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MFA Financial, Inc. (NYSE:MFA)

J.P. Morgan SMid Cap Conference Transcript

November 28, 2012 2:30 PM ET

Executives

Stewart Zimmerman - Chairman and CEO

William Gorin - President

Craig Knutson - Executive Vice President

Analysts

Rich Shane - J.P. Morgan

Rich Shane - J.P. Morgan

Good afternoon. It’s our last presentation of the day. This is Rich Shane from J.P. Morgan. I’m delighted to introduce the management team from MFA Financial. MFA is one of the longstanding and survivors in the mortgage REIT group. We are delighted to have them here. And with that, I will turn it over to Stewart Zimmerman.

Stewart Zimmerman

Thank you. Thank you very much. MFA is an internally managed real estate investment for us and we are positioned to benefit from an investment both Agency and Non-Agency residential mortgage-backed securities.

I think what’s important in this particular slide as we’ve underlined it, we are self-advised and self-managed. And we’ve had a history of investment in a very positive way in both Agency and Non-Agency residential mortgage-backed securities.

Our strategy is to identify the best investment opportunities throughout the residential MBS universe. Our Non-Agency MBS selection is driven by credit analysis and expected return, Agency MBS selection is driven by an analysis of interest rate sensitivity, prepayment exposure and expected return.

We are very proud that our book value per common share grew at $8.80 as of September 30, 2012, compared to $6.74 as of December 31, 2011. This 30% increase in book value per share in the first nine months of 2012 was a result of MFA’s total return strategy of investing in both Agency and discounted Non-Agency mortgage-backed securities.

I’m particularly proud of this particular slide, that we’ve had a long track record of delivering attractive shareholder return, 16% annual return since January of 2000 and 572% total stockholder returns since the similar date of January 2000.

On that note, I’m going to turn it over to Mr. Gorin, President of the company.

William Gorin

Thanks Stewart. Welcome everybody.

Rich Shane - J.P. Morgan

Do you need chairs.

William Gorin

So thank you. On this slide we show you how we’ve allocated our equity and where our assets lie. The majority of our assets are Agency MBS, the yield on these assets is 2.66. Our cost of funds is 1.53 and so the spread is 113 basis points.

We point out that the cost of funds in our agencies reflects the fact that we put on swaps in prior years and the good news is the most expensive of these swaps will be running off at the end of this quarter. So there should be a downward trend in our cost of funds for agencies in 2013.

Our Non-Agency MBS has a market value in excess of $5 billion. We think this is one of the largest holdings of the public mortgage REITs and therefore we think we actually have good exposure and are, and we continue to benefit from the seeming rebound in home prices. So we are clearly sensitive to that credit and we’re glad that we are.

The loss adjusted unlevered yield on these assets is 6.65% and as I say, that's loss adjusted, our funding cost is $240, obviously it’s a little costlier to finance your non-agencies and your agencies, but surprisingly we get longer term financing for Non-Agency.

So many cases this term financing there, the net interest rate spread of the non-agencies is 4.25%, cash yield almost nothing these days. As a result, with the leverage of only 3.2 times we are generating double-digit ROEs and the unlevered asset yield is 4.12%.

Focusing first on the agencies, within our Agency portfolio, we focus on lower duration assets, 70% of these Agency assets are hybrids, which means they are fixed for a period of time and then become one-year adjustable. And 30% of our Agency assets are 15-year fixed rate assets. Good news about 15-year fixed rates is the amortize over 15-years, so we don't have extension risk beyond the 15th year.

Compared to the other agency mortgage REITs. We are the very low end of premium exposure, our average amortized cost is 103.2%. As I previously mentioned, $341 million of existing swaps with the weighted average fixed pay rate of 4.4% are scheduled to expire at the end of this quarter.

So foremost in peoples mind is the Fed and impact of QE3. So the FOMC has kept their target range for the Fed funds rate at 0% to 0.25%, and they currently anticipate that this exceptionally low level will likely to be warranted at least through mid-2015. So, when people say, well, rates will be lower through mid-2015. The Fed does have some legal room in terms of their language.

They've also announced the Fed will increase their holdings of Agency MBS by $40 billion per month until the labor market improves. That's interesting, previously they talked about purchases of a dollar amount over certain period of time. We hear the same. We are going to keep buying it till we determine the labor market improves. Nobody knows exactly what that means, but again that gives them flexibility.

In addition, they continue to reinvest runoff. So, it looks like the total monthly purchase will be near $85 billion. And clearly, this put downward pressure on Agency MBS yields and we’ll not be surprise if this elevated Agency MBS prepayments into 2013.

With that, I'd like to hand it over to Craig to discuss the Non-Agency portfolio.

Craig Knutson

Thanks, Bill. So we also have a significant investment in Non-Agency MBS. Bill mentioned, it’s a little more than $5 billion market value, $6.5 billion face amount, our average amortized cost is 73% on these securities. And in the third quarter of 2012, we generated a loss adjusted yield of 6.65%, again that’s loss adjusted and unlevered.

And we’ve seen some increasing signs of home price stabilization, which obviously is a good thing for this Non-Agency portfolio, given that it is somewhat of a credit play. The thing that we worry most about when we look at these securities are the LTV’s on the underlying loans. So, obviously any home price appreciation is helping that LTV component.

So this is an illustration of the technicals around this Non-Agency markets. So if you go back to mid-2007, you'll see that the existing universe was a little over $2.2 trillion of these Non-Agency securities. It’s now just under a $1 trillion and it declines by about 15% a year.

So, the story there is -- it s a shrinking universe, they are not making any more of these. The sector that we play and is actually the green sector and probably part of that red sector, which is the jumbo and Alt-A sector. So you can see it’s a rapidly shrinking universe.

So this slide illustrates the top 20, the largest single positions that we have. So couple things that I would note on this slide. First of all the largest position is only 2% of the whole portfolio. So it's a pretty diversified portfolio.

By the time you get down to the number 20, you are less than 1% of the portfolio and if you look across the bottom of the slide, the couple things I would point out, the weighted average FICO and this is FICO origination was 729. So, again, that’s pretty good indication of the credit quality of these bonds.

The WALA which is the next column, which is the weighted average loan age of 73, that’s really pretty significant, because these loans are on average over six years old, which means we have six years of pay history on these loans.

So for instance, we give you an example of loan that has what we think is a 140% LTV, you’d say, well, [G], that probably has a high likelihood of default. But if I told you that the borrower hadn’t missed one payment over the last six years. You might feel little bit better about that. So pay history is a big thing and the more season this is the more we rely on pay history.

If you skip over to the 60 plus delinquencies, so this is 60 plus days delinquent. Its 20% of the loans in the portfolio. And when we make assumptions to generate yields and this is how we book yields on these securities, we make assumptions with respect to defaults, loss severity, prepayment rates and also future coupon adjustments.

And so the default assumption on these 20 securities, we’re assuming that approximately 39% of the underlying loans default. So if we think about that, the 20% that are delinquent assume that those default, we’re basically assuming that another 20% or another 19% also default in the future. And those are loans that are current today.

The projected principle recovery is what we expect to get back on these bonds so -- on each bond. So it's not -- it's not the total losses in the pool because many of these pools also have credit enhancement.

So this is a slide and we actually updated this, this quarter. We have this in our investor deck last quarter and it just shows -- it just shows house price appreciation in California, which comprises about 46% of our portfolio. And when we have the slide in three months ago, I would say that it was lot more light green and there was actually some pink slides in there too.

So clearly, we are seeing some pockets of home price appreciation, which again is a very powerful thing when the single biggest factor that we worry about are these underwater borrowers. When we started buying non-agencies three or four years ago, everybody said what’s your percentage of California? We would say well it’s close to 50%. Everybody thought that was a bad thing. Now, we don’t hear that so much.

So this is an illustration of how we how we account for non-agencies. So you can see on the left, the total current phase is $6.5 billion dollars. Our purchase price is 73%. So we have a discount of 26%, 27% that’s a discount from par given our 73% purchase price. So what do we do with that?

Well, if you look over on the right, what we’ve done is we’ve set up a credit reserve which is actually most of that discount. So we have set up a credit reserve of almost $1.5 billion, which is about 23% of the face amount and then out at the very bottom that blue sliver is the acretable discount. So that’s the portion of the discount that we’re accreting into income along with the coupon to book income on these securities.

So the other way of looking at that is our purchase price is approximately 73% and because we have a credit reserve of 23%, we purchase these bonds at 73% and we’re assuming that we get back $0.77 on the dollar. And that’s behind those yield assumptions that in the third quarter gave us that 6.65% yield.

So again just to conclude, our strategy is to identify the best investment opportunities within the entire residential MBS universe. We are internally advised, internally managed. Our returns over the last 12 years we think have been excellent. And we do have a very significant investment in non-agencies which as Bill pointed out, we think it gives a real good upside play to our home price appreciation.

And with that we’ll open it up to questions.

Question-and-Answer Session

Rich Shane - J.P. Morgan

I will indulge the first question if I may?

Stewart Zimmerman

Sure.

Rich Shane - J.P. Morgan

I think, it was surprise for you guys, I know. You have a hybrid strategy and I think now we’re in a part of the market where that's certainly starting to work in your favor. When you look at sure, agency portfolio, what is your focus there, are you focused on generics? Are you pursuing a strategy that a lot of other mortgage REITs are at this point of specified pools and really paying up for targeted assets.

William Gorin

We have always looked at. We’ve never been a big buyer into the TBA market. We’ve always enjoyed looking at pool specifics. This maybe, never bought a TBA that certainly would be accurate. But we -- where we think it’s appropriate, yes, we look at lower balance as an example where you have some prepay protection and we continue to enjoy the agency market. But again right now we are seeing as you know greater value in the non-agency market.

Rich Shane - J.P. Morgan

Got it.

Stewart Zimmerman

And you know the nomenclature, we’ve never been comfortable with the hybrid. We focused on residential mortgage-backed securities as do the other REITs. We just don't put blinders on when it comes with non-agency. So we invest across the whole sector. I think the world may evolve that way but the hybrid strategy, the hybrid name doesn’t mean anything to us. It’s a residential mortgage-backed securities without blinders.

Rich Shane - J.P. Morgan

Fair enough. And Stewart, to your point before, I mean, and actually to Bill’s point as well, the strategy is very fluid whether its agency, non-agency TBA specified pool. As it seems like capital within the agency market is flowed more and more towards the specified pool strategies, are you seeing better relative value at this moment in the TBA markets and are there any policy initiatives out there that you’re particular concerned about on the agency side?

Stewart Zimmerman

In terms of specified pools, again -- buying a TBA is somewhat -- the two of them have started laughing. It’s kind of buying the pig and pork and they were not going to -- we don’t enjoy that. I’d rather had some specificity in terms of what we’re buying with an idea that we understand that you much better have identified the risk profile what you’re about to own in that asset. But you don’t own this assets for now or for month, you own these assets for a significant period of time and rather know what we have.

In terms of the pay up, as long as the pay up is reasonable pay up and we’re a getting a reasonable return on our investment and return on equity, those are assets, we feel very comfortable with.

Craig Knutson

An important thing to point out, the majority of our agencies for hybrids, in the hybrids you don’t have the breakout of loan balance. So it’s not like G, you never want specified pools before. You have different ability to pick in fixed rate than you do in hybrid and since we’ve nearly been a hybrid player. That’s try the way to distinguish it, not that. We won’t care about underlying characteristics. To the extent, we do own fixed rate, which are 15 years, mainly they do have a low loan balance characteristics.

Rich Shane - J.P. Morgan

One of the other things, you guys have pointed out throughout the year is that you’re reaching a point where the catch up between GAAP and common taxable income is probably here to cross over the next couple of quarters. When you think about your divined policy, given frankly the improvements in terms of GAAP income but the crossing over on the taxable side, what sort of dictates the policies we’re looking at?

Stewart Zimmerman

By the way, I don’t think we said they are crossing over, we said they are moving closer together.

Rich Shane - J.P. Morgan

Okay. Fair enough. The crossing over is my assumption at some point. Eventually they do after.

Stewart Zimmerman

Yeah. So, I said the moving closer together and therefore to except they doom of closed together core earnings prior will be a better predictor of the dividends and you’re right, historically you really need to look through the taxable but I think going forward core earnings will give you better feel what the dividend will be.

Rich Shane - J.P. Morgan

Okay. Great.

William Gorin

And Rick, I think you know that we’re required to pay 90% of our taxable -- of our taxable income, right. So if tax is higher than GAAP that’s why we pay the taxable income because we need to as a REIT.

Rich Shane - J.P. Morgan

Right. In sort of the heart of my question is, as that is the core is more stable, again it’s just -- I realized in accounting convention between the GAAP and the tax, what’s going to sort of settle the limit and it sounds to me like it is -- it will be the core as those start to call less or cross over depending on how you look at it and I think that’s the….

Stewart Zimmerman

And without over seeing the obvious, the board determines your dividend going forward, but our general thinking is tax in core going to be close together. It’s not going to be big distinction.

Rich Shane - J.P. Morgan

Got you. Great. Any questions from the room.

William Gorin

Thanks. Well, we appreciate everybody’s interest in MFA. We look forward to seeing you at another conference of JP Morgan.

Rich Shane - J.P. Morgan

Thank you guys for being here. Nice to see you.

William Gorin

Thank you.

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