ITEM 3. Quantitative and Qualitative Disclosures about Market Risk
The Company seeks to manage its risks related to the credit quality of its assets, interest rates, liquidity, prepayment speeds and market value, while, at the same time, seeking to provide an opportunity to stockholders to realize attractive risk-adjusted returns through ownership of its capital stock. While risks are inherent in any business enterprise, the Company seeks to quantify and justify risks in light of available returns and to maintain capital levels consistent with the risks the Company undertakes.
One of the Company’s strategic focuses is acquiring assets that it believes to be of high credit quality. The Company believes this strategy will generally keep its credit losses and financing costs low. However, the Company is subject to varying degrees of credit risk in connection with its other target assets. The Company seeks to mitigate this risk by seeking to acquire high quality assets, at appropriate prices given anticipated and unanticipated losses, and by deploying a value-driven approach to underwriting and diligence, consistent with the Manager’s historical investment strategy, with a focus on current cash flows and potential risks to cash flow. The Manager seeks to enhance its due diligence and underwriting efforts by accessing the Manager’s knowledge base and industry contacts. Nevertheless, unanticipated credit losses could occur, which could adversely impact the Company’s operating results.
Interest Rate Risk
Interest rates are highly sensitive to many factors, including fiscal and monetary policies and domestic and international economic and political considerations, as well as other factors beyond the Company’s control. The Company is subject to interest rate risk in connection with its target assets and its related financing obligations.
To the extent consistent with maintaining the Company’s REIT qualification, the Company seeks to manage risk exposure to protect its portfolio of financial assets against the effects of major interest rate changes. The Company generally seeks to manage this risk by:
attempting to structure its financing agreements to have a range of different maturities, terms, amortizations and interest rate adjustment periods;
using hedging instruments, interest rate swaps and interest rate caps; and
to the extent available, using securitization financing to better match the maturity of the Company’s financing with the duration of its assets.
At March 31, 2017, all of the Company’s borrowings outstanding under the Goldman Loan, the JPM Facility, the DB Repurchase Facility and participations sold were floating-rate borrowings. At March 31, 2017, the Company also had floating rate assets with a face amount of $? resulting in net variable rate exposure of $?. A 50 basis point increase in LIBOR would increase the quarterly net interest income related to this variable rate exposure by approximately $?. Any such hypothetical impact on interest rates on the Company’s variable rate borrowings does not consider the effect of any change in overall economic activity that could occur in a rising interest rate environment. Further, in the event of a change in interest rates of that magnitude, the Company may take actions to further mitigate the Company’s exposure to such a change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, this analysis assumes no changes in the Company’s financial structure.
Prepayment risk is the risk that principal will be repaid at a different rate than anticipated, causing the return on an asset to be less than expected. The Company does not anticipate facing prepayment risk on most of its portfolio of assets since most of the commercial loans held directly by the Company or securing the Company’s CMBS assets contain provisions preventing prepayment or imposing prepayment penalties in the event of loan prepayments.
Market value risk. The Company’s available-for-sale securities and securities at estimated fair value are reflected at their estimated fair value. The change in estimated fair value of securities available-for-sale is reflected in accumulated other comprehensive income while the change in estimated fair value of securities at estimated fair value is reflected as a component of net income. The estimated fair value of these securities fluctuates primarily due to changes in interest rates and other factors. Generally, in a rising interest rate environment, the estimated fair value of these securities would be expected to decrease;