Item
3.
Quantitative and Qualitative Disclosures about Market Risk
Market
risk is the exposure to loss resulting from changes in interest rates, credit
spreads, foreign currency exchange rates, commodity prices and equity prices.
Because we are invested solely in U.S.-dollar denominated instruments, primarily
residential mortgage instruments, and our borrowings are also domestic and
U.S.
dollar denominated, we are not subject to foreign currency exchange, or
commodity and equity price risk; the primary market risk that we are exposed
to
is interest rate risk and its related ancillary risks. Interest rate risk is
highly sensitive to many factors, including governmental monetary and tax
policies, domestic and international economic and political considerations
and
other factors beyond our control. All of our market risk sensitive assets,
liabilities and related derivative positions are for non-trading purposes
only.
Management
recognizes the following primary risks associated with our business and the
industry in which we conduct business:
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Interest
rate and market (fair value) risk
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Liquidity
and funding risk
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Interest
Rate Risk
Our
primary interest rate exposure relates to the portfolio of adjustable-rate
mortgage loans and mortgage-backed securities we acquire, as well as our
variable-rate borrowings and related interest rate swaps and caps. Interest
rate
risk is defined as the sensitivity of our current and future earnings to
interest rate volatility, variability of spread relationships, the difference
in
re-pricing intervals between our assets and liabilities and the effect that
interest rates may have on our cash flows, especially the speed at which
prepayments occur on our residential mortgage related assets.
Changes
in the general level of interest rates can affect our net interest income,
which
is the difference between the interest income earned on interest earning assets
and our interest expense incurred in connection with our interest bearing debt
and liabilities. Changes in interest rates can also affect, among other things,
our ability to acquire loans and securities, the value of our loans, mortgage
pools and mortgage-backed securities, and our ability to realize gains from
the
resale and settlement of such originated loans.
In
our
investment portfolio, our primary market risk is interest rate risk. Interest
rate risk can be defined as the sensitivity of our portfolio, including future
earnings potential, prepayments, valuations and overall liquidity to changes
in
interest rates. We attempt to manage interest rate risk by adjusting portfolio
compositions, liability maturities and utilizing interest rate derivatives
including interest rate swaps and caps. Management’s goal is to maximize the
earnings potential of the portfolio while maintaining long term stable portfolio
valuations.
We
utilize a model based risk analysis system to assist in projecting portfolio
performances over a scenario of different interest rates. The model incorporates
shifts in interest rates, changes in prepayments and other factors impacting
the
valuations of our financial securities, including mortgage-backed securities,
repurchase agreements, interest rate swaps and interest rate caps.
Based
on
the results of this model, as of March 31, 2007, an instantaneous shift of
100
basis points in interest rates would result in an approximate decrease in the
net interest spread by 30-35 basis points as compared to our base line
projections over the next year.
The
following tables set forth information about financial instruments (dollar
amounts in thousands):
