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Hatteras Financial Corporation (NYSE:HTS)

Q3 2008 Earnings Call Transcript

October 29, 2008, 10:00 am ET

Executives

Mark Collinson – IR, CCG

Michael Hough – Chairman and CEO

Ken Steele – CFO, Treasurer and Secretary

Ben Hough – President and COO

Bill Gibbs – EVP and Co-Chief Investment Officer

Fred Boos – EVP and Co-Chief Investment Officer

Analysts

Steven DeLaney – JMP Securities

Bose George – KBW

Mike Widner – Stifel Nicolaus

Jordan Hymowitz – Philadelphia Financial

Jim Ackor – Sterne, Agee

Steve Covington – Stieven Capital

Larry Lytton – Second Line Capital Management

Operator

Hello and welcome to the Hatteras Financial Corp. third quarter earnings conference call. All participants will be in listen-only mode. There will be an opportunity for you to ask questions at the end of today’s presentation. (Operator instructions)

Now, I would like to turn the conference over to Mark Collinson from CCG. Mr. Collinson, please go ahead.

Mark Collinson

Thanks Andrea. Good morning everyone and welcome to the Hatteras Financials third quarter earnings conference call. With me today are the company’s Chairman and Chief Executive Officer, Michael Hough; the company’s President and Chief Operating Officer, Ben Hough; and the company’s Chief Financial Officer, Ken Steele; and also available to answer your questions are the company’s Co-Chief Investment Officers Bill Gibbs and Fred Boos.

Before I hand the call over to them, please note that on this call, certain information presented contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management’s current expectations and are subject to risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, expected, estimated or projected.

The following factors, among others, could cause actual results to differ materially from those described in the forward-looking statements. The company’s limited operating history; changes in its business and investment strategy; changes in interest rates, interest rate spreads, the yield curve or prepayment rates; changes in economic conditions generally, inflation or deflation, availability of suitable investment opportunities; availability, terms or deployment of capital; the degree and nature of the company’s competition, general volatility of the capital markets and dependence on the company’s manager and the company’s ability to find a suitable replacement if the manager were to terminate its management relationship; and other factors that are set forth in the company’s prospectus for its recent initial public offering filed with the Securities and Exchange Commission and subsequent reports on Forms 10-Q and 8-K.

The content of this conference call contains time-sensitive information that is accurate only as of today, October 29, 2008; and the company undertakes no obligation to make any revision to the statements contained in these remarks or update them to reflect the events or circumstances occurring after this conference call.

So with that, it is my pleasure to turn over the call to Michael Hough.

Michael Hough

Thanks, Mark. And welcome everyone to our third quarter conference call. As Mark said, I have the key members of the management team with me today and following our prepared remarks, we are all looking forward to answering any questions that you may have regarding our third quarter results and the current operating environment.

We'd like to spend just a few minutes outlining the quarter and discussing how we performed during what turned out to be a very volatile and unpredictable environment. The credit crisis of the past year has been a pretty incredible time for us to enter the public arena. It has been exciting to say the least, and when you consider the new level of crisis we've recently lived through, I think we had a very good quarter. And we'll say we are pleased to have the investment philosophy we have, as our narrowly defined model seems to be a pretty sound mixture of offense and defense.

Our exclusive dedication to agent-guaranteed ARM securities has enabled us to find investment opportunities over the past year, by exporting the disconnected MBS market, and also to fund those opportunities in the repo market using one of the few remaining asset classes that qualifies as attractive collateral. In the third quarter, we were able to operate profitably. We maintained a quality short duration portfolio. We successfully funded that portfolio, and we engaged willing derivative counter parties during the time where many financial institutions were either going away or are in need of outside help. But while the volatility has been incredible, we keep walking the line that we set for ourselves.

But with that, I'll hand it over to Ken Steele, our CFO, to go over our operating results in detail.

Ken Steele

Thanks, Michael. Good morning everyone and thanks for joining us on the call today. Now, if you set aside the remarkable markets we've been through this last quarter, this would have been pretty uneventful time for Hatteras. One thing that didn't change during this quarter’s market turmoil was our strategy and its performance. We were able to generate significant income from the spread between the yields on our assets and our funding costs.

The third quarter was our first full quarter of operations where we are fully invested for all three months. We were able to fund it at our targeted leverage ratio that we wanted to obtain a financing we needed, when we needed it, albeit on terms that were fairly difficult to predict at times. Key bullet points about the quarter, which all this was in our release last night, we did have an average portfolio size throughout the quarter of about $5.1 billion, comprised of 71% Fannie Mae and 29% Freddie Mac ARMs.

Our yield for the quarter was 5.08%, up slightly from the 5.03% in the second quarter, as principle pay down slowed significantly from 12% to 8% on an annual basis. Our average cost of funds moved up to 284 from 270, in part due to adding more fixed rate borrowings and hedges and also from a higher-than-anticipated refill rate, especially right at quarter end. Ben will discuss this more in detail later, but (inaudible) financing was available throughout the quarter but was somewhat constrained from a competitive standpoint.

LIBOR remained elevated especially towards quarter end, and export refill rates up well beyond our historic relationship with Fed Fund. This led to a slightly lower net interest margin of 224 for the quarter as compared to 233 in Q2. Our expenses increased slightly from $2.2 million to $2.5 million, mostly from the fact that we had a larger average capital base, of which our management fee is calculated. Our quarter-ending leverage was 8.7 with a total repurchase agreement balance of $4.6 million and a quarter-ending equity of $527 million. The change in leverage from June 30 will be resulting in the change in equity and not a change in borrowing size or portfolio size.

As a result of all this, our earnings came right in line with our projections. We made $29.7 million or $1.11 per weighted average share for the quarter. We had a return of average equity of 21.64%, (inaudible) declare dividend of a $1.05 per share in September which represented an annualized yield of 18.96% based on our September 30 closing price of $22.15.

There are a few comments about book value. The end of September was particularly erratic in the MBS markets. As the quarter came to a close, prices on our securities fluctuated greatly from day-to-day and even hour-to-hour as news and some forced sales hit the markets. We shed some fears and resulting soft interest rate forecast also decreased the value of our swap positions, despite the higher short term borrowing rates. This affected us more than what has been the case of the prior quarter, because we took a more cautious stance in this volatile environment and added 5 new swap contracts and one extended repurchase agreement during the quarter, bringing our total notional amount of fixed rate financing up to $1.9 billion, which is slightly over 40% of our borrowings.

Normally the value of our swap positions and our assets positions, we're moving in opposite directions with the changing in interest rate forecast. But this was not the case with September 30. The overall marking at September 30 reduced our book value per share down to $19.69, now slightly about 6% from the June 30 level of $20.96. Despite this decline, which was based on temporary evaluations, we are very satisfied with the quarter from the income and balance sheet perspective.

Now I will turn this back over Michael.

Michael Hough

Okay. Thanks Ken. So looking back at our performance of the quarter on paper, the third quarter seemed operationally fairly smooth for Hatteras. However, as you know, many market events that were completely unprecedented happened during the quarter, especially toward the end of it. Perhaps fortunately for us, none of which was more important to what we did than the fact that our assets effectively became government securities.

And at the same time, the US government and governments around the world aggressively intervened into the money markets and provided capital to the world's biggest and best financial institutions. If you think about it in these terms, both sides of our balance sheet, assets and liabilities have been directly supported by US and Global Central Banks and Treasuries.

Although this is easily the toughest environment that we've seen in the 10 years we've been in this business, this isn’t the first time our markets have been challenged by liquidity or asset quality issues. We believe that we are an important part of the solution to the base level problems our economy faces, specifically housing. As such, we think that the government recognizes this and is giving significant priority to maintaining the viability of the MBS markets for housing finance. And more so, since the MBS market is now comprised mostly of agency issuance.

I feel the other reason why we have been resilient in this, is that this team has been doing this for a long time. We recognize that the primary risk of effectively operating our strategy in this environment is the ability for us to finance our portfolio through the financial institutions and the costs associated with it. In just a second, Ben will discuss in more detail how funding actually went for us during the quarter, but I want to make sure I mention here that we were able to repo every position in the portfolio during the quarter over the quarter-end and also through the October rolls.

Since we've been in this business, we've been very sensitive to our counterparties and try to be as responsive and as transparent with them as possible. This approach has always served us well. Fred and Bill have been phenomenal in their efforts this way and actively worked at our existing counterparties to make sure we have excess capacity at all times.

So, at quarter-end, there was very little clarity in the MBS market as spreads on our assets widened to levels that were, in reality, pretty difficult to peg. The impact on our portfolio is evidenced by the decline in our book value of approximately 6% that Ken mentioned. As has been the norm recently, hybrid evaluations have been lagging those of the fixed rate market and quarter-end to the day has been no different.

Over the past two months, the treasury yield curve has shifted down significantly, but the mortgage yield curve hasn’t. For example, today the 10-year treasury yield is about 3.8% and the 2-year treasury yield is about 1.6%. That is a 220 basis point yield curve and compare that to a 30-year mortgage rate to the borrower of about 6.5% with a 5/1 ARM rate to the borrower's, about 6.25%. That's a 25 basis point yield curve over the same time horizon. It's very flat, obviously, but very flat relative to a steep treasury curve. If an ARM rates to the borrower are on top of 30-year fixed rates, there will obviously be very little supply of new ARM origination to the market. Intuitively, one would think this lack of supply should increase the value of ARMs, that's not been the case recently. We are in a world starved for liquidity and demand for assets has been low.

Increased liquidity brought on by lot of participation in the MBS market will hopefully bring a return to normality sooner than later. We do expect to see some of the TARP money going directly into agency MBS on a levered basis at some point and the GSEs and treasuries to step-up their agency MBS buying, which we think will also help bring back the traditional overseas buyers.

Also, when more clarity emerges on the direction of Fannie and Freddie, and the government puts its stamp of backing firmly in place, we expect the overseas buyers to again become aggressive participants in the agency market. All of this together leads us to the conclusion that there is a tremendous amount of built-up value on our portfolio that should be realized when conditions settle, demand increases and the mortgage yield curve adjusts to the steep sloping treasury yield curve.

It is imperative for spreads to significantly tighten and for yields to come down in the mortgage market if the housing market is going to stabilize and improve. This, I believe, is the ultimate mandate to get our economy back on the right track.

So with that, I'll hand the call over to Ben to discuss the funding environment during the quarter and end up with a review of our current position.

Ben Hough

Thanks Michael. What I'd like to do is briefly go over market and portfolio activity for the quarter from both a liability and asset perspective and give some color on the market since quarter-end. It's been challenging, but Bill and Fred have continued to stay on top of it. As Michael said, we did make funding a primary focus during the third quarter. If you remember from our second quarter call, we got fully invested in early July and we ended up placing over $3 billion in repo that month, anywhere from 30 to 90 days with repo rates generally around 2.5%, significantly higher than the 2% Fed Funds target at the time.

The repo market began to tighten a little in August, as Fannie and Freddie dominated the headlines. Repo rates ticked up to around 270, and we saw some of our lenders shorten the length of repo they would provide. We got a brief reprieve when the GSE conservatorship was announced and we saw some easing in funding terms and in agency hybrid ARM spreads. That all came to an end quickly as Lehman and AIG hit the tape and we approached the end of the quarter

The terms for going over quarter-end were all over the board, we had rate quotes from around 2.5% to 8%, and haircuts from 3% to 7%. As you can see from the earnings release, our average haircut went from just over 4.5% at June 30 to just over 5% at quarter-end. This was the first time we had executed repo at over a 5% haircut.

Our philosophy over quarter end was to push the lenders on terms where possible, but to be satisfied with what we got on the basis that this was a relatively short-term issue. We couldn’t really get good visibility into the underlying drivers for this very diverged terms in our view, was that visibility in October will get better and terms would improve from those counterparties that were sold off the market. Then we selectively placed repos and rolled the least favorable quotes the shortest and our best quotes the longest. For example, we rolled one repo at one of the least favorable terms we've seen in a while but rolled it only for a few days until October 2, where we replaced it with one of our new providers at much better terms.

One thing the spirit of volatility is doing is giving us even more confidence in the overall strength and viability of the agency MBS repo market as a whole. We began the quarter with 18 approved repo relationships in place. By the time we had to roll our September repos, we had lost Lehman as one of them, but had already added another one to offset it. Given the turmoil, overall funding costs were reasonable due to the strength of our relationships in the underlying asset quality.

This quarter end, conditions have approved somewhat as far as terms go, due to some market stability and additional repo options we have with our additional providers. More counterparties competing for business, the more competitive the terms will be for us. Today, 30-day repo rates are around 3% on average and range from the mid 2's up to 3 and 3 quarters. One week repo is available at a rate of around 2%. These wide ranges are a clear illustration of uncertainty and a continuing lack of liquidity, using a 1.5% Fed Fund's target rate, 30-day repo is about 150 basis points over Fed Funds on stronger collateral than ever before from a credit standpoint. To put this in perspective, since the summer of last year, this spread has averaged around 30 to 40 basis points; while historically, it has been around zero to ten basis points. So we feel that there's a lot of room for repo rates to come down from here, not only if the Fed cuts its target rate more but also when LIBOR and repo rates move more inline.

On the assets side, it's been just as volatile. Spreads on hybrid ARMs at quarter-end were all over the place but the terms of the spread to the zero coupon treasury curve or Z-spread, we would peg one on one dollar price five one to about 285 basis points and the spread to the swap's curve at about 175 over. Factors such as the government action at the GSEs, the volatility in treasuries and distress in the funding markets all contributed to a level of uncertainty that has resulted on somewhat illiquid market for hybrid ARMs.

Pricing in the spend market was very evident when we valued the portfolio at quarter-end. We primarily used dealer pricing inputs to get the fair market value of our assets, which historically has been a pretty effective indication of market levels. This time, we saw dramatically different prices for similar securities and our book value reflects the impact of pricing in that kind of market.

This quarter end, agency hybrids have widened a little more and yields have remained high. Given the fact that the credit quality of our assets is now even another notch higher and the market for funding this assets is improving, we feel that the current spread agency ARMs offer to treasuries and swaps should bring demand, and with it, higher spreads and lower yields.

Okay, so in summary, we had a solid quarter and a very volatile market that increased in fluctuation especially as the quarter ended. This meant very satisfactory income performance with a somewhat diminished quarter end book value. We did great work increasing our sources of liquidity in managing the size, duration, and leverage of our book right throughout the quarter. Our view of the market today is a positive one, we are expecting more liquidity rather than less and so we are positioning ourselves to be able to maximize the asset base as the market develops throughout the fourth quarter. We feel comfortable with our sources of financing and again believe that the terms will be more rather less favorable as time goes on. Even though we are starting the fourth quarter with abnormally high short borrowing rates on a relative basis, they are in decline.

A caveat to that level of comfort is that we do expect the year-end has potential to be as volatile as recent experience; but hopefully by then, the initiatives that have been taken across the world to support the financial markets would be working their way through the system and may serve to mitigate that. Even though we can't say how these markets will develop, we are happy with were we sit. Again, we are confident in our funding capacity; our portfolio is positioned just where we want it to be; and our asset liability mix is optimal for the current market.

So in conclusion, I want to emphasize that this very experienced team is focused on all of the risk and opportunities in front us. And we will continue to manage through this incredible time diligently and conservatively.

With that, I would like to open the lines up to questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from Steve DeLaney of JMP Securities.

Steven DeLaney – JMP Securities

Hey, good morning guys. How are you?

Ben Hough

Good Steve.

Steven DeLaney – JMP Securities

Good. So, congratulations on getting through a difficult quarter especially on the funding side. That’s great work. So Michael, I was going to ask ─ I know everyone wants to talk about repos, I was going to ask you about – if you would give us some color on your view of the MBS spreads and sort of the cause and the cure there on your second set of comments following Ken. I think you did that pretty well so we’ll skip that. But I just ─ I do want to clarify on that that given the better market on hybrids and the wide bid asked that both bids were existent at the end of September and continue today, are you saying to us and are you still convinced that staying with 100% hybrids even though we are dealing with a thinner product, that you still like that product versus the fixed rate product?

Michael Hough

Yes, I mean I think obviously it’s been less liquid in the fixed rate market and we’ve seen that in the way spreads have behaved. We still think long term it’s very viable for our product and strong alternative for a home buyer. And as the liquidity situation and the overall market settles down, we think that this value that we see now, on a relative basis, harbors the fix will be recognized and those spreads will ─ those yields will come down quickly and spreads will tighten. I think that is where a lot of inherent value is right now.

Steven DeLaney – JMP Securities

Yes, it is thinner but I guess on one respect too, it’s been a little less volatile here lately too because all the action has sort of been on the other side. And is it not true that historically that when the banks have come in to the market which, I think, some of us are hoping happens after these TARP checks get in their hands, have they not focused on the hybrid for the ARM products versus fixed over the years?

Michael Hough

I don’t know how – to what degree that would be but ─

Steven DeLaney – JMP Securities

Okay.

Michael Hough

I would say yes, specific from the reduced duration that they can get.

Steven DeLaney – JMP Securities

Right.

Bill Gibbs

This is Bill. We are starting to see that already. Last week, a week and a half, we have definitely seen a lot more bank participation and as you see their deposit bases build, which they are definitely gathering deposits right now as well as the money coming in from the TARP program, we are definitely seeing banks come back into the market.

Steven DeLaney – JMP Securities

Good to hear, we certainly need them. And just one last, sort of housekeeping thing, your Lehman receivable, it’s about $0.26 per share so certainly it’s something that you can manage, you’d like to not have it but I guess the question I have there, are you far enough along working with your lawyers to know whether in the bankruptcy, are you considered a secured or an unsecured creditor?

Ken Steele

Steve, this is Ken. Good morning. We can’t say too much about it, but we are ─ technically, we are an unsecured creditor.

Steven DeLaney – JMP Securities

Okay.

Ken Steele

To the loss, probably that receivable will actually include some unrealized gains to ─ that the part of the maximum loss is going to be down somewhere closer to $0.20 a share.

Steven DeLaney – JMP Securities

Okay.

Michael Hough

There’s also some insurance funds available, but actually the one thing is that most likely this trade is going to end up getting respected, I mean, CIFIX is going to work to settle these things out; there’s a large group of repos that have already been assumed by another repo provider. And so ─ and that happened this last week. So, while there’s certainly by far no guarantee, we’re still pretty hopeful that this is ─ at the end of the day, we’re just going to end up putting this back on our books as to assets and the liabilities and moving forward.

Steven DeLaney – JMP Securities

Great. Okay, well thanks for that clarification. Thank you guys.

Operator

Thank you. Our next question comes from Bose George of KBW. Please go ahead.

Bose George – KBW

Morning guys, again, good job in a tough quarter. I have a couple of questions. First, could you just go over where incremental spreads currently stand? I mean given your 3% repo rate, even lower swap rates, it would seem like spreads are quite a bit higher than where your current portfolio is.

Michael Hough

Yes, Bose, good morning. If you take a look now, you are looking somewhere in the neighborhood for 101 dollar price 51, around 5.75 quarters to 5.80 coupons, which will bring in to a yield around to 5.60. And if you look at funding as Ben mentioned, we’re looking at 30-day repo somewhere in the neighborhood of around 290. Similar type of funding cost if we go into a two and a half year swap as well. So you’re looking good 270-275 basis points of spread.

Bose George – KBW

Then switching to your leverage, are you guys pretty comfortable with where the leverage currently is?

Ken Steele

Yes we are ─ as I've said in my thing, basically, we didn’t change our borrowings or our portfolios and it’s purely having to do with the marks and our liquidity, which is main reason why we look at leverage size and make sure we have adequate liquidity. Remain strong and right in our target of over 5% throughout the quarter, it was about 5.4% at the end of the quarter. And so we’re pretty comfortable with that. We think it just comes back; it will come much more down in line. It’s just the temporary moves that happened.

Bose George – KBW

Thanks, and then actually just a follow up to Steve’s question on the Lehman receivable, while that has been resolved, do you guys continue to receive the PNI right on that receivable, on those assets?

Michael Hough

Well, I mean, we have and that is probably another sign that is likely or a good chance; I won’t say likely, but there’s a good chance it is going to get resolved. Legally, they could go ahead and leave that, but we did receive our PNI this week. So there’s a lot of signs. Like I said, I don’t want to be over promising here, but there are a lot of signs that indicate ─ and if CIFIX does their job and they don't come in when at a point where it's too late to give and there everybody looks to what they have back. So ─

Bose George – KBW

Good, thank you, and just one final question on ─ are you guys looking more at the Ginnie Mae market, it seems like there's a lot of more supply coming in, maybe there's better funding terms on Ginnie's. What are your thoughts on that market at the moment?

Michael Hough

Yes, we have looked at the Ginnie Mae market and you're right, the supplies picked up with the FHA program. Some of the things there, in terms of cap structure of Ginnie Mae, we look at a little differently because the cap structure is a little tighter, which will cause your duration to move out more in an operating environment and the Ginnie Mae's are CMT based. So we look at 1/1 or short 3/1 type part of the program, right now CMT and short reset CMT papers are not being treated kindly in the market. If that gets to the part where we think it is cheap enough and it makes sense and it fits our portfolio, we will definitely look at it, but there are some considerations we have to take into account.

Bose George – KBW

Right. Thanks again.

Operator

Thank you. Our next question comes from Mike Widner of Stifel Nicolaus. Please go ahead.

Mike Widner – Stifel Nicolaus

Hey. Good morning guys and congratulations on the first full quarter and (inaudible).

Michael Hough

Thank you.

Mike Widner – Stifel Nicolaus

Steve and Bose got a couple of my questions. Just one, I was looking a little more detail, if you could provide it, on the book value decline in the quarter. Looks like about a $1.27, that's a lot higher than I would have expected on the swap side. So I was just wondering if you could sort of talk about the swaps versus MBS or anything else that showed up in there.

Ken Steele

Yes. We would have expected the swaps, like said, to have gone the other way and they got − I would say how bad it's probably about. You look at the total market it's probably about 80, 85 to 20 or 15. But we were expecting, as far as the change, we would have expected to be fairly positive right now in our swaps which we worked hard starting the quarter that they came down. We were basically right there at quarter end.

Mike Widner – Stifel Nicolaus

Okay. But, so as far – I guess what I'm looking for was − if you could break out that $1.27 at all or at least you kind of give us a guess on what part was the mark on the swaps versus the MBS, because as I go through it just based on the swap details you guys provided and you provide better detail than most, I'm only getting to about $0.35 on that swap portfolio of decline over the quarter and I know there's a lot of volatility in MBS at the end of the quarter, but, you know, that would seem like a whole lot of mark down, you know, given that you guys, where you said the yields were at the end of the quarter. I'm just having a hard time reconciling sort of where you said yields were at the end of Q2, where you said they are at the end of Q3, which is presumably reflective of your mark and then sort of combining them to get to $1.27 decline in book.

Ken Steele

Michael, thank you. You're right on this as far as this probably good estimate on the $0.35 for the swaps. Roughly, we are just kind of eyeballing what it is, you know, a lot of it was just the fact that pricing was just very, very difficult at quarter end and we were fairly conservative there. The market was quite disconnected on the MBS pricing side; we saw on the same securities from our different dealers, sometimes a 1.5 difference. And the trading was so thin, the bid-ask was so wide right there − it was just a difficult time to get prices. We went a little conservative with that regard, but I can see it being a little surprising. It's difficult too when the markets get a little dysfunctional of pricing certain assets.

Mike Widner – Stifel Nicolaus

Got you. Okay, well I appreciate that. And then let me just follow up on the Lehman piece as well. You indicate you have a receivable for that, and I think as Steve said. And my math puts that at about $26.5. Is that falling through OCI at all right now or is that still sort of reflected in – is that completely absent from your book value adjustments or in other words, if you don't get that back, do we expect to see another decline in book or is it sort of already in there?

Ken Steele

Correct. There's not much in book value related to that.

Mike Widner – Stifel Nicolaus

Okay. And then I guess just a one final question on the repo. You showed that you have 11 counter parties there. Just wondering if you guys are working on broadening that list at all? And then just a second question related to that, you mentioned the cost of one week repo being substantially lower than sort of 30-day or longer repo. Have you guys, are you utilizing that at all or are you kind of sticking to the 30-day and longer?

Michael Hough

Fred?

Fred Boos

Hi, Mike. Thank you for the question. This is Fred. I'll take the second one first. When we guess we are utilizing one week and even some overnight weights down in the 2%, 1.5% range. So we see that and we are taking advantage of it. To the first part of your question, we're very encouraged and optimistic about the repo market. Despite the recent inter bank credit challenges and the exit of a few players, namely Lehman in the third quarter and (inaudible) in the second quarter. We've been fortunate to sign on five new counter parties since the end of the second quarter, with two more currently pending. So that leaves us with 20 with 2 pending approvals, so we feel very optimistic about the repo financing marketplace. The agency repo business is becoming more profitable for lenders. That's our view. It provides greater spreads, greater margins, and greater way rock contributions from Aon perspective for banks and less credit risk in terms of government agencies.

So, we also constantly pursue new financing relationships. We believe that their new avenues will possibly develop the emergence of more tri-party repo brokers we've seen. We're positive about that. We believe that there's direct access to possible repo cash providers, money managers is an example. And lastly, there is also the possibility of interaction with US facilities down there, GSE direct repo, Fed direct repo. Those are all potential sources of financing that we see could be on the horizon and so, we're very constructive on the financing side.

Mike Widner – Stifel Nicolaus

Well, great. Thanks guys. I appreciate that commentary, Fred – some of the conversations about possible extending repo facilities as well, hopefully, for those to materialize. I think it would take a lot of concerns off about you guys and the whole group. But thanks for answering the questions and congrats on a pretty solid quarter.

Fred Boos

Thanks Mike.

Operator

Thank you. Our next question comes from Jordan Hymowitz of Philadelphia Financial. Please go ahead.

Jordan Hymowitz – Philadelphia Financial

Hey guys. Bunch of questions, and I apologize for that. First of all, can you see what the monthly margin was as opposed to the quarterly average margin?

Ken Steele

Are you talking about the previous monthly margin?

Jordan Hymowitz – Philadelphia Financial

Yes. July, August, September.

Ken Steele

Yes. I mean, we can't – we have to get back to you on that. We don't have that right in front of us.

Jordan Hymowitz – Philadelphia Financial

Okay. If you could do that, that would be great. And you said, what's the marginal margin today? Because you said the marginal spread is about 270, so the marginal margin has got to be a little higher.

Ken Steele

Well, yes. It's really tough to peg that right now as repo rates are moving around so much. I mean that's the difficult thing that puts up money. And I think we've said that given several levels away, the asset yields on and you have to look at the repo side and there is no consistency right now from the borrowing and even if you go really short. So, I'm not trying to avoid that question. I just think it's a hard one to answer given the volatility. I mean you could say it is 400 basis points, you can say it is 200 basis points.

Jordan Hymowitz – Philadelphia Financial

Well, let us put it a different way; I mean your spread today you said was 270 on the margin, right?

Ken Steele

I think we said 270 on a new purchase and that's what the market spreads are today.

Jordan Hymowitz – Philadelphia Financial

That's right. I'm saying that your marginal business is coming under the 270 spread, right?

Ken Steele

Yes.

Jordan Hymowitz – Philadelphia Financial

And that means the minimum because you're 801 leverage is closer to three today, correct?

Ken Steele

If we we're adding assets at that level, yes.

Jordan Hymowitz – Philadelphia Financial

We are – I mean if you would buy something today that would be them, anything you replace today is coming on at that level?

Ken Steele

Correct.

Jordan Hymowitz – Philadelphia Financial

So, this level may not stay, tomorrow the world could change cause its changing dramatically. But if you just think about a 3% minimum versus 230 minimum, you got $0.70 or $0.80 more in earnings power that hypothetically could come on just from the spreads thing where they are today.

Ken Steele

Correct, absolutely.

Jordan Hymowitz – Philadelphia Financial

And given that purchase, the question you got to ask yourselves is does it makes sense to take advantage of this dislocation in this market by trying to come back to the market to take advantage of those at this point?

Ken Steele

Well, I think that's a very good question and a very good thought Jordan. It's something we think about, but we currently don't have plans to raise capital. However, we see the opportunity here. And we believe that there's a lot of value in these assets today. And I think we have to temper that with the volatility and the equity markets as well. But we actually believe that there's an attractive investing market.

Jordan Hymowitz – Philadelphia Financial

You've got 5% haircuts today so that means hypothetically, you could go up to about 10 to 1 leverage comfortably; would that be fair?

Ken Steele

I mean I think we could go to 10 to 1 leverage, I don’t know if we feel comfortable, but–

Jordan Hymowitz – Philadelphia Financial

Let me ask a question. How high do you feel comfortable going at this point? Let me ask the question that way.

Ken Steele

I think we're right where we want to be. We have – like we say, it's based on our liquidity. You know, we want to have that cushion to be able to deal with all the markets and we're in one right now and we are in a great shape. So, I think our leverage to the market we are in is just right now. I mean theoretically, we could take it off and still have a cushion, but maybe not to the degree that we feel comfortable.

Jordan Hymowitz – Philadelphia Financial

Well, if you think about the fourth quarter, will you assume you run at approximately this leverage plus or minus a tad?

Ken Steele

If conditions are where they are today, I would say yes.

Jordan Hymowitz – Philadelphia Financial

So, given that that's the case and given that marginal spreads are higher today, you would have to think that, again, if everything stayed where it was, does it mean that the dividend – well, let's forget the dividend, the earnings would only be trending up in Q4 versus Q3 from today?

Ken Steele

I think that is a reasonable thought.

Michael Hough

Yes, I mean it certainly depends on cost of funds, but it's certainly a reasonable thought.

Jordan Hymowitz – Philadelphia Financial

Okay, and one more question. I apologize for the many here. But based on lots of talk about the government directly doing repos or guarantying repos, can you give your thoughts on that and the likelihood that it would it happen?

Ken Steele

Yes. It's something that we've heard rumors about, we've reached out to the government and it really had no good feedback. I would expect others have as well. I don't think we have any really strong data points to answer that question. However, if it was something that made sense to the government and they did that up, I think it would free the repo market up immensely.

Jordan Hymowitz – Philadelphia Financial

And do you know if Barack Obama has any view on this or comment on it from the economic policy people?

Ken Steele

I do not know.

Jordan Hymowitz – Philadelphia Financial

Thank you. I apologize to the numerous questions.

Ken Steele

Thanks Jordan.

Jordan Hymowitz – Philadelphia Financial

If you can call me back about the minimum I would appreciate that.

Ken Steele

Okay.

Operator

Thank you. Our next question comes from Jim Ackor of Sterne, Agee. Please go ahead.

Jim Ackor – Sterne, Agee

Thank you. Good morning, guys.

Michael Hough

Hi, Jim.

Jim Ackor – Sterne, Agee

Hey Jordan, if you make under $250,000, the repos are free under Obama. Yes, okay. Anyway, I have got two quick questions. Jordan mentioned, which I think was a good line of questioning, given the incremental spreads you guys are seeing out there and what you perceive to be an attractive relative valuation with the hybrids versus the 30-year fixed, capital raising seemed like an obvious choice to me. But given the volatile in the equity markets and stocks trading in and around book value, et cetera presents some challenges. If you've done sort of a basic map on doing some preferred stock issuance?

Michael Hough

We have thought about it. I mean we have thought about all options that would be on the table and we don't really have – and obviously there are things to consider within the marketplace. But we really don't have any plans right now at this time to do it and then think – however, again, think that something that we will consider going forward.

Jim Ackor – Sterne, Agee

Okay, that's fair enough. And the question I wanted to see if you guys might be willing to flush out just a little bit with some more detail. How you might characterize some of the new repo providers, their relationships, the types of companies that you're signing on to replace the Lehman’s and whoever else has disappeared, the Bear Stearns and all that? You did mention that you replaced Lehman with one and that you had a couple pending. And without naming names, can you sort of generically describe the types of firms that are stepping in and filling some of this void?

Fred Boos

Hi, it is Fred. There have been some foreign banks with US operations in New York we have approached and some have approached us, so that's sort of the nature – say, some of the recent counterparties that we have signed on. There are a few brokerage-type operations that are interested and those are some of the ones pending. So those are sort of the nature and you would expect that our relationships are deep with most of the US banks currently.

Jim Ackor – Sterne, Agee

And the other thing you mentioned which has been talked about quite a bit over the last month or so is the whole concept of trying to develop direct relationships with sources of cash, so it's be holding to the middleman, so to speak. Is that something that's viable over the near term and then used in any meaningful scale or is that just going to be sort of bits and pieces and patch work for the foreseeable future?

Fred Boos

This is Fred again. We're exploring all avenues right now, certainly via the tri-party brokers. In terms of direct relationship with cash providers, they obviously look for weightings. For their counterparties, we're working on those angles as well. And maybe Ken can speak to that. So we're exploring all opportunities. We think there's some viable sources there, especially on the brokerage side and it increases the competitiveness both weight and term for Hatteras, and we like that of course.

Ken Steele

I think there is opportunity there, it may not be significant in a very short term, but every bit as helpful and I could see it being meaningful out six to nine months possibly.

Jim Ackor – Sterne, Agee

Okay. So that's not too far down the road. Okay, fair enough. Thanks a lot guys.

Michael Hough

Thank you.

Operator

And your next question comes from Steve Covington of Stieven Capital. Please go ahead.

Steve Covington – Stieven Capital

Good morning guys. Most of my questions have been answered but I did want to follow up on a previous question. Are there opportunities and you guys actually didn't trade during the quarter, but are there opportunities to trade out of some of the lower coupon securities you have into some of the newer higher yielding production and would that trade make sense today?

Michael Hough

We are always looking at possibilities of upgrading the portfolio, but with the dislocation that has occurred in the current market right now, you are seeing large, really large bid-ask spread and it would take an awful long time to make up the difference of that bid-ask and additional coupon right now. But we're definitely looking at that possibility at all times.

Steve Covington – Stieven Capital

Okay, thanks.

Michael Hough

Thank you.

Operator

Thank you. Our next question comes from Larry Lytton of Second Line Capital Management. Please go ahead.

Larry Lytton – Second Line Capital Management

Thank you. I wasn't clear on the Lehman receivable. Is that built into the book value here and such that if you collect, we get back another $0.20 or so or is it not in there, if you didn't collect, we would lose $0.20?

Michael Hough

It wouldn't be lost. If we did not collect, it wouldn't directly hit the value. It would then go to earnings, which does mean dividend, but not a direct typical value.

Larry Lytton – Second Line Capital Management

All right. And in terms of your– obviously, you have a lot of dislocations, they kind of exist (inaudible) the end of the quarter. Are things any better as we can speak today in terms of normalization than they were at September 30 or you'd basically say they're more or less identical?

Michael Hough

I think you have seen a little bit of improvement. At the end of the quarter, you had a lot of constraints in terms of balance sheet, and particular dealers. We're not participating in the market. They're lacking with brokers but they wouldn't really take things onto their own balance sheet. You started to see that change a little bit. The inventories of the dealers are low, but they are not afraid to bid bonds and hold them right now. In addition to that, we've definitely see a pickup in bank activity, which has given more two-way flow to the market. So, it has, in our view improved somewhat since September 30.

Larry Lytton – Second Line Capital Management

So, I guess I'm saying without being precise, if you were valuing the book values today as opposed to September 30, it might be a little bit more favorable in terms of your ability to mark things.

Michael Hough

Yes, I think so, and I think part of that just comes from the more flow means you'll get more accurate read on where things are.

Larry Lytton – Second Line Capital Management

Okay.

Ken Steele

The treasury market at the end of the quarter was moving 30 basis points up and down for those three or four days, which adds another level of uncertainty unto the pricing.

Larry Lytton – Second Line Capital Management

Okay. Thanks a lot.

Michael Hough

Thank you.

Operator

Gentlemen, at this time we have no further questions and I would like to return the conference back over to Mr. Hough for any closing remarks.

Michael Hough

Okay. Well, thank you all for your interest and for being on this call and for good questions, and we'll talk to you – look forward to talking to you at the end of the year.

Operator

Conference has now concluded. Thank you for attending today's presentation.

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Source: Hatteras Financial Corporation Q3 2008 Earnings Call Transcript
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