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Friedman Billings Ramsey Group, Inc (NYSE:FBR)

Q3 2008 Earnings Call

October 23, 2008 9:00 am ET

Executives

Kurt Harrington - Chief Financial Officer

Eric Billings - Chairman and CEO

Analysts

Richard Malone

Frank Dameno

Bernard Fonovich

Operator

Good morning. My name is Felicia and I will be your conference operator today. At this time, I would like to welcome everyone to the FBR Group Third Quarter 2008 Earnings Call. All lines have been placed on mute to prevent background noise. (Operator Instructions). Thank you.

I would now like to turn the conference over to Chief Financial Officer, Kurt Harrington. Sir you may begin.

Kurt Harrington

Thank you and good morning. There has been a slight collusion in the PR news service; we expect a release to go out over the wire in any second. But as that comes through, before we begin this morning’s call, I would like to remind everyone that statements concerning future performance, developments, events, market forecasts, revenues, expenses, earnings, run rates, and any other guidance on present or future periods constitute forward-looking statements. These forward-looking statements are subject to a number of factors, risks, and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances.

These factors include, but are not limited to the effect of demand for public offerings, activity in the secondary securities markets, interest rates, our cost of borrowing, interest spreads, mortgage prepayment fees, mortgage delinquencies and defaults, the risks associated with merchant banking investments, the realization of gains and losses on principal investments, available technologies, competition for business and personnel, and general economic, political, and market conditions.

Additional information concerning these factors that could cause results to differ materially is contained in the FBR Group’s Annual Report on Form 10-K and in Quarterly Reports on Form 10-Q.

Joining me on the call this morning are FBR Group's President and Chief Operating Officer, Rock Tonkel and Eric Billings, Chairman and Chief Executive Officer of FBR Group.

I'll now turn call over to Eric Billings for remarks.

Eric Billings

Thank you, Kurt. Obviously, the environment continues to be as challenging as we have ever seen. What we are experiencing in terms of the nature and severity of the dislocation in the financial markets, as well as the impact on an increasingly interconnected global ex-economy is unprecedented. We expect the duration of this downturn will be prolonged.

Furthermore, it is clear that the structured finance industry has undergone and it will continue to undergo profound change. In this environment of deteriorating market conditions, we have continued to evaluate our strategy and tactics accordingly to maximize the value of FBR Group's assets and liabilities.

For the quarter, we announced the net after tax loss of $169 million for quarter ended September 30, 2008 or $1.12 per share diluted. This is compared to a net after tax loss of $210 million or $1.25 per share for the third quarter. Of the total losses for quarter 1.5 million was cash operating loss, $23.9 million were net realized investment losses on the sale of agency MBS and hedged instrument and $14.7 million related to net minority interest in FBR Capital Markets.

During the quarter, the company also recorded a $4.1 million gain on the extinguishment of $6.8 million of trust preferred debt, so remaining losses were $3.8 million of non cash compensation charges plus $129 million of non cash impairment losses on MBS strategy of which $85.5 million had already been reflected in AOCI as of June 30, 2008.

At the end of the quarter, consolidated total tangible capital was $572 million comprised of total tangible capital of $349 million in FBR Group's ownership interest and FBR Capital Markets which had tangible capital of $223 million as of September 30, 2008.

Tangible book value at the end of September was $268 million or $1.81 per share. Due to the continued deterioration of market conditions during the quarter, we implemented a program to downsize the MBS portfolio and extinguish trust preferred debt. From the beginning of the third quarter through today, we have reduced the size of the MBS portfolio by $1.8 billion and reduced our IPO exposure by $1.7 billion.

Today, as a result the company's agency MBS portfolio is valued at $503 million and super senior AAA MBS is valued at $195 million with total repurchase agreements reduced to $568 million. Along with our MBS portfolio downsizing average to reduce exposure deteriorating market conditions, we have the opportunity to extinguish our remaining trust preferred debt at substantial discounts to face, resulting and gains.

During and after the third quarter through today, we have extinguished a total of $45 million of trust preferred debt resulting in a $27million gain. We believe these values are reflective of current market conditions. We are seeking to maximize the value of our assets and remaining $273 million of trust preferred debt liability.

Through this program of reducing our balance sheet and extinguishing our trust preferred debt, we'll have the flexibility to maximize the value of our remaining assets and liabilities over time for our shareholders.

As we announced in our press release, to assist us in this effort we have retained financial advisors to evaluate strategic alternatives to include the possible sale of the company or it’s assets or the distribution of it’s assets to shareholders.

I'd like to conclude with the following observations about FBR Capital Markets. First, it is important to reiterate that FBR group's results have no effect or impact on the financial strength, performance, or ongoing operations of our majority owned subsidiary.

FBR Group does however consolidate FBR Capital Markets financial results on a proportionate basis and as announced yesterday, FBR Capital Markets reported a third quarter loss of $28.6 million or $0.44 per share, of which, $14.7 million was realized by FBR Group's interest during the quarter.

During the quarter FBR Capital Markets implemented a cost reduction initiative and targeted annualized fixed cost reductions of $30 million and variable cost reductions that together will result in a material lowering of the break even levels.

Importantly, the company operated at a cash break even level in September. As mentioned in its release, at the end of the quarter FBR Capital Markets reported $452 million dollar of capital, all equity.

FBR Capital Markets is a firm that has historically performed well in challenging environments. With substantial balance sheet strength, the franchise is as strong as it has ever been and should be well positioned take advantage of the changing competitive landscape and opportunities created by this extraordinary period in our industry.

In closing, I want to emphasize over the next several months, we will continue to focus on maximizing the value of FBR Groups assets and trust preferred liabilities as we execute strategic alternatives. I will now open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions). We have a question from the line of [Richard Malone].

Richard Malone

Gentlemen, my first comment is, I'm disappointed that you first come out with your release almost simultaneously with the call. I don't know why you can't get this information out first so it can be digested before the conference call. That's my comment.

My question is; I don't understand how FBR Capital Markets is trading around $4. We own, as I understand, more than 50% of Capital Markets, and stock is FBR Group is trading around $0.50. Could you explain this dichotomy please?

Eric Billings

Richard, number one, we apologize for the confusion. There are a number of releases going out simultaneously and there was just difficulty getting it through the news services.

As it relates to the stock, I think Richard, all of us have to recognize that given the incredible dislocation and chaos in the equity capital markets, we have securities and stocks that are trading at levels that don't reflect value of franchises, don't reflect liquidation values, don’t reflect many things, and there's not a lot that can be done about it.

Obviously, as we've described here, although this is obviously a very disappointing quarter given the chaos in the financial system, the fact that we lost $169 million however, only $36 million of which was cash. In that sense, obviously, $133 million was a mark.

It is important that people realize because of our opportunity to generate to-date substantial gains from the sale of our liabilities, our trust preferred liabilities. We are actually generating very substantial gains and that will facilitate our ability to add, we believe, significant value to the company as we patiently await the markets on agency government backed assets and AAA super-senior assets to revert back to a far more normalized levels, ideally resulting in significant economic gain and value improvement in our business.

We are positioning the company so that we can do this with great patience. And eventually it will be recognized in the stock price. The stock price may give us opportunity to take advantage of its stock price if it continues to trade meaningfully below what we believe is the value of the franchise. So these are all things that we are thinking about and considering.

Richard Malone

Right now you said the book value as of September 30 was at $1.81. Can you tell me what cash you have on-hand right now. I'm still looking through this report and I don't have all these numbers in front of me. Second, you mentioned FBR capital markets and I caught that call is running on a breakeven point right now. What about FBR group? Is this loss going to continue? Is this cash going to get eaten up? What is the status? Can you give us some forward look on this?

Eric Billings

Yes, in response to that, Richard number 1, the cash in the company as we speak including

Kurt Harrington

September 30, it was about 82 million.

Eric Billings

In addition to that of course, we have cash in our agency portfolio and agency assets that are highly liquid agency assets in the north of 50 million.

Richard Malone

How much is that per share?

Eric Billings

That would total about $0.80 of the book and then in addition to that FBR Capital Markets has our proportional share of roughly 230 million of equity, substantial portion of that is cash. So the totality of the cash and cash equivalents in the company, in the aggregate are a substantial part of the book value.

Richard Malone

So are you saying; it's close to $1.80 in cash?

Eric Billings

It's not the entire tangible book; it's a substantial part of the book.

Richard Malone

Can you give me that number?

Eric Billings

We'll have to calculate it and Richard, we can get back to you, but again, as you can see from the release, it's about $130 million, $140 million of cash. It grew in the cash end or agency securities and FBR Capital Markets on the same basis is going to be approximately and I'm working off the top of my head, Richard. So I probably shouldn't be doing that. In total it's a substantial part of the tangible book value of the company. We can do the calculations, if you like off line.

Richard Malone

Okay, that's fine. Now can you tell me going forward answer the other part of the question, going forward what do you see as far as breakeven for FBR Group?

Eric Billings

I think we said in the script, but definitely it's in the release. We lost on an operating basis $1.5 million for the quarter. So the company is on an operating basis is functionally at a cash breakeven level. That obviously has been an important objective. We will seek to maintain that at the group side of the balance sheet as we continue to recognize the value on the liability side by selling trust preferred at significant discounts to face recognizing substantial gains. We will be endeavoring to do these activities and to simultaneously keep the operating cash of the business at about a breakeven level.

Richard Malone

So, you're trying to preserve FBR Group right now to the extent possible on a cash breakeven, that's what you're attempting to do right now.

Eric Billings

That's certainly from an operating perspective, that's exactly right, Richard.

Richard Malone

And if FBR Capital can start to make some money then the outlook for FBR Group would the rosiest scenario, right now in this environment.

Eric Billings

I wouldn't describe is as rosy or not rosy, Richard, I would just simply say that that's exactly what we're doing at this time. The company is operating at very close to or functionally at around cash breakeven from an operating perspective which gives us the ability with the very high levels of cash and liquidity that we have in significantly reduced balance sheet. We're in a position now where we can patiently realize the value and the totality of our balance sheet.

As we've said right now there is great value on our judgment and as we have recognized in the liability side of our balance sheet for the sale of our trust preferred securities at significant discounts. In addition, as stated in the release and script, our agency securities and super senior AAA securities on a mark basis are marked significantly below par to the degree that we can patiently await for markets to stabilize and the credit markets to 'thaw', overtime we would expect portions of those marks to return back to us.

So, this is our corporate process at this time and in addition as you observed, we are taking the proper steps at FBR Capital Markets, very aggressively cutting costs, we operated at cash breakeven in September. So, to the degree and time as the capital markets activities pick up, we think FBR Capital Markets is very strategically poised to have very strong operating performance and between that plus, the realization of these values in the total group balance sheet, that is our strategy, that is our operating plan. We believe we have the flexibility, the liquidity, the patience to achieve these objectives as we go forward.

Richard Malone

Okay. One final question. You mentioned almost in passing that you have some strategic alternatives that you are looking at. Can you just give me a little more insight into what it is; what assets you're trying to sell? What strategic alternatives are you referring to?

Eric Billings

We're exploring many things and we're not going go into all the detail at this time. But as things unfold, we certainly would go into more. For instance, in recognizing the value of our trust preferred liabilities, it could be necessary to sell part of the corporate structure or shell.

We would explore that possibility. We have significant NOLs. There may be ways to realize some of the value of those NOLs through sales of parts of the corporate shell, etc. There are numerous different things that we are looking at and will continue to look at to maximize the economic value. We can't be assured that any of these things will occur. But obviously, we have made meaningful progress on a number of these items and we intend to continue moving forward and exploring all alternatives that can maximize the value.

Richard Malone

All right. Thank you.

Eric Billings

Thank you.

Operator

Your next question comes from the line of [Frank Dameno].

Frank Dameno

Just a quick follow-up. Rick, who came along before said most of them. The strategic alternatives; one has been to buyback stock, where are we on that process? I mean, at $0.50 a share or so, why wouldn't that have been something we've been active in?

Eric Billings

In terms of buying back stock?

Frank Dameno

Right.

Eric Billings

Frank, there are times where companies because of activities they're pursuing are precluded from buying back stock. And because of some of the activities and strategic alternatives we're exploring, we have been advised that it would be best that we not do that from time to time. However, having said that, I want to be clear that we are evaluating the value of the stock. We do believe that at these levels, it obviously is dramatically below the value of the business, and we would intend within the proper bounds of the rules of this activity to take advantage of these circumstances as is appropriate.

Frank Dameno

If we stay under a dollar, is there a threat of delisting?

Eric Billings

The technical issue there I believe is that if it trades under $0.35 for a certain period of time, that is a possibility. Having said that, I think the New York Stock Exchange does have flexibility in this regard under periods of difficulty. And so these are things that we are mindful of and there are steps we can take to prevent that from occurring.

Frank Dameno

Okay. Thank you.

Eric Billings

Operator

Your next question comes from the line of [Bernard Fonovich].

Bernard Fonovich

Hi, guys. A quick question for you. It sounds like you guys are just sort of trying to ride out the storm until you can kind of get the value of FBCM. What things can happen that would prevent that from occurring? Is it just continued marks on the MBS portfolio such that your equity goes into a negative position? I mean would that matter? Or is it repo counterparties? I'm just trying to think of what the risks here are.

Eric Billings

Bernard, I think the company between the tangible common, the trust preferred capital, the capital in the business is very significant. So that certainly gives us the ability to sit here and withstand just about any storm. So we don't see that as the type of things right now as being problematic.

But, clearly, as markets continue to mark, if the world continues to mark, agency securities lower and or AAA super-senior assets lower, the counterparties our repo providers could require more balance. Our agency securities are on a repo line where the vast majority of them are until the end of the December of '09.

So these kinds of things, they could require more margin balance requiring more of our cash, but we believe we're positioned to with stand those kinds of things and , again, to patiently as you said wait out this storm and take advantage of it. And obviously as odd as that may sound, we believe that the evidence of our selling the trust preferred liabilities at very substantial gains is obviously evidence of the fact that in a very severe break in the financial system, providing people the opportunity to buy our liabilities, in other words, buy a funding source in absence of other means for companies to have that, they are willing to pay substantially below the par value of those securities that we have differently.

We are able to sell our liabilities at meaningfully below par, generating very substantial cash gains and providing the buyer with what is a functional cash financing at a 1000, 1,2000,1,500, 1,800 over LIBOR. But that unfortunately in the current circumstance of our financial system is in many cases the cheapest financing that exists in the country.

So, this is a very difficult time for everybody. But it does create opportunities in certain circumstances where we have been able and will be endeavoring to continue to take advantage of that to create incremental value for the company.

Bernard Fonovich

How big was that sale?

Eric Billings

We sold 45 million so far and we are actively working on other parts of the trust preferred as we speak. The 45 million we sold at a $27 million cash gain.

Bernard Fonovich

Okay. So actually, the holder of the trust preferred had to agree to that sale? I'm just trying to understand how that would work?

Eric Billings

There's numerous ways too that, Bernard. We're not going into that over the phone. But there are many different ways to do it. Obviously, people are buying back their trust preferred and other kinds of activities all over the United States. But it is something that we are doing.

Bernard Fonovich

Okay. And then just on the MBS portfolio, obviously you guys seems in a pretty good capital position at the end of the last quarter and a lot of cash and just basically a more conservative portfolio than you ever had, but it seems like even that portfolio came under a lot of stress. Maybe just run me down the sub segments of the portfolio that you have left and where that portfolio is currently marked as a percent of par?

Kurt Harrington

So today, Bernard, the predominance portfolio is agency floaters, those are about 500 million. In addition to that, you may recall the portfolio of super senior AAA's, those are just under 200 million, so you totaled MBS portfolio balance that the REIT is about 700 million and you're IPO balance against that is about $570 million. The agency assets as are now explicitly treasury guaranteed. Those assets are marked in the mid-90s and the other assets are marked in the mid-70s. So you have super senior AAA's in the mid-70s.

Bernard Fonovich

Okay. And that as of 930 or is that a more recent mark, because there's been a lot of dislocation since the end of the quarter.

Kurt Harrington

That's actually more current.

Bernard Fonovich

Okay.

Kurt Harrington

At 930 those assets, again the information you'll see in the release is forwarding to today from the subsequent to the end of the quarter and the marks at the end of the quarter were somewhat higher and these marks that I gave you are current mark levels. So, it’s a current mark level.

Bernard Fonovich

Is the problem with the agency? Because that seems like a mid-90s mark for government guarantees seems pretty amazing. So, is the problem there more of a technical issue since the government is out there guaranteeing bank paper and putting more explicit guarantees out there to that, there is just less demand for agencies and that's going to put some pressure on the prices or is there something else?

Eric Billings

Specifically Bernard, this goes to the heart of the financial crisis and the magnitude and the significance and the pervasiveness of the financial crisis that exists on the globe. Specifically, floater paper today is government guaranteed. It's treasury equivalent from a credit perspective. It floats with interest rate, so it actually has no interest rate risk and there is no credit risk. It's the literally the greatest security every created. And these assets trade below par.

It's obviously a remarkable event, probably one fair to say, none of us could imagine but it's in fact true, it is again the measure of the magnitude of this financial break. It's a measure of the fact that the liquidity in the global system is very, very strained. That lack of liquidity is causing a circumstance where companies are de-leveraging and they're downsizing and as this occurs, it's caused government assets to trade below par.

Obviously, governments around the world are interjecting trillions of dollars of cash and capital into the financial system to cause this problem to be stopped and reversed. We are seeing evidence of that, we are seeing evidence of 'thawing' in the credit markets and clearly, one would expect that these assets will be the first to see that. But it is an extraordinary unprecedented circumstance.

Bernard Fonovich

Obviously, you don't think, it's an arbitrage of government guarantees. I can get a higher yield on bank paper and agency, so I'll buy that and there is just less buyers for agency.

Eric Billings

I would say it in this way. In a sense without getting too philosophical here, some of that exists of course right now. But, remember from that perspective, you'd have to look at the United States and the global stock markets trading at something in the vicinity of the five or six or seven ROI, spending a lot earnings, numbers people want to use. And in that context one can buy AAA super senior mortgage assets where there's no possibility of loss. And you can buy those to 20% to 50% cash yields to maturity.

So, we know the markets are completely out of kilter. It's impossible for the global stock markets to trade at these kinds of ROIs and have treasury assets and or super-senior AAA type assets trade at those kids of valuations, nonetheless, they all do.

So I think we are in a process right now where the globe and the world capital markets are normalizing and they are finding an equilibrium which is going to cause ROIs in all of these markets ultimately on a risk adjusted basis to move back to proper levels. And that is going to mean that either the massive liquidity injected into the global financial system is going to allow these extraordinarily high grade financial assets to move back toward and above par, and then equity capital markets could stabilize, or, we are going to have further erosion in these kinds of markets as that cash flows out of these markets into much higher grade markets or agencies and/or super-senior AAAs until the system finds an equilibrium.

But the world is working at it in an unprecedented global way, and we are seeing evidence of success even in the credit markets, in the high grade credit markets. We are confident that these coordinated efforts will continue to have success. But in any case, we certainly believe we are positioning FBR Group to be able to withstand these activities and actually be able to benefit, again, vis-à-vis things like selling our liabilities at significant gains.

Bernard Fonovich

Okay. All right. Thanks.

Eric Billings

Thank you.

Operator

(Operator Instructions). And there are no further questions. Mr. Billings, do you have any closing remarks?

Eric Billings

No, we thank everybody for participating. Again, we apologize for the delay in the release. And we look forward to speaking to everybody next quarter.

Operator

Ladies and gentlemen, this does conclude today's conference call.

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