPRs expected during periods of declining interest rates and lower CPRs expected during periods of rising interest rates.

We continue to explore alternative business strategies, alternative investments and other strategic initiatives to complement our core business strategy of investing, on a leveraged basis, in high quality Investment Securities.  No assurance, however, can be provided that any such strategic initiative will or will not be implemented in the future.

For the purposes of computing ratios relating to equity measures, throughout this report, equity includes Series B preferred stock, which has been treated under GAAP as temporary equity.  In this “Management Discussion and Analysis of Financial Condition and Results of Operations”, net income attributable to controlling interest is referred to as net income.

Recent Developments

During the period of market dislocation that began in August 2007, fiscal and monetary policymakers established new liquidity facilities for primary dealers and commercial banks, reduced short-term interest rates, and passed legislation intended to address the challenges of mortgage borrowers and lenders.  In September 2008, Fannie Mae and Freddie Mac were placed into the conservatorship of the Federal Housing Finance Agency, or FHFA, their federal regulator, pursuant to its powers under The Federal Housing Finance Regulatory Reform Act of 2008, a part of the Housing and Economic Recovery Act of 2008.  In addition to FHFA becoming the conservator of Fannie Mae and Freddie Mac, the Treasury and FHFA  entered into Preferred Stock Purchase Agreements (PSPAs) between the Treasury and Fannie Mae and Freddie Mac pursuant to which the Treasury will ensure that each of Fannie Mae and Freddie Mac maintains a positive net worth.  On December 24, 2009, the Treasury amended the terms of the PSPAs with Fannie Mae and Freddie Mac to remove the $200 billion per institution limit established under the PSPAs until the end of 2012.  The Treasury also amended the PSPAs with respect to the requirements for Fannie Mae and Freddie Mac to reduce their portfolios.
 
 
39

 
 
In 2010, Freddie Mac and Fannie Mae began purchasing seriously delinquent mortgage loans out of securities that they currently guarantee.  The loans which they consider seriously delinquent are those loans that are more than 120 days past due.  The repurchases materially impacted the rate of principal prepayments on our Agency mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac because of higher premium amortization expense, a decline in higher yielding Agency mortgage-backed securities assets and an increase in lower yielding investments.  As of December 31, 2010, we had net purchase premiums of $2.3 billion, or 3.0% of current par value, on our Agency mortgage-backed securities.  In addition, the U.S. Government, the Board of Governors of the Federal Reserve System, or Federal Reserve, and other governmental and regulatory bodies may take other actions in the future to address the financial crisis and recovery from the crisis.

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (or the Dodd-Frank Act).  The Dodd-Frank Act provides for new regulations on financial institutions and creates new supervisory and advisory bodies, including the new Consumer Financial Protection Bureau.  The Dodd-Frank Act tasks many agencies with issuing a variety of new regulations, including rules related to mortgage origination and servicing, securitization and derivatives.  Because a significant number of regulations under the Dodd-Frank Act have either not yet been proposed or not yet been adopted in final form, it is not possible for us to predict how the Dodd-Frank Act will impact our business.

On February 11, 2011, the U.S Department of the Treasury issued a White Paper titled “Reforming America's Housing Finance Market” that lays out, among other things, proposals to limit or potentially wind down the role that Fannie Mae and Freddie Mac play in the mortgage market.  Any such proposals, if enacted, may have broad adverse implications for the mortgage-backed securities market and our business, operations and financial condition.  We expect such proposals to be the subject of significant discussion and it is not yet possible to determine whether or when such proposals may be enacted, what form any final legislation or policies might take and how proposals, legislation or policies emanating from the White Paper may impact the mortgage-backed securities market and our business, operations and financial condition.  We are evaluating the potential impact of the proposals set forth in the White Paper.
 
Market conditions are evolving on a number of fronts. Regulatory and technical dynamics continue to develop, and monetary policy initiatives, including additional large scale asset purchases by the Federal Reserve, continue to support asset prices and lower yields across a wide range of market sectors, including ours.

Critical Accounting Policies

Management’s discussion and analysis of financial condition and results of operations is based on the amounts reported in our financial statements.  These financial statements are prepared in conformity with GAAP.  In preparing the financial statements, management is required to make various judgments, estimates and assumptions that affect the reported amounts.  Changes in these estimates and assumptions could have a material effect on our financial statements.  The following is a summary of our policies most affected by management’s judgments, estimates and assumptions.

Fair Value of Investment Securities:  Investment Securities classified as available-for-sale are reported at fair value, based on market prices.  Although we generally intend to hold most of our Investment Securities until maturity, we may, from time to time, sell any of our Investment Securities as part our overall management of our portfolio.  Accordingly, we are required to classify all of our Investment Securities as available-for-sale.  Our policy is to determine fair values from internal sources and compare them to independent sources.  Fair values from internal prices are compared to independent sources for reasonableness.  Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.  The determination of whether a security is other-than-temporarily impaired involves judgments and assumptions based on subjective and objective factors.  Consideration is given to (1) our intent to sell the Investment Securities, (2) whether it is more likely than not that we will be required to sell the Investment Securities before recovery, or (3) whether we do not expect to recover the entire amortized cost basis of the Investment Securities.  Further, the security is analyzed for credit loss (the difference between the present value of cash flows expected to be collected and the amortized cost basis).  The credit loss, if any, will then be recognized in the statement of earnings, while the balance of impairment related to other factors will be recognized in other comprehensive income (or OCI).
 
 
40

 
 
Interest Income:  Interest income is accrued based on the outstanding principal amount of the Investment Securities and their contractual terms.  Premiums and discounts associated with the purchase of the Investment Securities are amortized or accreted into interest income over the projected lives of the securities using the interest method.  Our policy for estimating prepayment speeds for calculating the effective yield is to evaluate historical performance, Wall 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.

Derivative Financial Instruments/Hedging Activity:   Prior to the fourth quarter of 2008, we designated interest rate swaps as cash flow hedges, whereby the swaps were recorded at fair value on our balance sheet as assets and liabilities with any changes in fair value recorded in OCI.  In a cash flow hedge, a swap would exactly match the pricing date of the relevant repurchase agreement.  Through the end of the third quarter of 2008 we continued to be able to effectively match the swaps with the repurchase agreements therefore entering into effective hedge transactions.  However, due to the volatility of the credit markets, it is no longer practical to match the pricing dates of both the swaps and the repurchase agreements.

As a result, we voluntarily discontinued hedge accounting after the third quarter of 2008 through a combination of de-designating previously defined hedge relationships and not designating new contracts as cash flow hedges.  The de-designation of cash flow hedges requires that the net derivative gain or loss related to the discontinued cash flow hedge should continue to be reported in accumulated OCI, unless it is probable that the forecasted transaction will not occur by the end of the originally specified time period or within an additional two-month period of time thereafter.  We continue to hold repurchase agreements in excess of swap contracts and have no indication that interest payments on the hedged repurchase agreements are in jeopardy of discontinuing.  Therefore, the deferred losses related to these derivatives that have been de-designated will not be recognized immediately and will remain in OCI.  These losses are reclassified into earnings during the contractual terms of the swap agreements starting as of October 1, 2008.  Changes in the unrealized gains or losses on the interest rate swaps subsequent to September 30, 2008 are reflected in our statement of operations.

Results of Operations:

Net Income Summary

For the year ended December 31, 2010, our net income was $1.3 billion or $2.12 basic net income per average share available to common shareholders, as compared to $2.0 billion net income or $3.55 basic net income per average share related to common shareholders for the year ended December 31, 2009, and net income was $346.2 million or $0.64 basic net income per average share related to common shareholders for the year ended December 31, 2008.  Net income per average share decreased by $1.43 per average share available to common shareholders and total net income decreased $694.2 million for the year ended December 31, 2010, when compared to the year ended December 31, 2009.  We attribute the decrease in total net income for the year ended December 31, 2010 from the year ended December 31, 2009 in part to recording of unrealized loss related to interest rate swaps of $318.8 million for the year ended December 31, 2010, compared to an unrealized gain of $349.5 million which was recorded in for the year ended December 31, 2009.  Net income for the year ended December 31, 2010, also decreased due to net interest income decreasing by $107.0 million for the year ended December 31, 2010, as compared to the year ended December 31, 2009, due to the decline in the interest rate spread.

We attribute the increase in total net income for the year ended December 31, 2009 from the year ended December 31, 2008 in part to recording of unrealized gains related to interest rate swaps of $349.5 million for the year ended December 31, 2009, comparison to an unrealized loss of $768.3 million which was recorded in for the year ended December 31, 2008.  Net income for the year ended December 31, 2009, also increased due to net interest income increasing by $400.3 million for the year ended December 31, 2009, as compared to the year ended December 31, 2008, due to the improved interest rate spread.  For the year ended December 31, 2009, net gain on sale of Agency mortgage-backed securities was $99.1 million, as compared to a net gain of $10.7 million for the year ended December 31, 2008.

 
41

 
 
Net Income Summary
(dollars in thousands, except for per share data)
 
   
For the Years Ended December 31,
 
   
2010
   
2009
   
2008
 
Interest income
                 
  Investment Securities
  $ 2,676,307     $ 2,922,499     $ 3,115,428  
  Securities loaned
    3,997       103       -  
  U.S Treasury Securities
    2,830       -       -  
     Total interest income
    2,683,134       2,922,602       3,115,428  
                         
Interest expense
                       
  Repurchase agreements
    397,971       575,867       1,560,976  
  Interest rate swaps
    735,107       719,803       327,936  
  Convertible Notes
    24,228       -       -  
  Securities borrowed
    3,377       -       -  
  U.S Treasuries Sold, not yet purchased
    2,649       92       -  
    Total interest expense
    1,163,332       1,295,762       1,888,912  
                         
 Net interest income
    1,519,802       1,626,840       1,226,516  
                         
Other (loss) income:
                       
  Investment advisory and service fees
    58,073       48,952       27,891  
  Gain on sale of Mortgage-Backed Securities and agency debentures
    181,791       99,128       10,713  
  Income from trading securities
    -       -       9,695  
  Dividend income
    31,038       17,184       2,713  
  Loss on other-than-temporarily impaired securities
    -       -       (31,834 )
  Loss on receivable from Prime Broker
    -       (13,613 )     -  
  Unrealized (loss) gain on interest rate swaps
    (318,832 )     349,521       (768,268 )
  Net Loss on trading securities
    (2,351 )     -       -  
  Income from underwriting
    2,095       -       -  
     Total other (loss) income
    (48,186 )     501,172       (749,090 )
                         
Expenses:
                       
  Distribution fees
    360       1,756       1,589  
  General and administrative expenses
    171,487       130,152       103,622  
     Total expenses
    171,847       131,908       105,211  
                         
Income before income on equity method investment, income taxes
  and noncontrolling interest
    1,299,769       1,996,104       372,215  
                         
Income on equity method investment
    2,945       (252 )     -  
                         
Income taxes
    (35,434 )     (34,381 )     (25,977 )
                         
Net income
    1,267,280       1,961,471       346,238  
                         
Noncontrolling interest
    -       -       58  
                         
Net income attributable to controlling interest
    1,267,280       1,961,471       346,180  
                         
Dividends on preferred stock
    18,033       18,501       21,177  
                         
Net income available to common shareholders
  $ 1,249,247     $ 1,942,970     $ 325,003  
                         
Weighted average number of basic common shares outstanding
    588,192,659       546,973,036       507,024,596  
Weighted average number of diluted common shares outstanding
    625,307,174       553,129,907       507,024,596  
                         
Basic net income per average common share
  $ 2.12     $ 3.55     $ 0.64  
Diluted net income per average common share
  $ 2.04     $ 3.52     $ 0.64  
                         
Average total assets
  $ 76,242,938     $ 65,224,198     $ 58,540,508  
Average equity
  $ 9,701,233     $ 8,644,228     $ 6,679,431  
                         
Return on average total assets
    1.66 %     3.01 %     0.59 %
Return on average equity
    13.06 %     22.69 %     5.18 %
 
 
42

 
 
Interest Income and Average Earning Asset Yield

We had average earning assets of $67.0 billion, $58.6 billion, and $56.0 billion for the years ended December 31, 2010, 2009 and 2008, respectively. Our primary source of income is interest income. Our interest income was $2.7 billion, $2.9 billion and $3.1 billion for the years ended December 31, 2010, 2009, and 2008, respectively. The yield on average Interest Earning Assets was 4.01%, 4.99%, and 5.57% for the respective years. The prepayment speeds increased to an average of 27% CPR for the year ended December 31, 2010 from an average of 19% CPR for the year ended December 31, 2009. For the year ended December 31, 2010, as compared to the year ended December 31, 2009, interest income declined by $239.5 million, due to the decline in yield on average Interest Earning Assets of 98 basis points. Interest income decreased by $193.0 million for the year ended December 31, 2009, as compared to the year ended December 31, 2008, due to the decrease in yield on interest earning assets of 58 basis points.
 
Interest Expense and the Cost of Funds

Our largest expense is the cost of borrowed funds.  We had average borrowed funds of $60.2 billion and total interest expense of $1.2 billion for the year ended December 31, 2010.  We had average borrowed funds of $52.4 billion and total interest expense of $1.3 billion for the year ended December 31, 2009.  We had average borrowed funds of $50.3 billion and total interest expense of $1.9 billion for the year ended December 31, 2008.  Our average cost of funds was 1.93%, 2.47% and 3.76% for the years ended December 31, 2010, 2009 and 2008, respectively.  The cost of funds rate decreased by 54 basis points and the average borrowed funds increased by $7.8 billion for the year ended December 31, 2010 when compared to the year ended December 31, 2009.  The cost of funds rate decreased by 129 basis points and the average borrowed funds increased by $2.1 billion for the year ended December 31, 2009 when compared to the year ended December 31, 2008.  Interest expense for the year ended December 31, 2010 decreased by $132.4 million over the prior year due to the substantial decrease in the average cost of funds rate.  Interest expense for the year-ended December 31, 2009 decreased by $593.1 million when compared to interest expense for the year ended December 31, 2008. Our average cost of funds was 1.66% above average one-month LIBOR and 1.41% above average six-month LIBOR for the year ended December 31, 2010.  Our average cost of funds was 2.14% above average one-month LIBOR and 1.36% above average six-month LIBOR for the year ended December 31, 2009.  Our average cost of funds was 1.08% above average one-month LIBOR and 0.70% above average six-month LIBOR for the year ended December 31, 2008.
 
The table below shows our average borrowed funds and average cost of funds as compared to average one-month and average six-month LIBOR for the years ended December 31, 2010, 2009, 2008, 2007, and 2006 and the four quarters in 2010.
 
 
43

 
 
Average Cost of Funds
(Ratios for the four quarters in 2009 have been annualized, dollars in thousands)
 
   
 
 
 
Average Borrowed Funds
 
 
Interest-Bearing Liabilities at Period End
 
 
 
 
 
Interest Expense
 
 
 
 
Average Cost of Funds
   
 
 
Average One-Month LIBOR
   
 
 
Average Six-Month LIBOR