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Capstead Mortgage (NYSE:CMO)

Q4 2012 Earnings Call

January 31, 2013 9:00 am ET

Executives

Lindsey Crabbe

Andrew F. Jacobs - Chief Executive Officer, President, Director and Member of Executive Committee

Robert R. Spears - Executive Vice President and Director of Residential Mortgage Investments

Phillip A. Reinsch - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Secretary

Analysts

Bose T. George - Keefe, Bruyette, & Woods, Inc., Research Division

Joel J. Houck - Wells Fargo Securities, LLC, Research Division

Stephen Laws - Deutsche Bank AG, Research Division

Steven C. Delaney - JMP Securities LLC, Research Division

Jason Stewart - Compass Point Research & Trading, LLC, Research Division

Gabriel J. Poggi - FBR Capital Markets & Co., Research Division

Operator

Good morning, and welcome to the Capstead Mortgage Corporation Fourth Quarter 2012 Earnings Conference Call. [Operator Instructions] Please note that this event is being recorded.

And now, I'd like to turn the conference over to Lindsey Crabbe. Ms. Crabbe, please go ahead.

Lindsey Crabbe

Good morning. Thank you for attending Capstead Fourth Quarter 2012 Earnings Conference Call. The fourth quarter 2012 earnings press release was issued yesterday January 30. The press release is posted on our website at www.capstead.com. The link to this webcast is in the Investor Relations section of our website and archive of the webcast will be available for 60 days. A telephonic replay of this call will be available through April 2. Details of the replay are included in yesterday's release. Starting off today's call is Andy Jacobs, our President and CEO.

Before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, and are based on certain assumptions and expectations of management. For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC, which are available on our website. The information contained in this call is current only as of the date of this call, January, 31, 2013. The company assumes no obligation to update any statements, including any forward-looking statements made during this call.

With that, I'll turn the call over to Andy.

Andrew F. Jacobs

Well, good morning, and welcome to our fourth quarter 2012 earnings call. As usual I'm joined by Robert Spears, our Portfolio Manager; and Phil Reinsch, our CFO, both of whom will be available for questions after a few opening remarks.

Net income for the fourth quarter totaled $35.1 million or $0.31 per diluted common share. Net interest margin for the fourth quarter decreased to $38.3 million as a result of a 17 basis point decline in financing spreads on our investment portfolio to 113 basis points. Portfolio yields averaged 1.76%, which was a 10 basis point decline from the third quarter. Yields were impacted by the lower weighted average coupons on the holdings currently resetting ARM securities, which reflect current underlying indices to which these loans reset. Yields also reflects higher investment premium amortization due largely to higher mortgage prepayment, which averaged at the fourth quarter 19.6% CPR, which was compared to 18.7% in the previous quarter. This increase in prepayments resulted in an additional $2.2 million in premium amortization, which for the quarter totaled $29.3 million.

Interest rates on repo, including the effect of the interest rate swap agreement that we used to hedge our borrowing costs, they increased 7 basis points to 63 basis points for the fourth quarter. This reflects generally higher market rates for repo, primarily for stuff -- for repo that was extended beyond year end. And also impacts -- the impact of an additional $500 million in current paying swap agreement that we had, which had an average rate that was about to 58 basis points.

Operating cost as a percent of our long-term investment capital declined to 79 basis points during the quarter from 88 basis points in the previous quarter, due to primary lower compensation-related expenses, a significant portion which is performance based. For the year, our operating costs as a percent of long-term investment capital was 97 basis points compared to 127 basis points in 2011.

Regarding the portfolio, acquisitions during the fourth quarter totaled $428 million and did not keep pace with runoff, which was $830 million. We used a meaningful portion of our capital that is made available through runoff was utilized to repurchase common shares, which total repurchases during the fourth quarter totaled $35 million. Subsequent to the end of the year, we purchased an additional $7 million in common shares that totaled at this point $42 million of the $100 million authorization. We ended the year with an investment portfolio of $13.9 billion, reflecting an overall market price of $105.58, it was leveraged 8:1 and a net duration gap of 1.75 months.

Overall, this portfolio is backed by mortgages with -- requiring borrowers to make mortgage prepayment based on average interest rate of 3.33%, which is a pretty low number overall even in this environment.

58% or $7.8 billion of our overall portfolio was invested in current-reset ARM securities, of which 93% was originated prior to 2008 and carried coupon interest rate at/or below prevailing fixed-rate mortgages, diminishing most any economic advance of refinancing and also continued -- the pre-2008 origination continued to be hampered by low housing prices and credit problems. Newer originations primarily held in our longer-to-reset portfolio, as we say, remain more susceptible to refinancing because it's easier for these borrowers to qualify for new mortgages and it may be more attractive to do so from a rate perspective. While most of these acquisitions -- while most of our acquisitions in recent quarter have in the longer-to-reset securities, it's important to note that these higher prepay characteristics are taken into consideration at the time of purchase, so higher prepayment rates in this portion of portfolio is not a surprise.

Overall, we expect mortgage prepayment levels to remain manageable in coming quarters, absent additional government intervention or to lower interest rates beyond where they are right now.

Book value per common share decreased $0.30 to $13.58 due primarily to a $0.44 decline in the investment portfolio as previously mentioned, offset by a $0.09 increase in the value of our swap position and $0.06 accretion from our stock repurchase.

With that, I will open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And the first question comes from Bose George of KBW.

Bose T. George - Keefe, Bruyette, & Woods, Inc., Research Division

I have a couple of questions. First, as you noted that repo rates were up into quarter end. Just wanted to get any commentary on how things have been trending since then?

Robert R. Spears

Yes, sure. Bose, I'll take that. Since at the end of the year, repo rates were down, I'd say, roughly 7 or 8 basis points, so now you're kind of funding in the 38 to 40 basis point area.

Bose T. George - Keefe, Bruyette, & Woods, Inc., Research Division

And then just on the asset yield side, just curious how that's been trending since quarter end in terms of where you're putting stuff on?

Robert R. Spears

On the spread basis, we're probably looking at 125 to 135 basis points. But I would like to add that it's been a good start this year, because with the curves steepening fixed-rate mortgages have been hit fairly hard, whereas ARMs are hanging in there really well. And so from a standpoint of our portfolio, both book value and on the acquisition front it's been a good start so far this year.

Operator

And the next question comes Joel Houck with Wells Fargo.

Joel J. Houck - Wells Fargo Securities, LLC, Research Division

This question is related to how you guys look at investment returns. Obviously, the share buyback is a good thing for shareholders and I think it also signaled may be lower than current rate of returns in the fourth quarter. What does that look like now in terms of stuff that's brought -- prepayments that you get, the capital that you're investing, what did the IRR's look like here in kind of the first quarter of 2013?

Robert R. Spears

Well, 125 to 135 basis points spread, on a levered basis 8x. You're kind of looking in the 12%-ish to 13% area right now on new acquisitions.

Joel J. Houck - Wells Fargo Securities, LLC, Research Division

Okay. And maybe give us a sense for what that look like in the fourth quarter when you're buying back stock?

Robert R. Spears

Well, I think when we bought back stock in the fourth quarter, our stock was trading in at 15% discount to book. And so you look at that, at that point in time, and returns on MBS were probably in the 10% to 12% range something like that. So at that point in time, it looked like a smart thing to do.

Joel J. Houck - Wells Fargo Securities, LLC, Research Division

So obviously, there was -- the delta was 700 basis points in terms of buying back the stock, that's what I'm looking for.

Operator

The next question comes from Steve Delaney from JMP Securities. I'm sorry, actually, it comes from Stephen Laws from Deutsche Bank.

Stephen Laws - Deutsche Bank AG, Research Division

Can you maybe hit on prepay speeds. I know with you guys on ARMs, and I know you touched on it on your prepared remarks, but with the curve, I guess steepening some, and should homeowners -- is there anybody who thinks, that's been in, say, ARM securities, that now if they think rates have bottomed, are they going to turn other way or will look to kind of extend their duration in refi out of an ARM into fixed? Kind of how do you guys look at that? Can you maybe talk about the dynamic there you guys are trying to -- are unique and that you have your ARM portfolio versus a bunch of peers that, really, mainly fixed-rate investors. So can you talk about the differences in prepay sensitivity with your portfolio given the ARM characteristics?

Robert R. Spears

Yes, sure. It appears right now that ARMs that are refinancing 75%, 80% are going into fixed rate. Having said that, since the end of last year, I think a 30-year no-cost refinance has probably moved up from the 3.5% area today closer to 3 7/8%. So if you look at our gross coupon, and as Andy mentioned earlier, the 3.33%, some of them don't have been incentive. Having said that, our portfolio is kind of unique and that we have a very seasoned component where those securities are 7 years older plus, and have a low coupons. And from both a credit standpoint and an interest rate standpoint, they don't have much incentive to refinance. And generically, a portfolio like that is prepaying in the low- to mid-teens. Most of our prepayment exposure is in our longer reset, newer securities, and we've got a net WAC on that book as we point out in the last page of around 3%. So some of those underlying borrowers have mortgage rates that are 3.5% to 4%, and that's kind of the hot button right now. And those guys, I think for the most part, are the ones that are prone to refinance into fixed-rate mortgage. I don't think somebody that has a 3% mortgage rate is going to refinance into a 4% fixed-rate mortgage. So it's very unique and you almost have to break our portfolio out into those 2 pieces. So we'll continue to see a little bit of prepay pressure on our newer, longer-reset securities. But we -- January speeds have already come out and they're a hair higher than what you saw in the fourth quarter, but that should moderate, so I think, right now. The fourth quarter and first quarter speeds should be fairly the same range.

Andrew F. Jacobs

Yes. I think it's also fair to note that, in talking about some of our older originated products that goes back, these guys have had a number of opportunities to refinance during this period that they haven't done it to this point. There are some reasons behind that, but they've had many opportunities. And we kind of say that, that I think on the short end of the curve, the indexes and stuff are not going to go through the roof, people are very much concerned about what's going on with the 10-year part of the curve and such. But on the short end of the curve, these guys are in the ARM for a reason. They have a pretty good run with low interest rates in here. And based on what the Fed is saying, short-term interest rate are not going up greatly anytime soon. And so I think these people are just betting that for the next several years they can keep these lower rates versus taking a higher fixed-rate mortgage loan today. Like I said, they've had many chances and they concluded to stick where they are.

Stephen Laws - Deutsche Bank AG, Research Division

That's a great point. I appreciate you mentioning that. When we think about the spread, you commented on were new money is going to work, the press release talked about declines in yields being more muted here given we're much closer to kind of the fully, I guess, fully indexed rate on the portfolio. And then when you think about the positive developments with the swap book, kind of as we look out 12 to 24 months with what's rolling off and what's replacing it, is it fair to say that we've kind of reached the trough here with net interest spreads? Are you comfortable with that as far as where we are today looking forward?

Robert R. Spears

Well, I mean, the 2 dynamics that -- to say that we've reached the trough, I don't think anybody knows that. I mean, the 2 dynamics that are going to move this more than anything right now are obviously speeds and then our repo costs. As we've said earlier, it's been a good start for the year because our repo cost could come down and the curve has steepened, which theoretically is good for speeds. But if -- obviously, those dynamics change, it could go the other way. But we're very happy with the start that we've seen this year and the shape of the curve and obviously, we'd like to see more steepening and with longer rates going up even more since we don't have fixed-rate exposure.

Phillip A. Reinsch

It is true though that we are bouncing along towards the fully indexed WAC on our current reset portfolio, so there's not that much downward coupon adjustment to come. There are something there, but not a ton. And having those swaps roll-off at higher rates and replace with ones we've already entered into at lower rates, it certainly gives us a tailwind on the bond side.

Andrew F. Jacobs

Just a couple of points, relative to -- during the fourth quarter, as we said, repo rates were higher going into year end. What was really kind of interesting, at least from a finance guys-type perspective, is that we were able to enter into swap agreements that were lower than 30-day repo rate. So whether the rates were short-term repo or true going over year end or not, that you could put a longer duration swap on at lower levels, is just kind of interesting. But just another point, one of the remarks we did make in the press release, again, is forward-looking, is that we felt that we're kind of bouncing towards the lower end of the portfolio coupon, almost everything is getting reset. And we did say, we expect 2013 results to be more stable. So I think that's, hopefully, a very positive statement that, obviously, we don't know at the end of the day.

Operator

The next question does come from Steve Delaney from JMP Securities.

Steven C. Delaney - JMP Securities LLC, Research Division

One thing I didn't see in the press release, on the repo rate as of December 31 of 47 basis points, do you know what the average remaining term and days because that kind of matters as to how fast we're going to apply these lower rates now?

Robert R. Spears

We didn't disclose that, but it is safe to say that we have a lot of that rolling off early in the quarter and so we'll get a good, a nice bump or a decline in speed early -- in the rates early on.

Steven C. Delaney - JMP Securities LLC, Research Division

And as far the swap strategy, you've kind of painted a picture for us, which you've been doing over the last several quarters, and that is this, these higher cost swaps roll-off. You were replacing them but with forward starting swaps 2 years out. So this $2.9 billion we have in 2013 at 85 basis points, should we just assume that as they mature, and especially this $1.1 billion in the first quarter, that what we're going to see is that will be replaced but with something that will basically kick in, in the...

Phillip A. Reinsch

Sure. Steve, if you look at Page 9, there's a chart we provide that shows that -- what our termination quarter by quarter in swaps and then the forward starts, you can back those dates up 2 years, you see them kicking in, in the respective quarters. So yes, there's $1.1 billion rolling off in the first quarter at 81 basis points, and there's a $1.1 billion coming on stream at 50 basis points. They don't match up perfectly on the calendar, they're at various dates within the quarters. But in a global sense, that's what you see happening.

Steven C. Delaney - JMP Securities LLC, Research Division

Got it. Okay. And then as far as just the last thing that you kind of -- the trade-off between the buybacks and the portfolio, given that the stock is now $0.50, $0.75 higher, almost $1 than where you are buying it in a little while ago, should we -- you shrunk the portfolio by about $400 million, obviously taking advantage of the buyback, it would seem now that looking at first quarter there might be more of a flatter type portfolio in the first quarter versus fourth quarter, is that -- are you seeing it?

Phillip A. Reinsch

I mean, we are acquiring securities to replace runoff right now.

Operator

The next question comes from Jason Stewart with Compass Point.

Jason Stewart - Compass Point Research & Trading, LLC, Research Division

Could you give us a little bit of a sense for what the production of hybrid ARMs and then the supply of securities looks like, and maybe talk about how that might mitigate what happened in that sector versus fixed-rate mortgages during the quarter?

Robert R. Spears

Sure. In the fourth quarter, there was $15 billion in supply, which was down a little bit from the prior quarter which is $16 billion and outstanding, you still have north of $300 billion of agency ARMs, which is about 6% of the agency MBS universe. So as ARMs, some ARMs refinance in to fixed-rate mortgages, the supply will come down a little bit, but it's still north of $300 billion. Obviously, as the curve steepens and the loan rates goes up, supply will pick back up. I guess we're not concerned about not being able to find products. I mean you've also always have secondary selling that varies from quarter-to-quarter, but we're not that really concerned about it right now. If you look back historically, I think agency ARMs have been anywhere from 5% to 15% of the outstanding MBS flow. And we're, obviously, down closer to the lower end of that range, but it's somewhat stabilized. So we're fine with the amount of supply out there and there aren't a ton of people that are playing in the sector right now.

Jason Stewart - Compass Point Research & Trading, LLC, Research Division

Okay. And then if we did see a backup in rates and you saw spreads widen like we've seen in fixed-rate space, would you consider taking leverage up intra-quarter to take advantage of that opportunity?

Robert R. Spears

I mean, we're on the longer range basis, we're comfortable with 8x leverage. When we take it up a hair higher on an intra-quarter basis, if we saw unique purchase opportunity, sure. But I think 8x is going to be our run rate going forward unless things change.

Operator

The next question will come from Gabe Poggi with FBR.

Gabriel J. Poggi - FBR Capital Markets & Co., Research Division

Can you provide a little color on what specifically you're buying right now and what you're paying for those bonds?

Robert R. Spears

Well, that obviously isn't disclosed so we can't tell you specifically. We're, obviously, not buying fixed-rate mortgages, we're buying ARMs. Last quarter, our basis in the securities we bought was around 104 3/4. We are buying both seasoned and new issued securities with a focus more on season. And once again, in the overall strategy, we're keeping our duration low. Our duration gap, as you notice, actually dropped to below 2 months, which is the lowest we've been. And so we're playing in a little bit on the defensive side and sticking to shorter duration bonds. In other words, we're not buying new issue, longer-reset securities with one handles. We're definitely going up a little bit in coupon.

Operator

And there are no more questions at the present time, so I like to turn the call back over to management for any closing remarks.

Lindsey Crabbe

Thanks again for joining us today. If you have further questions, please give us a call. And we look forward to speaking with you next quarter.

Operator

Thank you. This concludes our teleconference. Thank you for attending today's presentation. You may now disconnect your lines.

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