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Section 1: 10-Q

Unassociated Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
______________
 
FORM 10-Q
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2009
 
OR
 
¨ 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ______________ to ______________
 
Commission File Number: 1-13991
 
MFA FINANCIAL, INC.
 (Exact name of registrant as specified in its charter)
______________
 
Maryland
(State or other jurisdiction of
incorporation or organization)
 
350 Park Avenue, 21st Floor, New York, New York
(Address of principal executive offices)
13-3974868
(I.R.S. Employer
Identification No.)
 
10022
(Zip Code)
 
(212) 207-6400
(Registrant’s telephone number, including area code)
______________

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes     ü  No       
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ___No ___
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer [ü]
 
Accelerated filer [  ]
 
       
Non-accelerated filer [  ]
 
Smaller reporting company [  ]
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 
        Yes        No   ü  
 
222,768,526 shares of the registrant’s common stock, $0.01 par value, were outstanding as of July 23, 2009.
 

 
TABLE OF CONTENTS
 
Page
PART I
FINANCIAL INFORMATION

Item 1.
Financial Statements
 
     
 
1
   
 
 
2
     
 
   3
     
 
4
     
 
   5
     
 
6
     
Item 2.
30
     
Item 3.
  41
     
Item 4.
     46
     
     
PART II
OTHER INFORMATION
     
Item 1.
47
     
Item 1A.
47
     
Item 4.
47
     
Item 6.
47
     
 
50 


 
MFA FINANCIAL, INC.
CONSOLIDATED BALANCE SHEETS
 
   
June 30,
2009
   
December 31,
2008
 
(In Thousands, Except Per Share Amounts)
 
(Unaudited)
       
Assets:
           
  Investment securities at fair value (including pledged mortgage-backed
    securities (“MBS”) of $8,766,779 and $10,026,638 at June 30, 2009
    and December 31, 2008, respectively)  (Notes 2(b), 3, 5, 7, 8 and 14)
  $ 9,417,042     $ 10,122,583  
  Cash and cash equivalents (Notes 2(c), 7 and 8)
    282,492       361,167  
  Restricted cash (Notes 2(d), 5 and 8)
    39,930       70,749  
  Interest receivable (Note 4)
    45,549       49,724  
  Real estate, net (Note 6)
    11,188       11,337  
  Securities held as collateral, at fair value (Notes 7, 8 and 14)
    -       17,124  
  Goodwill (Note 2(e))
    7,189       7,189  
  Prepaid and other assets
    2,804       1,546  
     Total Assets
  $ 9,806,194     $ 10,641,419  
                 
Liabilities:
               
  Repurchase agreements (Notes 7 and 8)
  $ 7,951,931     $ 9,038,836  
  Accrued interest payable
    14,851       23,867  
  Mortgage payable on real estate (Note 6)
    9,224       9,309  
  Interest rate swap agreements (“Swaps”), at fair value (Notes 2(l), 5,
   8 and 14)
    173,410       237,291  
  Obligations to return cash and security collateral, at fair value (Notes
   8 and 14)
    -       22,624  
  Dividends and dividend equivalents payable (Note 10(b))
    -       46,351  
  Accrued expenses and other liabilities
    6,196       6,064  
     Total Liabilities
  $ 8,155,612     $ 9,384,342  
                 
Commitments and contingencies (Note 9)
               
                 
Stockholders' Equity:
               
   Preferred stock, $.01 par value; series A 8.50% cumulative redeemable;
    5,000 shares authorized; 3,840 shares issued and outstanding at
    June 30, 2009 and December 31, 2008 ($96,000 aggregate
    liquidation preference) (Note 10)
  $ 38     $ 38  
  Common stock, $.01 par value; 370,000 shares authorized;
   222,459 and 219,516 issued and outstanding at June 30, 2009
   and December 31, 2008, respectively (Note 10)
    2,225       2,195  
  Additional paid-in capital, in excess of par
    1,793,315       1,775,933  
  Accumulated deficit
    (141,296 )     (210,815 )
  Accumulated other comprehensive loss (Note 12)
    (3,700 )     (310,274 )
     Total Stockholders’ Equity
  $ 1,650,582     $ 1,257,077  
     Total Liabilities and Stockholders’ Equity
  $ 9,806,194     $ 10,641,419  
 
The accompanying notes are an integral part of the consolidated financial statements.
 
1


MFA FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS

   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
(In Thousands, Except Per Share Amounts)
 
2009
   
2008
   
2009
   
2008
 
         
(Unaudited)
       
                         
Interest Income:
                       
Investment securities (Note 3)
  $ 126,477     $ 118,542     $ 258,630     $ 243,607  
Cash and cash equivalent investments
    260       2,151       871       5,182  
      Interest Income
    126,737       120,693       259,501       248,789  
                                 
      Interest Expense (Notes 5 and 7)
    58,006       76,661       130,143       170,133  
                                 
      Net Interest Income
    68,731       44,032       129,358       78,656  
                                 
Other-Than-Temporary Impairments:  (Note 3)
                               
Total other-than-temporary impairment losses
    (76,586 )     (4,017 )     (78,135 )     (4,868 )
Portion of loss recognized in other comprehensive income
    69,126       -       69,126       -  
      Net Impairment Losses Recognized in Earnings
    (7,460 )     (4,017 )     (9,009 )     (4,868 )
                                 
Other Income/(Loss):
                               
Net gain/(loss) on sale of MBS (Note 3)
    13,495       -       13,495       (24,530 )
Revenue from operations of real estate (Note 6)
    384       398       767       812  
Loss on early termination of Swaps, net (Note 5)
    -       -       -       (91,481 )
Miscellaneous other (loss)/income, net
    (1 )     87       43       179  
      Other Income/(Loss)
    13,878       485       14,305       (115,020 )
                                 
Operating and Other Expense:
                               
Compensation and benefits (Note 13)
    3,612       2,687       7,114       5,331  
Real estate operating expense and mortgage interest (Note 6)
    453       424       915       873  
New business initiative
    -       998       -       998  
Other general and administrative expense
    1,978       1,353       3,846       2,471  
      Operating and Other Expense
    6,043       5,462       11,875       9,673  
                                 
Net Income/(Loss) Before Preferred Stock Dividends
    69,106       35,038       122,779       (50,905 )
Less:  Preferred Stock Dividends (Note 10(a))
    2,040       2,040       4,080       4,080  
      Net Income/(Loss) to Common Stockholders
  $ 67,066     $ 32,998     $ 118,699     $ (54,985 )
                                 
Income/(Loss) Per Share of Common Stock-Basic and Diluted (Note 11)
  $ 0.30     $ 0.20     $ 0.53     $ (0.35 )
                                 
Dividends Declared Per Share of Common Stock (Note 10(b))
  $ 0.22     $ 0.18     $ 0.22     $ 0.18  
 
The accompanying notes are an integral part of the consolidated financial statements.
 
2

 
MFA FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
 
   
For the
Six Months
Ended
June 30, 2009
 
(In Thousands, Except Per Share Amounts)
 
(Unaudited)
 
       
Preferred Stock, Series A 8.50% Cumulative Redeemable – Liquidation
  Preference $25.00 per Share:
     
Balance at December 31, 2008 and June 30, 2009 (3,840 shares)
  $ 38  
         
Common Stock, Par Value $0.01:
       
Balance at December 31, 2008 (219,516 shares)
    2,195  
  Issuance of common stock  (2,943 shares)
    30  
Balance at June 30, 2009 (222,459 shares)
    2,225  
         
Additional Paid-in Capital, in excess of Par:
       
Balance at December 31, 2008
    1,775,933  
  Issuance of common stock, net of expenses
    16,515  
  Shares withheld for tax withholdings for exercise of common stock options
    (33 )
  Share-based compensation expense
    900  
Balance at June 30, 2009
    1,793,315  
         
Accumulated Deficit:
       
Balance at December 31, 2008
    (210,815 )
  Net income
    122,779  
  Dividends declared on common stock
    (48,996 )
  Dividends declared on preferred stock
    (4,080 )
  Dividends declared on dividend equivalent rights (“DERs”)
    (184 )
Balance at June 30, 2009
    (141,296 )
         
Accumulated Other Comprehensive Loss:
       
Balance at December 31, 2008
    (310,274 )
  Unrealized gains on investment securities, net
    242,693  
  Unrealized gains on Swaps
    63,881  
Balance at June 30, 2009
    (3,700 )
         
Total Stockholders' Equity at June 30, 2009
  $ 1,650,582  
 
The accompanying notes are an integral part of the consolidated financial statements.
 
3

 
MFA FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
   
Six Months Ended
 
   
June 30,
 
(In Thousands)
 
2009
   
2008
 
   
(Unaudited)
 
Cash Flows From Operating Activities:
           
Net income/(loss)
  $ 122,779     $ (50,905 )
Adjustments to reconcile net income/(loss) to net cash provided by operating activities:
               
Losses on sale of MBS
    -       25,101  
Gains on sales of MBS
    (13,495 )     (571 )
Losses on early termination of Swaps
    -       91,481  
Other-than-temporary impairment charges
    9,009       4,868  
Amortization of purchase premium on MBS, net of accretion of discounts
    7,729       10,910  
Decrease/(increase) in interest receivable
    4,175       (7,177 )
Depreciation and amortization on real estate
    221       236  
Increase in prepaid and other assets and other
    (910 )     (308 )
Increase in accrued expenses and other liabilities
    132       649  
Decrease in accrued interest payable
    (9,016 )     (43 )
Equity-based compensation expense
    900       639  
Negative amortization and principal accretion on investment securities
    (12 )     (339 )
   Net cash provided by operating activities
  $ 121,512     $ 74,541  
                 
Cash Flows From Investing Activities:
               
Principal payments on MBS and other investments securities
  $ 834,085     $ 809,416  
Proceeds from sale of MBS
    438,507       1,851,019  
Purchases of MBS and other investment securities
    (327,588 )     (4,954,094 )
Net additions to leasehold improvements, furniture, fixtures and real estate investment
    (460 )     (98 )
   Net cash provided/(used) by investing activities
  $ 944,544     $ (2,293,757 )
                 
Cash Flows From Financing Activities:
               
Principal payments on repurchase agreements
  $ (33,833,050 )   $ (27,731,494 )
Proceeds from borrowings under repurchase agreements
    32,746,145       29,515,656  
Payments made on termination of Swaps
    -       (91,481 )
Payments made for margin calls on repurchase agreements and Swaps
    (101,800 )     (140,724 )
Cash received for reverse margin calls on repurchase agreements and Swaps
    127,158       156,354  
Proceeds from issuances of common stock
    16,512       557,964  
Dividends paid on preferred stock
    (4,080 )     (4,080 )
Dividends paid on common stock and DERs
    (95,531 )     (45,455 )
Principal payments on mortgage loan
    (85 )     (77 )
   Net cash (used)/provided by financing activities
  $ (1,144,731 )   $ 2,216,663  
Decrease in cash and cash equivalents
  $ (78,675 )   $ (2,553 )
Cash and cash equivalents at beginning of period
  $ 361,167     $ 234,410  
Cash and cash equivalents at end of period
  $ 282,492     $ 231,857  
 
The accompanying notes are an integral part of the consolidated financial statements.
 
4


MFA FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME/(LOSS)
 
   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
(In Thousands)
 
2009
   
2008
   
2009
   
2008
 
         
(Unaudited)
       
                         
Net income/(loss) before preferred stock dividends
  $ 69,106     $ 35,038     $ 122,779     $ (50,905 )
Other Comprehensive Income/(Loss):
                               
Unrealized gain/(loss) on investment securities arising during the period, net
    124,419       (66,545 )     236,861       (56,797 )
Reclassification adjustment for MBS sales
    (12,377 )     -       (3,033 )     (8,241 )
Reclassification adjustment for net losses included in net income for other-than-temporary impairments
    7,460       2,117       8,865       1,506  
Unrealized gains on Swaps arising during period, net
    53,060       100,819       63,881       10,806  
Reclassification adjustment for net losses included in earnings from Swaps
    -       -       -       48,162  
Comprehensive income/(loss) before preferred stock dividends
  $ 241,668     $ 71,429     $ 429,353     $ (55,469 )
Dividends declared on preferred stock
    (2,040 )     (2,040 )     (4,080 )     (4,080 )
Comprehensive Income/(Loss) to Common Stockholders
  $ 239,628     $ 69,389     $ 425,273     $ (59,549 )
                                 
 
The accompanying notes are an integral part of the consolidated financial statements.
 
5

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
1.     Organization
 
MFA Financial, Inc. (the “Company”) was incorporated in Maryland on July 24, 1997 and began operations on April 10, 1998.  The Company has elected to be treated as a real estate investment trust (“REIT”) for federal income tax purposes.  In order to maintain its qualification as a REIT, the Company must comply with a number of requirements under federal tax law, including that it must distribute at least 90% of its annual REIT taxable income to its stockholders.  (See Note 10(b).)
 
On December 29, 2008, the Company filed Articles of Amendment with the State Department of Assessments and Taxation of Maryland changing its name from “MFA Mortgage Investments, Inc.” to “MFA Financial, Inc.”  The name change became effective on January 1, 2009.
 
2.     Summary of Significant Accounting Policies
 
(a)  Basis of Presentation and Consolidation
The interim unaudited financial statements of the Company have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted according to such SEC rules and regulations.  Management believes, however, that the disclosures included in these interim financial statements are adequate to make the information presented not misleading.  The accompanying financial statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2008.  In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at June 30, 2009 and results of operations for all periods presented have been made.  The results of operations for the six-month period ended June 30, 2009 should not be construed as indicative of the results to be expected for the full year.
 
The consolidated financial statements of the Company have been prepared on the accrual basis of accounting in accordance with GAAP.  The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  The consolidated financial statements of the Company include the accounts of all subsidiaries; significant intercompany accounts and transactions have been eliminated.
 
(b)  MBS/Investment Securities
The Company accounts for its investment securities in accordance with Statement of Financial Accounting Standards (“FAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“FAS 115”) which requires that investments in securities be designated as either “held-to-maturity,” “available-for-sale” or “trading” at the time of acquisition.  All of the Company’s investment securities are designated as available-for-sale and are carried at their fair value with unrealized gains and losses excluded from earnings and reported in other comprehensive income/(loss), a component of Stockholders’ Equity.  (See Note 2(j).)
 
Although the Company generally intends to hold its investment securities until maturity, it may, from time to time, sell any of its securities as part of the overall management of its business.  Upon the sale of an investment security, any unrealized gain or loss is reclassified out of accumulated other comprehensive income/(loss) to earnings as a realized gain or loss using the specific identification method.
 
Interest income is accrued based on the outstanding principal balance of the investment securities and their contractual terms.  Premiums and discounts associated with MBS that are issued or guaranteed as to principal and/or interest by a federally chartered corporation, such as Fannie Mae or Freddie Mac, or an agency of the U.S. Government, such as Ginnie Mae (collectively, “Agency MBS”) and non-Agency MBS rated AA and higher at the time of purchase, are amortized into interest income over the life of such securities using the effective yield method.  Amortization and adjustments to premium amortization are made for actual prepayment activity in accordance with FAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases” (“FAS 91”).
 
6

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
The Company accounts for its non-Agency MBS that were purchased at a deep discount and/or were rated below AA at the time of purchase in accordance with Emerging Issues Task Force (“EITF”) of the Financial Accounting Standards Board (“FASB”) Consensus No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” as amended by FASB Staff Position (“FSP”) No. EITF 99-20-1 “Amendments to the Impairment Guidance of EITF 99-20” (collectively, “EITF 99-20-1”).  Under EITF 99-20-1, management estimates, at the time of purchase (or at the time EITF 99-20-1 becomes applicable), the future expected cash flows and determines the effective interest rate based on the estimated cash flows.  Cash flow projections are an estimate based on the Company’s observation of current information and events and include assumptions related to interest rates, prepayment rates and the timing and amount of credit losses. On at least a quarterly basis, the Company reviews and, if appropriate, makes adjustments to its cash flow projections based on input and analysis received from external sources, internal models, and its judgment about interest rates, prepayment rates, the timing and amount of credit losses, and other factors.  Changes in cash flows from those originally projected, or from those estimated at the last evaluation, may result in a prospective change in interest income and the prospective yield recognized on such securities.  (See Notes 2(n) and 3.)
 
The Company determines the fair value of its Agency MBS based upon prices obtained from a third-party pricing service, which are indicative of market activity.  In determining the fair value of its non-Agency MBS, management judgment is used to arrive at fair value that considers prices obtained from a third-party pricing service, broker quotes received and other applicable market based data.  If listed prices or quotes are not available, then fair value is based upon internally developed models that primarily use observable market-based inputs, in order to arrive at the securities fair value. (See Note 14.)  When the fair value of an investment is less than its amortized cost at the balance sheet date of the reporting period for which impairment is assessed, the impairment is designated as either “temporary” or “other-than-temporary.”  The Company assesses its securities for other-than-temporary impairment on at least a quarterly basis, applying the guidance prescribed in FSP No. FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” and, by FSP No. FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments,” (“FSP 115-2”), which was adopted April 1, 2009 and EITF 99-20-1, which was adopted by the Company on December 31, 2008.
 
If the Company intends to sell an impaired security, or it is more likely than not that it will be required to sell the impaired security before its anticipated recovery, then it must recognize an other-than-temporary impairment through earnings equal to the entire difference between the investment’s amortized cost and its fair value at the balance sheet date.  If the Company does not expect to sell an other-than-temporarily impaired security, only the portion of the other-than-temporary impairment related to credit losses is recognized through earnings.  The amount of credit impairment is determined by comparing the amortized cost of an impaired security to the present value of cash flows expected to be collected, discounted at the security’s yield prior to recognizing the impairment.  The portion of the other-than-temporary impairment related to all other factors is recognized as a component of other comprehensive income/(loss) on the consolidated balance sheet.   (See Note 2(n).)
 
Following the recognition of an other-than-temporary impairment, a new cost basis is established and may not be adjusted for subsequent recoveries in fair value through earnings.  Other-than-temporary impairments recognized through earnings may be accreted back to the amortized cost basis of the security through interest income, while amounts recognized through other comprehensive loss do not impact earnings.  Because management’s assessments are based on factual information as well as subjective information available at the time of assessment, the determination as to whether an other-than-temporary impairment exists and, if so, the amount considered other-than-temporarily impaired is subjective and, therefore, the timing and amount of other-than-temporary impairments constitute material estimates that are susceptible to significant change.  (See Note 3.)
 
Certain of the Company’s non-Agency MBS were purchased at a deep discount to par value, with a portion of such discount considered credit protection against future credit losses.  The initial credit protection (i.e., discount) on these MBS may be adjusted over time, based on the performance of the security, its underlying collateral, actual and projected cash flow from such collateral, economic conditions and other factors.  If the performance of these securities is more favorable than forecasted, a portion of the amount designated as credit discount may be accreted into interest income over time.  Conversely, if the performance of these securities is less favorable than forecasted, impairment charges and write-downs of such securities to a new cost basis could result.
 
The Company’s MBS pledged as collateral against repurchase agreements and Swaps are included in investment securities on the Consolidated Balance Sheets with the fair value of the MBS pledged disclosed parenthetically.  (See Notes 3, 5, 7, 8 and 14.)
 
7

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
(c)  Cash and Cash Equivalents
Cash and cash equivalents include cash on deposit with financial institutions and investments in high quality money market funds, all of which have original maturities of three months or less.  Cash and cash equivalents may also include cash pledged as collateral to the Company by its repurchase agreement and/or Swap counterparties as a result of reverse margin calls (i.e., margin calls made by the Company).  The Company did not hold any cash pledged by its counterparties at June 30, 2009 and held $5.5 million of cash pledged by its counterparties at December 31, 2008.  At June 30, 2009, all of the Company’s cash investments were in high quality overnight money market funds.  (See Note 8.)
 
(d)  Restricted Cash
Restricted cash represents the Company’s cash held by counterparties as collateral against the Company’s Swaps and/or repurchase agreements.  Restricted cash, which earns interest, is not available to the Company for general corporate purposes, but may be applied against amounts due to Swap or repurchase agreement counterparties or returned to the Company when the collateral requirements are exceeded or at the maturity of the Swap or repurchase agreement.  The Company had restricted cash, held as collateral against its Swaps of $39.9 million and $70.7 million at June 30, 2009 and December 31, 2008, respectively.  (See Notes 5 and 8.)
 
(e)  Goodwill
The Company accounts for its goodwill in accordance with FAS No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”) which provides, among other things, how entities are to account for goodwill and other intangible assets that arise from business combinations or are otherwise acquired.  FAS 142 requires that goodwill be tested for impairment annually or more frequently under certain circumstances.  At June 30, 2009 and December 31, 2008, the Company had goodwill of $7.2 million, which represents the unamortized portion of the excess of the fair value of its common stock issued over the fair value of net assets acquired in connection with its formation in 1998.  Goodwill is tested for impairment at least annually at the entity level and, through June 30, 2009, the Company had not recognized any impairment against its goodwill.
 
(f)  Real Estate
At June 30, 2009, the Company indirectly held 100% of the ownership interest in Lealand Place, a 191-unit apartment property located in Lawrenceville, Georgia (“Lealand”), which is consolidated with the Company.  This property was acquired through a tax-deferred exchange under Section 1031 of the Internal Revenue Code of 1986, as amended (the “Code”).  (See Note 6.)
 
The property, capital improvements and other assets held in connection with this investment are carried at cost, net of accumulated depreciation and amortization.  Maintenance, repairs and minor improvements are expensed in the period incurred, while real estate assets, except land, and capital improvements are depreciated over their useful life using the straight-line method.
 
(g)  Repurchase Agreements
The Company finances the acquisition of a significant portion of its MBS with repurchase agreements.  Under repurchase agreements, the Company sells securities to a lender and agrees to repurchase the same securities in the future for a price that is higher than the original sale price.  The difference between the sale price that the Company receives and the repurchase price that the Company pays represents interest paid to the lender.  Although structured as a sale and repurchase, under its repurchase agreements, the Company pledges its securities as collateral to secure the borrowing, which is equal in value to a specified percentage of the fair value of the pledged collateral, while the Company retains beneficial ownership of the pledged collateral.  At the maturity of a repurchase agreement, the Company is required to repay the loan and concurrently receives back its pledged collateral from the lender.  With the consent of the lender, the Company may renew a repurchase agreement at the then prevailing financing terms.  Margin calls, whereby a lender requires that the Company pledge additional securities or cash as collateral to secure borrowings under its repurchase agreements with such lender, are routinely experienced by the Company as the value of the MBS pledged as collateral declines as the MBS principal is repaid, or if the fair value of the MBS pledged as collateral declines due to changes in market interest rates, spreads or other market conditions.  To date, the Company had satisfied all of its margin calls and has never sold assets to meet any margin calls.  (See Notes 7 and 8.)
 
8

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
The Company’s repurchase agreements typically have terms ranging from one month to three months at inception, with some having longer terms.  Should a counterparty decide not to renew a repurchase agreement at maturity, the Company must either refinance elsewhere or be in a position to satisfy the obligation.  If, during the term of a repurchase agreement, a lender should file for bankruptcy, the Company might experience difficulty recovering its pledged assets which could result in an unsecured claim against the lender for the difference between the amount loaned to the Company plus interest due to the counterparty and the fair value of the collateral pledged to such lender.  The Company generally seeks to diversify its exposure by entering into repurchase agreements with multiple counterparties with a maximum loan from any lender of no more than three times the Company’s stockholders’ equity.  At June 30, 2009, the Company had outstanding balances under repurchase agreements with 18 separate lenders with a maximum amount at risk (the difference between the amount loaned to the Company, including interest payable, and the fair value of securities pledged by the Company as collateral, including accrued interest on such securities) to any single lender of $116.0 million, or 7.0% of stockholders’ equity, related to repurchase agreements.  (See Note 7.)
 
(h)  Equity Based Compensation
The Company accounts for its stock-based compensation in accordance with FAS No. 123R, “Share-Based Payment,” (“FAS 123R”).  The Company uses the Black-Scholes-Merton option model to value its stock options.  There are limitations inherent in this model, as with all other models currently used in the market place to value stock options.  For example, the Black-Scholes-Merton option model was not designed to value stock options which contain significant restrictions and forfeiture risks, such as those contained in the stock options that have been granted by the Company.  Significant assumptions are made in order to determine the Company’s option value, all of which are subjective.  The fair value of the Company’s stock options are expensed using the straight-line method.
 
Pursuant to FAS 123R, compensation expense for restricted stock awards, restricted stock units (“RSUs”) and stock options is recognized over the vesting period of such awards, based upon the fair value of such awards at the grant date.  Payments pursuant to DERs, which are attached to certain awards are charged to stockholders’ equity when declared.  Equity based awards for which there is no risk of forfeiture are expensed upon grant, or at such time that there is no longer a risk of forfeiture.  The Company applies a zero forfeiture rate for its equity based awards, given that such awards have been granted to a limited number of employees, and that historical forfeitures have been minimal.  Should information arise indicating that forfeitures may occur, the forfeiture rate would be revised and accounted for as a change in estimate.
 
Forfeiture provisions for dividends and DERs on unvested equity instruments on the Company’s equity based awards vary by award.  To the extent that equity awards do not vest and grantees are not required to return such dividend payments to the Company, additional compensation expense is recorded at the time an award is forfeited.  (See Note 13.)
 
(i)  Earnings per Common Share (“EPS”)
Basic EPS is computed by dividing net income/(loss) allocable to common stockholders by the weighted average number of shares of common stock outstanding during the period, which also includes participating securities representing unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents.  Diluted EPS is computed by dividing net income available to holders of common stock by the weighted average shares of common stock and common equivalent shares outstanding during the period.  For the diluted EPS calculation, common equivalent shares outstanding includes the weighted average number of shares of common stock outstanding adjusted for the effect of dilutive unexercised stock options and RSUs outstanding using the treasury stock method.  Under the treasury stock method, common equivalent shares are calculated assuming that all dilutive common stock equivalents are exercised and the proceeds, along with future compensation expenses for unvested stock options and RSUs, are used to repurchase shares of the Company’s outstanding common stock at the average market price during the reported period.  No common share equivalents are included in the computation of any diluted per share amount for a period in which a net operating loss is reported.
 
The Company’s adoption of FSP No. EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” (“EITF 03-6-1”) on January 1, 2009 did not have a material impact on the Company’s historical EPS.  (See Notes 2(n) and 11.)
 
(j)  Comprehensive Income/Loss
The Company’s comprehensive income/(loss) includes net income/(loss), the change in net unrealized gains/(losses) on its investment securities and hedging instruments, adjusted by realized net gains/(losses) included in net income/(loss) for the period and is reduced by dividends declared on the Company’s preferred stock.
 
9

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
(k)  U.S. Federal Income Taxes
The Company has elected to be taxed as a REIT under the provisions of the Code and the corresponding provisions of state law.  The Company expects to operate in a manner that will enable it to continue to be taxed as a REIT.  A REIT is not subject to tax on its earnings to the extent that it distributes its REIT taxable income to its stockholders.  As such, no provision for current or deferred income taxes has been made in the accompanying consolidated financial statements.
 
(l)  Derivative Financial Instruments/Hedging Activity
As part of the Company’s interest rate risk management process, it periodically hedges a portion of its interest rate risk by entering into derivative financial instrument contracts.  The Company’s derivatives are entirely comprised of Swaps, which have the effect of modifying the interest rate repricing characteristics of the Company’s repurchase agreements and cash flows for such liabilities.  The Company does not enter into derivative transactions for speculative or trading purposes.  The Company accounts for its Swaps in accordance with FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (“FAS 133”).  No cost is incurred at the inception of a Swap, under which the Company agrees to pay a fixed rate of interest and receive a variable interest rate, generally based on one-month or three-month London Interbank Offered Rate (“LIBOR”), on the notional amount of the Swap.  The Company documents its risk-management policies, including objectives and strategies, as they relate to its hedging activities, and upon entering into hedging transactions, documents the relationship between the hedging instrument and the hedged liability.  The Company assesses, both at inception of a hedge and on a quarterly basis thereafter, whether or not the hedge is “highly effective,” in accordance with FAS 133.
 
The Company discontinues hedge accounting on a prospective basis and recognizes changes in the fair value through earnings when:  (i) it is determined that the derivative is no longer effective in offsetting cash flows of a hedged item (including forecasted transactions); (ii) it is no longer probable that the forecasted transaction will occur; or (iii) it is determined that designating the derivative as a hedge is no longer appropriate.
 
Swaps are carried on the Company’s balance sheet at fair value, as assets, if their fair value is positive, or as liabilities, if their fair value is negative.  Since the Company’s Swaps are designated as “cash flow hedges,” changes in their fair value is recorded in other comprehensive income/(loss) provided that the hedge remains effective.  A change in fair value for any ineffective amount of the Company’s Swaps would be recognized in earnings.  The Company has not recognized any change in the value of its existing Swaps through earnings as a result of ineffectiveness of the hedge, except that the Company recognized all gains and losses realized on Swaps that were terminated early, as all of the associated hedges were deemed ineffective.
 
FASB Interpretation (“FIN”) No. 39-1, “Amendment of FIN No. 39” (“FIN 39-1”), defines “right of setoff” and specifies the conditions that must be met for a derivative contract to qualify for this right of setoff.  FIN 39-1 also addresses the applicability of a right of setoff to derivative instruments and clarifies the circumstances in which it is appropriate to offset amounts recognized for those instruments in the balance sheet.  In addition, FIN 39-1 permits offsetting of fair value amounts recognized for multiple derivative instruments executed with the same counterparty under a master netting arrangement and fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) arising from the same master netting arrangement as the derivative instruments.  The Company’s adoption of FIN 39-1 on January 1, 2008 did not have any impact on its consolidated financial statements, as the Company does not offset cash collateral receivables or payables against its net derivative positions.  (See Notes 5, 8 and 14.)
 
(m)  Fair Value Measurements and The Fair Value Option for Financial Assets and Financial Liabilities
The Company applies the provisions of FAS No. 157, “Fair Value Measurements” (“FAS 157”), which defines fair value, provides a framework for measuring fair value in accordance with GAAP and sets forth certain disclosures about fair value measurements.  FAS 157 stipulates that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability.  The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability.  FAS 157 provides a consistent definition of fair value which focuses on exit price and prioritizes, the use of market-based inputs over entity-specific inputs when determining fair value.  In addition, FAS 157 provides a framework for measuring fair value, and establishes a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date.  (See Notes 2(n) and 14.)
 
10

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
In October 2008, the FASB issued FSP No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP 157-3”).  FSP 157-3 clarifies the application of FAS 157 in a market that is not active and provides an example to illustrate key consideration in determining the fair value of a financial asset when the market for that financial asset is not active.  The issuance of FSP 157-3 did not have a material impact on the Company’s determination of fair value for its financial assets.
 
FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”), permits entities to elect to measure many financial instruments and certain other items at fair value.  Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date.  A decision to elect the fair value option for an eligible financial instrument, which may be made on an instrument by instrument basis, is irrevocable.  The adoption of FAS 159 on January 1, 2008 did not have any impact on the Company’s consolidated financial statements, as it did not elect the fair value option for any of its assets or liabilities.
 
(n)  Adoption of New Accounting Standards and Interpretations
Accounting for Transfers of Financial Assets and Repurchase Financing Transactions
On January 1, 2009, the Company adopted FSP No. 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions” (“FSP 140-3”), which provides guidance on accounting for transfers of financial assets and repurchase financings.  FSP 140-3 presumes that an initial transfer of a financial asset and a repurchase financing are considered part of the same arrangement (i.e., a linked transaction) under FAS No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“FAS 140”).  However, if certain criteria are met, as described in FSP 140-3, the initial transfer and repurchase financing shall not be evaluated as a linked transaction and shall be evaluated separately under FAS 140.  If the linked transaction does not meet the requirements for sale accounting, the linked transaction shall generally be accounted for as a forward contract, as opposed to the current presentation, where the purchased asset and the repurchase liability are reflected separately on the balance sheet.  The adoption of FSP 140-3 had no impact on the Company’s consolidated financial statements, as the Company has not entered into any linked transactions since its adoption.
 
Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities
On January 1, 2009, the Company adopted EITF 03-6-1, which provides that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of basic earnings per share pursuant to the two-class method.  EITF 03-6-1 requires that all previously reported EPS data is retrospectively adjusted to conform with the provisions of EITF 03-6-1.  The Company’s adoption of EITF 03-6-1 on January 1, 2009 did not have a material impact on the Company’s historical EPS amounts.
 
New FASB Staff Positions
In April 2009, the FASB issued three Staff Positions, that were required to be adopted concurrently, which included: (i) FSP FAS 115-2, (ii) Staff Position No. FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for an Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly,” (“FSP FAS 157-4”), and (iii) Staff Position No. FAS 107-1 and Accounting Principles Board 28-1, “Interim Disclosures About Fair Value of Financial Instruments, (“FSP FAS 107-1”).  The Company adopted these Staff Positions as of April 1, 2009.
 
As discussed in Note 2(b), FSP FAS 115-2 provides additional guidance for other-than-temporary impairments on debt securities.  In addition to existing guidance, under FSP FAS 115-2, an other-than-temporary impairment is deemed to exist if an entity does not expect to recover the entire amortized cost basis of a security.  Among other things, FSP FAS 115-2 addresses: (i) the determination as to when an investment is considered impaired; (ii) whether that impairment is other-than-temporary; (iii) the measurement of an impairment loss; (iv) accounting considerations subsequent to the recognition of an other-than-temporary impairment; and (v) certain required disclosures about unrealized losses that have not been recognized as other-than-temporary impairments.  Should an other-than-temporary impairment be deemed to have occurred, for a security that the Company expects to continue to hold, the security is written down, with the total other-than-temporary impairment bifurcated into (i) the amount related to credit losses, which are recognized through earnings, and (ii) the amount related to all other factors, which are recognized as a component of other comprehensive income.  The disclosures required by FSP FAS 115-2, are included in Note 3 to the consolidated financial statements.  The Company’s adoption of FSP FAS 115-2 on April 1, 2009 required a reassessment of all securities which were other-than-temporarily impaired through March 31, 2009. This reassessment did not result in a cumulative effect adjustment to any component of stockholders’ equity in connection with the adoption of FSP FAS 115-2.
 
11

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
FSP FAS 157-4 provides additional guidance for fair value measures under FAS 157 in determining if the market for an asset or liability is inactive and, accordingly, if quoted market prices may not be indicative of fair value.  The adoption of FSP FAS 157-4 did not have a material impact on the Company’s consolidated financial statements.
 
FSP FAS 107-1 extends the existing disclosure requirements related to the fair value of financial instruments to interim periods that were previously only required in annual financial statements.  Given that FSP FAS 107-1 provides for additional disclosures, its adoption did not have any impact on the Company’s consolidated financial statements.  The disclosure requirements under FSP FAS 107-1 are included in Note 14 to the consolidated financial statements.
 
(o)  Reclassifications
Certain prior period amounts have been reclassified to conform to the current period presentation.
 
12

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
3.      Investment Securities
 
At June 30, 2009 and December 31, 2008, the Company’s investment securities portfolio consisted primarily of MBS secured by hybrid mortgages that have a fixed interest rate for a specified period, typically three to ten years, and, thereafter, generally reset annually (“Hybrids”), and adjustable-rate mortgages (“ARMs”) (collectively, “ARM-MBS”).  The Company’s ARM-MBS are primarily comprised of Agency MBS and, to a lesser extent, non-Agency MBS.  In addition, the Company may have investments in other mortgage-related securities and other investments, which may or may not be rated.  The Company may pledge its MBS as collateral against its repurchase agreements and Swaps.  (See Note 8.)
 
Agency MBS: Agency MBS are guaranteed as to principal and/or interest by a federally chartered corporation, such as Fannie Mae or Freddie Mac, or an agency of the U.S. Government, such as Ginnie Mae, and, as such, carry an implied AAA rating.  The payment of principal and/or interest on Ginnie Mae MBS is backed by the full faith and credit of the U.S. Government.  During the third quarter of 2008, Fannie Mae and Freddie Mac were placed in conservatorship under the newly-created Federal Housing Finance Agency, which significantly strengthened the backing for these guarantors.
 
Non-Agency MBS:  The Company’s non-Agency MBS, which are primarily comprised of residential MBS which are the most senior tranches from the MBS structure (“Senior MBS”), are certificates that are secured by pools of residential mortgages, which are not guaranteed by the U.S. Government, any federal agency or any federally chartered corporation.  The Company’s Senior MBS are rated by a nationally recognized rating agency, such as Moody’s Investors Services, Inc. (“Moody’s”), Standard & Poor’s Corporation (“S&P”) or Fitch, Inc. (collectively, “Rating Agencies”).  At June 30, 2009, the Company’s non-Agency MBS were rated from AAA to C by one or more of the Rating Agencies or were unrated (i.e., not assigned a rating by any Rating Agency).  The rating indicates the opinion of the Rating Agency as to the credit worthiness of the investment, indicating the obligor’s ability to meet its financial commitment on the obligation.
 
The following table presents certain information about the Company's investment securities at June 30, 2009 and December 31, 2008:

June 30, 2009
 
(In Thousands)
 
Principal/ Current Face
   
Purchase Premiums
   
Purchase Discounts (1)
   
Amortized Cost (2)
   
Carrying Value/
Fair Value
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Net Unrealized Gain/(Loss)
 
Agency MBS:
                                               
   Fannie Mae
  $ 7,837,043     $ 104,532     $ (663 )   $ 7,940,912     $ 8,176,098     $ 243,808     $ (8,622 )   $ 235,186  
   Freddie Mac
    632,397       9,599       -       657,126       673,309       16,623       (440 )     16,183  
   Ginnie Mae
    26,660       474       -       27,134       27,605       471       -       471  
  Total Agency MBS
    8,496,100       114,605       (663 )     8,625,172       8,877,012       260,902       (9,062 )     251,840  
Senior MBS (3):
                                                         
   Rated AAA
    87,993       1,245       (14,942 )     74,296       58,015       2,225       (18,506 )     (16,281 )
   Rated AA
    3,331       31       (657 )     2,705       2,521       309       (493 )     (184 )
   Rated A
    34,142       56       (6,910 )     27,288       23,385       469       (4,372 )     (3,903 )
   Rated BBB
    104,556       323       (38,622 )     66,257       58,883       3,410       (10,784 )     (7,374 )
   Rated BB
    62,418       59       (27,263 )     35,214       36,186       3,224       (2,252 )     972  
   Rated B
    324,014       -       (74,054 )     243,883       199,629       8,192       (52,446 )     (44,254 )
   Rated CCC
    266,484       -       (143,185 )     123,299       128,943       7,336       (1,692 )     5,644  
   Rated CC
    29,791       -       (17,514 )     12,277       12,581       304       -       304  
   Rated C
    38,633       -       -       36,733       19,736       -       (16,997 )     (16,997 )
  Total Senior MBS
    951,362       1,714       (323,147 )     621,952       539,879       25,469       (107,542 )     (82,073 )
Other Non-Agency MBS
    2,141       -       (78 )     208       151       8       (65 )     (57 )
    Total MBS
  $ 9,449,603     $ 116,319     $ (323,888 )   $ 9,247,332     $ 9,417,042     $ 286,379     $ (116,669 )   $ 169,710  
 
13

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
Table continued
 
December 31, 2008
 
(In Thousands)
 
Principal/ Current Face
   
Purchase Premiums
   
Purchase Discounts (1)
   
Amortized Cost (2)
   
Carrying Value/
Fair Value
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Net Unrealized Gain/(Loss)
 
Agency MBS:
                                               
   Fannie Mae
  $ 8,986,206     $ 115,106     $ (1,401 )   $ 9,099,911     $ 9,156,030     $ 78,148     $ (22,029 )   $ 56,119  
   Freddie Mac
    714,110       10,753       -       732,248       732,719       3,462       (2,991 )     471  
   Ginnie Mae
    30,017       532       -       30,549       29,864       -       (685 )     (685 )
  Total Agency MBS
    9,730,333       126,391       (1,401 )     9,862,708       9,918,613       81,610       (25,705 )     55,905  
Senior MBS (3):
                                                         
   Rated AAA
    106,191       1,487       (7,290 )     100,388       71,418       961       (29,931 )     (28,970 )
   Rated AA
    29,064       352       -       29,416       17,767       -       (11,649 )     (11,649 )
   Rated A
    115,213       -       (1,845 )     113,368       67,346       269       (46,291 )     (46,022 )
   Rated BBB
    10,524       91       (2,705 )     7,910       4,999       66       (2,977 )     (2,911 )
   Rated BB
    79,700       -       (626 )     79,074       41,075       -       (37,999 )     (37,999 )
   Rated CCC
    1,852       -       (931 )     921       989       68       -       68  
  Total Senior MBS
    342,544       1,930       (13,397 )     331,077       203,594       1,364       (128,847 )     (127,483 )
Other Non-Agency MBS
    2,161       -       (197 )     1,781       376       -       (1,405 )     (1,405 )
     Total MBS
  $ 10,075,038     $ 128,321     $ (14,995 )   $ 10,195,566     $ 10,122,583     $ 82,974     $ (155,957 )   $ (72,983 )
                                                                 
(1) Purchase discounts included $219.8 million and $5.9 million of discounts designated as credit reserves at June 30, 2009 and December 31, 2008, respectively. These credit discounts are not expected to be accreted into interest income.
 
(2) Includes principal payments receivable, which are not included in the Principal/Current Face. Amortized cost is reduced by other-than-temporary impairments recognized through earnings.
 
(3) The Company’s non-Agency MBS are reported based on the lowest rating issued by a Rating Agency at the date presented.
 

Unrealized Losses on Investment Securities
 
The following table presents information about the Company’s investment securities that were in an unrealized loss position at June 30, 2009:
 
   
Unrealized Loss Position For:
       
   
Less than 12 Months
   
12 Months or more
   
Total
 
(In Thousands)
 
Fair
Value
   
Unrealized losses
   
Number of Securities
   
Fair
Value
   
Unrealized losses
   
Number of Securities
   
Fair
Value
   
Unrealized losses
 
Agency MBS:
                                               
  Fannie Mae
  $ 3,413     $ 25       6     $ 448,375     $ 8,597       63     $ 451,788     $ 8,622  
  Freddie Mac
    1,110       8       1       21,451       432       17       22,561       440  
  Total Agency MBS
    4,523       33       7       469,826       9,029        80       474,349       9,062  
Senior MBS:
                                                               
  Rated AAA
    -       -       -       40,253       18,506       4       40,253       18,506  
  Rated AA
    -       -       -       1,126       493       2       1,126       493  
  Rated A
    -       -       -       13,415       4,372       3       13,415       4,372  
  Rated BBB
    5,586       55       1       17,485        10,729       2       23,071        10,784  
  Rated BB
    9,256       275       1       3,090        1,977       1       12,346        2,252  
  Rated B
    26,655       317       3       91,774       52,129       1       118,429       52,446  
  Rated CCC
    61,167       1,692       7       -       -       -       61,167       1,692  
  Rated C
    -       -       -       19,736       16,997       3       19,736       16,997  
  Total Senior MBS
    102,664       2,339       12       186,879       105,203       16       289,543       107,542  
  Other Non-Agency MBS
    121       65       2       -       -       -       121       65  
    Total MBS
  $ 107,308     $ 2,437       21     $ 656,705     $ 114,232       96     $ 764,013     $ 116,669  
 
During the three months ended June 30, 2009, the Company sold 20 Agency MBS with an amortized cost of $425.0 million, realizing gross gains of $13.5 million.  These securities were sold to decrease the Company’s exposure to potential increases in interest rates in future years.  During March 2008, in response to tightening of market credit conditions, the Company adjusted its balance sheet strategy, decreasing the target range for its debt-to-equity multiple.  In order to reduce its borrowings, the Company sold MBS with an amortized cost of $1.876 billion and realized aggregate net losses of $24.5 million, comprised of gross losses of $25.1 million and gross gains of $571,000.
14

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
All of the unrealized gains on the Company’s Senior MBS were on the Senior MBS acquired by the Company through its wholly-owned subsidiary MFResidential Assets I, LLC (“MFR”), while $105.3 million of the gross unrealized losses were related to non-Agency MBS purchased by the Company prior to July 2007.  At June 30, 2009, the Company had borrowings under repurchase agreements of $96.5 million (1.2% of repurchase borrowings) against its non-Agency MBS portfolio.
 
Certain of the Company’s MBS have amortized costs that are in excess of their fair values.  This difference can be caused by, among other things, changes in interest rates, changes in credit spreads, realized/unrealized losses in the underlying securities and general market conditions. When such differences are credit related or the Company intends to sell securities in an unrealized loss position, the Company recognizes other-than-temporary impairments through earnings.
 
During the three and six months ended June 30, 2009, the Company recognized aggregate other-than-temporary impairments of $7.5 million and $9.0 million, respectively, against certain of its non-Agency MBS that were acquired prior to July 2007.  These other-than-temporary impairments were comprised of $7.5 million of impairments against four Senior MBS recognized at June 30, 2009 and impairments of $1.5 million recognized against five non-Agency MBS at March 31, 2009 (none of which were Senior MBS).  The Company projected adverse changes in expected cash flows for each of these non-Agency MBS.  With respect to the Senior MBS, impairments totaled $76.6 million, of which $7.5 million was identified as credit related and recognized through earnings and, with respect to the five non-Senior MBS, the entire $1.5 million impairment was identified as credit related and recognized through earnings.  The other-than-temporarily impaired Senior MBS had an aggregate amortized cost of $188.1 million prior to recognizing the impairments and the five non-Senior MBS had an amortized cost of $1.7 million prior to recognizing the impairments.  During the three and six months ended June 30, 2008, the Company recognized impairment charges of $4.0 million and $4.9 million, respectively, against unrated investment securities and, as a result these securities are carried at zero.
 
MBS on which impairments are recognized have experienced, or are expected to experience, adverse cash flow changes.  The Company’s estimation of cash flows expected for its non-Agency MBS is based on its review of the underlying mortgage loans securing the MBS.  The Company considers information available about the performance of underlying mortgage loans, including credit enhancement, default rates, loss severities, delinquency rates, percentage of non-performing, Fair Isaac Corporation (“FICO”) scores at loan origination, year of origination, loan-to-value ratios, geographic concentrations, as well as rating agency reports, general market assessments, and dialogue with market participants.  As a result, significant judgment is used in the Company’s analysis to determine the expected cash flows for its MBS.  In determining the component of the gross other-than-temporary impairment related to credit losses, the Company compares the amortized cost basis of each other-than-temporarily impaired security to the present value of its expected cash flows, discounted using its pre-impairment yield.
 
The Company’s assessment that it has the ability to continue to hold impaired non-Agency securities along with its evaluation of their future performance, as indicated by the criteria discussed above, provide the basis for it to conclude that the remainder of its non-Agency MBS in unrealized loss positions are not other-than-temporarily impaired.  Given the high credit quality inherent in Agency MBS, the Company does not consider any of the impairments on such MBS to be credit related.  In assessing whether it is more likely than not that the Company will be required to sell any impaired security before its anticipated recovery, which may be at their maturity, it considers the significance of each investment, the amount of impairment, as well as the Company’s current and anticipated leverage capacity and liquidity position.  As a result of its analyses, the Company determined at June 30, 2009 that the unrealized losses on its MBS on which impairments have not been recognized are temporary. These temporary unrealized losses are primarily believed to be related to an overall widening of spreads for many types of fixed income products, reflecting, among other things, reduced liquidity in the market and a general negative bias toward structured mortgage products, including non-Agency Senior MBS.  At June 30, 2009, the Company did not intend to sell any of its Agency and non-Agency MBS that were in an unrealized loss position, all of which were performing in accordance with their terms.
 
15

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
Certain of the other-than-temporary impairment amounts were related to credit losses and recognized into earnings, with the remainder recognized into other comprehensive income/(loss).  The table below presents the rollforward of other-than-temporary impairments for the three and six months ended June 30, 2009:
 
(Dollars in Thousands)
 
Gross Other-Than-Temporary Impairments
   
Other-Than-Temporary Impairments Included in Other Comprehensive Income/(Loss)
   
Net Other-Than-Temporary Impairments Included in Earnings
 
Balance January 1, 2009
  $ -     $ -     $ -  
Additions due to change in expected cash flows during
  the three months ended March 31, 2009
    1,549       -       1,549  
March 31, 2009
  $ 1,549     $ -     $ 1,549  
                         
Additions due to change in expected cash flows during
  the three months ended June 30, 2009
    76,586       69,126       7,460  
June 30, 2009
  $ 78,135     $ 69,126     $ 9,009  

The table below presents a summary of the significant inputs considered in determining the measurement of the credit loss component recognized in earnings for the four Senior MBS at June 30, 2009:
 
(Dollars in Thousands)
Senior MBS
MBS current face
 $        188,613
   
Credit enhancement (1):
 
  Weighted average (2)
           6.43%
   Range (3)
 2.97% - 23.11%
   
Projected CPR (4):
 
  Weighted average (2)
           7.75%
   Range (3)
   7.05% - 9.28%
   
Projected Loss Severity:
 
  Weighted average (2)
         50.30%
   Range (3)
50.00% - 60.00%
   
60+ days delinquent (5):
 
  Weighted average (2)
         13.34%
   Range (3)
10.26% - 29.03%

(1) Represents current level of protection (subordination) for the securities, expressed as a percentage of total current underlying loan balance.
 
(2) Calculated by weighting the relevant input/assumptions for each individual security by current outstanding face of the security.
 
(3) Represents the range of inputs/assumptions based on individual securities.
 
(4) CPR – constant prepayment rate.
 
(5) Includes underlying loans 60 or more days delinquent, foreclosed loans and other real estate owned.
 
The following table presents the impact of the Company’s investment securities on its other comprehensive income/(loss) for the three months and six months ended June 30, 2009 and 2008:
 
   
Three Months
Ended June 30,
   
Six Months Ended
June 30,
 
(In Thousands)
 
2009
   
2008
   
2009
   
2008
 
Accumulated other comprehensive income/(loss) from investment securities:
                       
Unrealized gain/(loss) on investment securities at  beginning of period
  $ 50,208     $ 30,128     $ (72,983 )   $ 29,232  
Unrealized gain/(loss) on investment securities arising during the period, net
    124,419       (66,545 )     236,861       (56,797 )
Reclassification adjustment for MBS sales
    (12,377 )     -       (3,033 )     (8,241 )
Reclassification adjustment for net losses included in net income for other-than-temporary impairments
    7,460       2,117       8,865       1,506  
Balance at the end of period
  $ 169,710     $ (34,300 )   $ 169,710     $ (34,300 )

16

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
The net yield on the Company’s MBS portfolio was 5.27% and 5.36% for the three months ended June 30, 2009 and June 30, 2008, respectively, and 5.25% and 5.49% for the six months ended June 30, 2009 and June 30, 2008, respectively.  The following table presents components of interest income on the Company’s investment securities portfolio for the three and six months ended June 30, 2009 and 2008:

   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
(In Thousands)
 
2009
   
2008
   
2009
   
2008
 
Coupon interest on MBS
  $ 129,978     $ 124,185     $ 266,359     $ 254,467  
Premium amortization
    (5,914 )     (5,705 )     (10,672 )     (11,063 )
Discount accretion
    2,413       62       2,943       153  
Interest income on MBS, net
    126,477     $ 118,542       258,630     $ 243,557  
Interest on income notes
    -       -       -       50  
  Total
  $ 126,477     $ 118,542     $ 258,630     $ 243,607  
 
The following table presents certain information about the Company’s MBS that will reprice or amortize based on contractual terms, which do not consider prepayment assumptions, at June 30, 2009:
 
   
June 30, 2009
 
Months to Coupon Reset or Contractual Payment
 
Fair Value
   
Percent
of Total
   
WAC (1)
 
(Dollars in Thousands)
                 
Within one month
  $ 458,971       4.9 %     3.62 %
One to three months
    142,408       1.5       4.85  
Three to 12 Months
    601,817       6.4       4.75  
One to two years
    1,290,057       13.7       5.61  
Two to three years
    1,431,283       15.1       5.85  
Three to five years
    2,057,677       21.9       5.59  
Five to 10 years
    3,434,829       36.5       5.57  
  Total
  $ 9,417,042       100.0 %     5.46 %
(1) "WAC" is the weighted average coupon rate on the Company’s MBS. The net yield is primarily reduced by premium amortization and the contractual delay in receiving payments, which delay varies by issuer and is increased by accretion of purchase discounts that are not designated as credit reserve.
 
 
4.      Interest Receivable
 
The following table presents the Company’s interest receivable by investment category at June 30, 2009 and December 31, 2008:
 
(In Thousands)
 
June 30,
 2009
   
December 31,
 2008
 
MBS interest receivable:
           
   Fannie Mae
  $ 35,791     $ 41,370  
   Freddie Mac
    5,770       6,587  
   Ginnie Mae
    114       136  
   Senior MBS
    3,844       1,596  
   Other non-Agency MBS
    9       9  
     Total interest receivable on MBS
    45,528       49,698  
   Money market investments
    21       26  
     Total interest receivable
  $ 45,549     $ 49,724  
 
17

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
5.      Swaps
 
The Company’s derivatives are comprised of Swaps that are designated as cash flow hedges against the interest rate risk associated with its borrowings.  The following table presents the fair value of the Company’s derivative instruments and their balance sheet location at June 30, 2009 and December 31, 2008:
 
Derivatives Designated as Hedging Instruments Under FAS 133
Balance Sheet Location
 
June 30,
2009
   
December 31,
 2008
 
(In Thousands)
             
Swaps, at fair value
Liabilities
  $ (173,410 )   $ (237,291 )

 
Consistent with market practice, the Company has agreements with its Swap counterparties that provide for collateral based on the fair values of its derivative contracts.  Through this margining process, either the Company or its Swap counterparty may be required to pledge cash or securities as collateral.  Collateral requirements vary by counterparty and change over time based on the market value, notional amount and remaining term of the Swap.  Certain Swaps provide for cross collateralization with repurchase agreements with the same counterparty.
 
A number of the Company’s Swaps include financial covenants, which, if breached, could cause an event of default or early termination event to occur under such agreements.  If the Company were to cause an event of default or trigger an early termination event pursuant to one of its Swaps, the counterparty to such agreement may have the option to terminate all of its outstanding Swaps with the Company and, if applicable, any close-out amount due to the counterparty upon termination of the Swaps would be immediately payable by the Company.  The Company was in compliance with all of its financial covenants through June 30, 2009.
 
At June 30, 2009, the Company had MBS with fair value of $148.6 million and restricted cash of $39.9 million pledged as collateral against its Swaps.  At December 31, 2008, the Company had MBS with fair value of $171.0 million and restricted cash of $70.7 million pledged against its Swaps.  (See Note 8.)
 
The use of hedging instruments exposes the Company to counterparty credit risk.  In the event of a default by a Swap counterparty, the Company may not receive payments to which it is entitled under its Swap agreements, and may have difficulty receiving back its assets pledged as collateral against such Swaps.  If, during the term of the Swap, a counterparty should file for bankruptcy, the Company may experience difficulty recovering its assets pledged as collateral which could result in the Company having an unsecured claim against such counterparty’s assets for the difference between the fair value of the Swap and the fair value of the collateral pledged to such counterparty.  At June 30, 2009, all of the Company’s Swap counterparties were rated A or better by a Rating Agency.
 
The following table presents the impact of the Company’s Swaps on its accumulated other comprehensive income/(loss) for the three and six months ended June 30, 2009 and 2008:
 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
(In Thousands)
 
2009
   
2008
   
2009
   
2008
 
Accumulated other comprehensive loss from Swaps:
                       
Balance at beginning of period
  $ (226,470 )   $ (141,584 )   $ (237,291 )   $ (99,733 )
Unrealized gain on Swaps arising during the
  period, net
    53,060       100,819       63,881       10,806  
Reclassification adjustment for net losses included in
  net income from Swaps
    -       -       -       48,162  
Balance at the end of period
  $ (173,410 )   $ (40,765 )   $ (173,410 )   $ (40,765 )

At June 30, 2009, all of the Company’s Swaps were deemed effective and no Swaps were terminated during the three and six months ended June 30, 2009.  During the six months ended June 30, 2008, the Company terminated 48 Swaps with an aggregate notional amount of $1.637 billion (all of which occurred in March 2008) and, in connection therewith, repaid the repurchase agreements hedged by such Swaps.  These transactions resulted in the Company recognizing net losses of $91.5 million.  Except for gains and losses realized on Swaps terminated early and deemed ineffective, the Company has not recognized any change in the value of its Swaps in earnings as a result of the hedge or a portion thereof being ineffective.
 
18

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
The following table presents the net impact of the Company’s Swaps on its interest expense and the weighted average interest rate paid and received for such Swaps for the three and six months ended June 30, 2009 and 2008:
 
   
For the Three Months
Ended June 30,
   
For the Six Months
Ended June 30,
 
(Dollars In Thousands)
 
2009
   
2008
   
2009
   
2008
 
Interest expense attributable to Swaps
  $ 29,118     $ 14,563     $ 56,166     $ 23,894  
Weighted average Swap rate paid
    4.21 %     4.18 %     4.20 %     4.40 %
Weighted average Swap rate received
    0.76 %     2.80 %     0.97 %     3.37 %

At June 30, 2009, the Company had Swaps with an aggregate notional amount of $3.520 billion, including $300.0 million notional for forward-starting Swaps, which had gross unrealized losses of $173.4 million and extended 27 months on average with a maximum term of approximately six years.  The following table presents information about the Company’s Swaps at June 30, 2009 and December 31, 2008:
 
   
June 30, 2009
   
December 31, 2008
 
Maturity (1)
 
Notional
Amount
   
Weighted
Average
Fixed-Pay
Interest Rate
   
Weighted
Average Variable
Interest Rate (2)
   
Notional
Amount
   
Weighted
Average
Fixed-Pay
Interest Rate
   
Weighted
Average Variable
Interest Rate (2)
 
(Dollars In Thousands)
                                   
Within 30 days
  $ 67,685       3.95 %     0.78 %   $ 78,348       3.92 %     2.36 %
Over 30 days to 3 months
    138,306       4.12       0.56       151,697       4.12       1.48  
Over 3 months to 6 months
    307,080       4.35       0.52       220,318       4.04       1.78  
Over 6 months to 12 months
    380,958       4.01       0.65       513,070       4.24       1.50  
Over 12 months to 24 months
    825,317       4.19       0.58       821,162       4.13       1.68  
Over 24 months to 36 months
    561,889       4.24       0.57       642,595       4.12       1.61  
Over 36 months to 48 months
    627,182       4.35       0.55       833,302       4.40       1.43  
Over 48 months to 60 months
    184,062       4.08       0.52       169,351       4.01       1.99  
Over 60 months
    127,214       4.32       0.60       240,212       4.21       1.77  
  Total active swaps
    3,219,693       4.21       0.58       3,670,055       4.19       1.62  
Forward Starting Swaps (3)
    300,000       4.39       0.31       300,000       4.39       0.44  
     Total
  $ 3,519,693       4.23 %     0.55 %   $ 3,970,055       4.21 %     1.53 %
(1) Each maturity category reflects contractual amortization and/or maturity of notional amounts.
 
(2) Reflects the benchmark variable rate due from the counterparty at the date presented, which rate adjusts monthly or quarterly based on one-month or three-month LIBOR, respectively. For forward starting Swaps, the rate reflects the rate that would be receivable if the Swap were active.
 
(3) $150.0 million of forward starting Swaps became active on July 21, 2009, and $150.0 million will become active on August 10, 2009.
 

6.      Real Estate
 
The following table presents the summary of assets and liabilities of Lealand at June 30, 2009 and December 31, 2008:

(In Thousands)
 
June 30, 2009
   
December 31, 2008
 
Real Estate Assets and Liabilities:
           
  Land and buildings, net of accumulated depreciation
  $ 11,188     $ 11,337  
  Cash and other assets
    164       144  
  Mortgage payable (1)
    (9,224 )     (9,309 )
  Accrued interest and other payables
    (270 )     (168 )
    Real estate assets, net
  $ 1,858     $ 2,004  
 
(1)  The mortgage collateralized by Lealand is non-recourse, subject to customary non-recourse exceptions, which generally means that the lender’s final source of repayment in the event of default is foreclosure of the property securing such loan.  This mortgage has a fixed interest rate of 6.87%, contractually matures on February 1, 2011 and is subject to a penalty if prepaid.  The Company has a loan to Lealand which had a balance of $185,000 at June 30, 2009 and December 31, 2008.  This loan and the related interest accounts are eliminated in consolidation.
 
19

MFA FINANCIAL, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
 
The following table presents the summary results of operations for Lealand for the three and six months ended June 30, 2009 and 2008:
 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
(In Thousands)
 
2009
   
2008