Invesco Mortgage Capital's CEO Discusses Q4 2012 Results - Earnings Call Transcript

| About: Invesco Mortgage (IVR)

Invesco Mortgage Capital Inc. (NYSE:IVR)

Q4 2012 Earnings Call

February 6, 2013 8:30 a.m. ET

Executives

Richard King – President & Chief Executive Officer

John Anzalone – Chief Investment Officer

Donald Ramon – Chief Financial Officer

Rob Kuster – Chief Operating Officer

Analysts

Douglas Harter- Credit Suisse

Kenneth Bruce - Bank of America Merrill Lynch

Bose George - KBW

Trevor Cranston - JMP Securities

Michael Widner - Stifel Nicolaus

Daniel Furtado – Jefferies

Gabe Poggi – FBR Capital Markets

Scott Bommer – SAB Capital

Unidentified Company Representative

This presentation and comments made in the associated conference call today may include forward-looking statements. Forward-looking statements include information concerning future results of operations, our ability to maintain or improve book value, the stability of earnings and dividends, our views on the economy, the positioning of our portfolio to meet current or future economic conditions, our ability to continue performance trends, our ability to select assets with slower prepayment speeds, the credit quality of our assets and deployment of capital from the stock offering.

In addition, words such as believes, expects, anticipates, intends, plans, estimates, projects, forecasts, and future or conditional words such as will, may, could, should, and would, as well as any other statement that necessarily depends on future events, are intended to identify forward-looking statements.

Forward-looking statements are not guarantees and they involve risks, uncertainties and assumptions. There can be no assurance that actual results will not differ materially from our expectations. We caution investors not to rely unduly on any forward-looking statements, and urge you to carefully consider the risks identified under the captions Risk Factors, Forward-Looking Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our annual report on Form 10-K and quarterly reports on Form 10-Q, which are available on the Securities and Exchange Commission’s website at www.sec.gov.

All written or oral forward-looking statements that we make, or that are attributable to us, are expressly qualified by this cautionary notice. We expressly disclaim any obligation to update the information in any public disclosure if any forward-looking statement later turns to be inaccurate.

Operator

Good morning, ladies and gentlemen. Welcome to the Invesco Mortgage Capital Inc’s Investor Conference Call, February 6, 2013. All participants will be on a listen only mode until the question-and-answer session. (Operator Instructions) As a reminder, this call is being recorded.

Now, I would like to turn the call over to the speakers for today to Mr. Richard King, Chief Executive Officer; John Anzalone, Chief Investment Officer; and Don Ramon, Chief Financial Officer.

Mr. King you may begin.

Richard King

Good morning and welcome to IVR’s fourth quarter earnings call. This morning I’m going to start by quickly reviewing 2012, discussing the results for the fourth quarter and then I’ll talk about our goal for 2013.

During our earnings calls in 2012 we highlighted our goals of one, maintaining and improving our book value and two, paying a stable and attractive dividend. On the topic of book value, we had a view as 2012 begun that we were well positioned. We were confident that the Fed’s QE program would cause our assets and book value to appreciate.

In Q1, our book value grew about 12%. Over the year we grew book value by about $4.42 per share or almost 27%. Each of the major components of our portfolio contributed agency RMBS and CMBS. We remained focused throughout the year on the dividend as well. Using improvement in the value of our assets and the equity and the cash, the appreciation created to increase earnings assets at attractive levels while maintaining a strong balance sheet.

We were able to maintain the dividend despite falling yields and faster prepays. We paid $2.60 per share in dividends in 2012. Total economic value added between book value appreciation and dividends was $7.02 per share which is about close to 43% of beginning book value. We ended the year with $0.16 per share of retained earnings.

On page three let’s review the fourth quarter. Q4 earnings were $0.77 per share. We paid a steady $0.65 dividend and retained $0.12. In addition to our goals of book value and dividend stability, we had two additional areas of focus, to allocate more of our capital to credit and prepare for the fiscal cliff at yearend.

On the topic of book value stability, despite higher rates and wider agency mortgage spreads, our book value is close to unchanged, down less than 0.5% at $20.83 per share because CMBS and RMBS performed well reducing our overall book value volatility. We were cognizant of political risk in the fourth quarter, because of the timing in the fiscal cliff coinciding with normal yearend balance sheet pressures.

In our base case, we did not expect the CRP to the 2011 debt ceiling or something worse, but we prepared for the turn by increasing liquidity and extending some repo terms. Maintaining a strong balance sheet in the fourth quarter was a top priority. We held $286 million in cash at yearend.

John will go over the portfolio in a few moments, but let me just say a few words on asset allocation. We reallocated capital out of agency mortgages into RMBS and CMBS to benefit from an improving housing market and a rising preference for real estate among investors. This better positioned the portfolio and resulted in approximately $23 million in gains during the quarter.

On page four, let’s talk about the Q4 book value change chart on the upper right. The changes in each asset bucket represent the change in the value of Other Comprehensive Income, OCI. Our agency mortgage portfolio OCI was down $0.90, but not all of that decline was lower prices. Part of that decline was the result of portfolio reallocation.

Selling agency MBS created gains in the quarter which reduced the OCI in the agency bucket by about $0.20 in this case. We retained $0.12 of that $0.20. Our interest rate hedges swaps also offset $0.30 because interest rates rose in the quarter, increasing our share value. The remainder of the agency MBS underperformance in the quarter was the result of spreads widening which we believe is temporary and likely to improve. The spread widening in our agency MBS made them much more attractive to us and led in part to the recent equity offering.

Increased values of RMBS and CMBS as I stated, made up most of the remaining difference in Q4 such that book value was within $0.10 of where we started. But what do we expect in 2013? We’re excited about the prospects IVR sees in 2013 and beyond. We believe housing is transitioning to a growth phase where housing meaningfully is going to add to the U.S economy. We see housing attracting investors in 2013 and expect that the inflow of capital will lead to broadening credit availability.

Private label securitization will return in a more meaningful way and then be much more prevalent in 2014. We also expect to see several pilot risk sharing transactions on behalf of the government, selling the first lot of credit risk on agency mortgage pools. We believe this will be the beginning of a meaningful opportunity for IVR for years to come.

For 2013, our goals remain maintaining and improving book value and providing an attractive stable dividend. We believe however that the best way to achieve those goals would be to continue to allocate more equity towards credit assets which will appreciate as the recovery in housing continues.

We believe a virtuous cycle is beginning with historically low prices on homes. With low interest rates at the same time, housing affordability is extraordinarily high. We’ll be positioning IVR to benefit from new opportunities that come with improving housing markets. Some of the evidence of strength in housing includes a very large decline in existing inventory to 4.5 months now of supply which is again about half of the level from 2007 to 2011. We see positive signs and demand. We see surveys showing home traffic is up significantly along with new home sales, pending and existing sales are better and net demand, that is the number of sales less inventory, is very strong indicating higher prices.

We’ve seen positive signs in distress sales. We’ve seen distress sales fall from half of home sales to about 30%. Short sales are growing as a portion of all distress sales and again the price discount for distress sales is also shrinking. We also see household formations beginning to improve in 2012 and we should continue to increase given pent up formations in supported demographics.

Certainly some challenges remain in the housing market, namely there’s shadow inventory, tight lending standards and we see a full pipeline of refis partly due to higher interest rates, making it harder for buyers to get a loan and there is some remaining regulatory uncertainty for sure, but we see most of these problems waning while the factors that are showing strength are improving. We expect prices to increase in 2013, home prices in excess of the consensus of approximately 3.3%. We think sales are being held back by the tight lending conditions for purchase loans especially and which we expect to loosen up gradually over 2013 and past. Invesco Mortgage Capital intends to position itself to fill a huge long term need for private capital in the mortgage capital.

With that I’m going to pass the call to John to go into more detail in the portfolio, our investment strategy and discuss our progress on the deployment from our recent capital raise.

John Anzalone

Thank you, Rich. On slide six I will start with the portfolio update. As Rich mentioned our focus during the fourth quarter was to reposition the portfolio to take further advantage of the improving housing market. To that effect, our agency book decreased by just over $600 million, while our non-agency RMBS book was up by $453 million and our CMBS book was up almost $300 million. I will elaborate on those moves over the next few slides as I go through the sectors individually. Additionally, we carried more cash into year end. $286 million versus $190 million last quarter, as we were positioning defensively heading into the fiscal cliff discussions. That cash has since been deployed which will further increase earnings assets. Total leverage on the portfolio increased from 5.8 times to 6.1 times. As you know we raised $359 million of capital a couple of weeks ago to take advantage of opportunities we are seeing in the market.

As it stands now, we have approximately 85% of that capital deployed. The raise is particularly well timed as we are able to quickly put the money to work on the agency side, just as valuations were cheapening. We are very pleased with the specified pools that we were able to pick up, as pay-ups on prepaid protected collateral were also softer. On the agency side, the raise is fully invested. On the credit side we are also making very good progress with over one-third of our credit allocation complete. In non-agencies where we have made the most progress, we have been focusing on increasing our allocation to legacy positions which will stand to benefit the most from the uptick in housing.

On the CMBS side we are anticipating that the new issue pipeline will increase providing most of the opportunities to take advantage of improving CRE fundamentals. Let’s turn slide seven in the agency sector. We made quite a few moves within the agency sector during the month as we saw some shift in prepayment behavior. The largest shift involved moving away from higher coupon investor pools, mostly in 4s and 4.5s, and moving into lower coupon loan balance in geo-paper in 3s and 3.5s.

We noticed that the rates being offered to investors were moving closer to where regular borrowers could obtain loans and speeds on that paper was beginning to tick up. As I mentioned earlier, we have seen some softening in pay-ups, particularly on lower coupon specifieds. So we moved into those stories. These moves generated about $20 million in gains while strengthening the prepayment protection of the portfolio.

On the funding side, we have seen repo rates fall since the end of the quarter with 30-day repo rates now in the high-30s, down from the high-40s at year-end. Leverage increased slightly to 9.3 times. We had another strong quarter on the prepayment front as the CPR on a 30-year collateral declined from 13.1 to 11.6 CPR. While we saw an increase in speeds for 15-year collateral and hybrids ARMs, those sectors only make up about a quarter of our agency book. Overall, approximately 90% of our agency collateral has some form of prepaid protection.

Now let’s turn to slide eight in non-agency. We made good progress in adding to our non-agency book during the fourth quarter with the book increasing by $453 million. These are primarily legacy bonds and in fact our allocations of legacy paper increased from 31% of our non-agencies to over 40% during the quarter. And that will continue to increase as we are also directing new capital towards legacy paper. As Rich went over, we are more positive on housing and are looking to position that portfolio to benefit from this fundamental improvement.

Further technical factors are still overwhelmingly positive. As net supply remains negative, we expect over $100 billion in negative net supply in 2013. And demand remains robust as investors search for yield. We continue to see yields decline as our hybrid ARM collateral resets lower and new purchases are put on a slightly lower yield. Funding costs have improved helping offset the decline in yields and leaving our net yield only slightly lower. Leverage on our non-agency books stood at 3.3 times at year-end.

Finally, I will discuss CMBS on slide nine. Just as we are seeing improving fundamentals on the residential side, we are also seeing CRE fundamentals continue to improve. We added almost $300 million to our CMBS book during the fourth quarter with new investments concentrated primarily in single A rated new issue bonds. CMBS rallied strongly during the fourth quarter with prices on our book up about two dollars on average. That strong performance has continued since year-end with our CMBS prices up between $0.50 and $1 on average as investor demand is fueled by the need for yield.

We saw our average yield fall to 4.82%, reflecting the increased credit quality of our book as well as tighter spreads on new purchases. Funding costs fell slightly to 1.50% leaving our net yield of 3.32%. Leverage on our CMBS book stood at 2.9 times at year-end. So that concludes our prepared remarks. So, operator, can we open it up for questions?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question does come from Doug Harter of Credit Suisse. Your line is open.

Douglas Harter- Credit Suisse

Could you talk a little bit about how book value has fared in the first quarter given some of the weakness pay-ups that you referenced?

John Anzalone

Sure. As of yesterday, book value was approximately unchanged over the quarter. And really it was the same dynamic that was going on in the fourth quarter in that agencies slightly underperformed and credit gains offset that. A little bit of a different flavor to it this quarter as non-agency prices improved a little bit more than CMBS prices so far in 2013, whereas in the fourth quarter CMBS kind of led the way. But we are seeing very stable book value.

Douglas Harter- Credit Suisse

Great. And with rates backing up, I guess you kind of answered this but I guess going to a little more detail as to why you still find the stories as attractive?

John Anzalone

I think we do like -- we continue to like higher coupon mortgages and given the premium on those, it’s really important to have prepaid protection given -- we probably are biased towards rates going on higher but certainly some (inaudible) rates are going to lower. So I think those pools just have a better convexity profile. So we are always going to pay up for higher or better convexity in the agency book. But we are still very much skewed towards how a coupon mortgage which we think that embedded IO and that is going to be decent protection against rising rates also.

Operator

Our next question does come from Kenneth Bruce Bank of America Merrill Lynch. Your line is open.

Kenneth Bruce - Bank of America Merrill Lynch

I guess, I was hoping you might be elaborate on the risk sharing bonds that you anticipate coming out later this year. Is there any thoughts around what those investments would be proxy to? How are you thinking about what the return profile would look like? If you could give us some color on that, that would be helpful.

John Anzalone

Sure. I think what's likely to happen this year is we will have a number of pilot transactions that pick various forms, senior subordinated, structure, maybe in embedded note, and maybe a pure derivative form. And from what we have seen recently in the private label market, you have seen some improvement in kind of execution and certainly ROE on buying loans and securitizing has tightened and the agency transaction is similar to that, so there is likely to be some competition for it. But the amount of volume that needs to get done in the agency market obviously is quite large overtime. And in addition to that, as the housing market picked up there will be a lot more of loan production and you should see improvement in the ROE on securitization as well. So we are positioned for both of those things. And we think that they will have to be priced attractively. I can't really tell you exactly what the ROE’s are going to be except that there is a huge need for capital in that space and that for the government to get out of the way, it’s going to have to be attractive.

Kenneth Bruce - Bank of America Merrill Lynch

Right. I guess is there anything that you would point to as maybe being an appropriate reference rate not knowing how the market is going to evolve. I guess I am maybe hoping you could provide just some context as to what you would look at for a proxy for that part of the market?

Richard King

I mean we are going to look to try to generate the types of ROEs like in the low double-digit, I would say, and maybe slightly higher. A lot of the ROE on any one transaction is going to depend on how thick the tranche is. Obviously, the thinner the higher the ROE will have to be.

Kenneth Bruce - Bank of America Merrill Lynch

Okay. And as you are looking at the private label market, could you elaborate just as to your strategy in that part of the market. Is that something you envision? Accumulating loans and then securitizing or just participating in other securitizations.

Richard King

Yeah, I think, first up I would say we have been very patient on this score because we have just seen better value for our shareholders and holding securitized assets and financing them. And that’s still the case today. But what we are doing is we are setting up, we are going through the steps we need to take to be able to buy loans and securitize them because we think it’s time to get set up. I think earlier we just thought, this is way too early. So essentially we are not looking to originate, we are not looking to service, but we are looking to position ourselves to buy loans from originators and securitize those loans.

Kenneth Bruce - Bank of America Merrill Lynch

Okay. And maybe lastly, is there a minimum allocation of agency MBS that you think is appropriate for the portfolio? Or how should we look at that going forward?

Don Ramon

Well, I think that -- I guess that kind of depends on the environment. And I think right now we are favoring credit because we see, like (inaudible) Rich went over, so many positive signs in the housing market. But clearly there is going to be a minimum amount we need just to meet our whole pool test. So I mean that would be the kind of the minimum level there. But as long as we see ROEs that are decent and we feel like we can find pretty good prepayment protection stories and hedge effectively, I mean you will still see us active in that space. But I think in terms of our allocation to credit, really what depends on mostly is just finding enough credit that we are comfortable holding. I mean that really is the limiting factor in terms of, there is positive signs and we are seeing pretty decent flows on the non-agency side. And the CMBS market is obviously, the pipeline is improving there, so as those come on it’s more a evolution than we don’t just dump all our agencies and pile on to credit. We definitely take our time and find bonds we like.

Operator

Our next question does come from Bose George of KBW. Your line is open.

Bose George - KBW

Just curious, the decline that we saw in your, in the prepayment speeds on the 30-year fixed, was that partly because you sold higher prepaying assets earlier in the quarter? Just curious about that.

John Anzalone

Yeah. I think that was most of it. I mean what we have found, I mean we go through this process pretty much constantly. But as we go through the portfolio, we try to figure out which stories are working better than others and the one really stuck out -- there were actually two that stuck out. One that stuck out was the investor property pools. In that we are seeing the rates that were coming to -- were available for investors. We are kind of converging on what the regular type borrower, and those guys tend to be in a better position to refinance. So we moved out of those.

And also there is a real diversion in terms of just pools originating before and after unit 2009. I mean pretty much even the story that the paper that does have prepayment protection that was HARP eligible, we are starting to see that paper pickup in speed. So we didn’t move out of some of those. And so that -- it’s a bit encouraging in that we are seeing -- it is kind of counterintuitive but when we see low balance pools that are HARP eligible, start to increase in speed. I mean to me that tells me that short of a low hanging fruit has been picked in terms of HARP and they are going after loans that are probably less profitable to refinance. So we are starting to maybe get comfortable with the fact that HARP might be starting to burn out.

Bose George - KBW

Great. And this is actually a follow-up just on HARP. Do you see any political changes that could sort of give HARP a further boost this year?

Richard King

We don’t anticipate any major changes. I think if there is changes they might be, we consider more around the edges. And I think that recess appointment being made unconstitutional makes it a lot less likely that the (inaudible) gets replaced in the near term. So major changes to HARP are probably not in the cards anytime soon.

Bose George - KBW

Okay. Great. And then just one follow up on that at the first loss credit risk. Is there any feel for the timing of that? Could that be a first half of this year thing?

Richard King

It could be. That’s hard to predict. I would guess, it’s more of second half.

Operator

Our next question does come from Trevor Cranston of JMP Securities. Your line is open.

Trevor Cranston - JMP Securities

It looks like the overall leverage went up a little bit this quarter even though the allocation of the portfolio shifted more towards the non-agency bucket. Can you guys just talk a little bit about how you are thinking about leverage today and what you view as the target for the portfolio once the capital from the raise is deployed.

Richard King

Sure. I would say just on the -- what we were looking in the second half of last year was kind of gaining confidence in the housing recovery and interest, and allocating or buying more assets that benefit from the housing recovery. So we did increase leverage on the non-agency book and in terms of -- and in CMBS as well. And we are comfortable with the levels we are there. On the agency side it’s been relatively constant. And I would say on the new capital we are looking at same type leverage numbers that we have on the existing capital.

Trevor Cranston - JMP Securities

And then just a kind of follow-up on the idea of the questions about HARP. We have seen some headlines recently about some possible programs coming through, about refing underwater borrowers who are in non-agency securities. Can you guys maybe share your thoughts on the likelihood of that type of thing coming through and how it might impact your portfolio?

Richard King

I mean it would be a positive. At this point I haven’t seen anything that indicates a likely path. I know there is a desire on the part of the administration to accomplish that. It’s kind of tough to see how that gets done unless the government is willing to essentially do something like TARP and put their own money towards it. So I would still say it’s not that likely but it would be beneficial in that, that would lower loss estimates on RMBS and improve ROEs.

Operator

Our next question does come from Mike Widner of Stifel Nicolaus. Your line is open.

Michael Widner - Stifel Nicolaus

So I got a couple of questions for you. And let me prefix by saying the book value appreciation I think is about 27% for the year. So very impressive there. You talked about going forward that your focus would be more on sort of maintaining as opposed to raising and you would like to raise. But let me just ask about that opportunity. I guess specifically you had a couple of strategies that played out well in 2012 and mostly it was the shift into credit and credit assets performed very well. And you also, I think, got into some of those investor pools and other things before those things fully rallied. But with a lot of those opportunities which are now being exploited. I mean how do you look at the book value opportunity in 2013 and specifically where do you see opportunities for assets that are not fully appreciated and not fully priced into the market yet.

Richard King

Right. So that’s the idea behind our shift into more legacy RMBS that is of lower dollar process versus the [remix]. It is meant to capture more book value appreciation. So on the agency side if you have a, let’s say it mildly rising interest rates. I mean our goal is to generate dividends and hedge interest rate risk. And you may get some book value improvement from agency mortgage spreads tightening. We think they are relatively attractive. Coming into 2012, prices were seriously undervalued so you got a lot of left last year. So you can't expect anything like that I think going forward. But we do think you could see continuing spread tightening in credit assets and some spread tightening in the agency market. So I think it’s reasonable to expect some book value appreciation.

Michael Widner - Stifel Nicolaus

So let me take the two sides sort of separately and just follow up. On the non-agency side first, you guys have stuck pretty close to the top of the credit stack overall and if I look at what you are holding right now, on the CMBS side your average carrying value I think is about 1.09 and 4. So they are up there pretty high. And so I guess one, my question, is there a top on that? I mean can we move a whole lot higher than 1.09 and change. And then on the RMBS side, you know, again, you guys have stuck pretty close to the top of the credit stack, it’s worked out very well for you. But your average carrying value right now is 92 and change. So do you see opportunity to kind of move deeper down into the credit stack where you can still get stuff at say $0.70 or it’s all no matter how far down you want to move. I mean do you see any opportunity kind of moving deeper into credit as opposed to just shifting the allocation towards credit. And if it’s just an allocation the issue, I guess the question is do you really see upwards potential for those prices from where they are.

Richard King

I mean the answer is, yes. We see upward potential in prices. We like prime and I will take collateral better than subprime. So dollar prices are more likely to be in the 80s than in the 70 range like you have mentioned.

John Anzalone

Yeah. And I would say at CMBS, I mean with high dollar prices, those are -- we think more about spread duration than actual duration in terms of how the prices are going to react. So we think that right now we are considering that single A is kind of the sweet spot for where we are comfortable taking risk and putting leverage on that. So I think that still we expect to see some spread tightening there. And CMBS is obviously, there is no convexity risk there, so dollar prices aren’t really constrained in the same way that they might be in agencies if you get too high a dollar price. And it’s easily hedgable.

Michael Widner - Stifel Nicolaus

Got you. So then my final question and I apologize, I’m easily confused sometimes, but you guys mentioned a couple of things where you said you think that rates are likely to rise and other times you’ve said that you think spreads are likely to tighten. So for example you said you took the opportunity to put the capital to work quickly on the agency side because you liked the backup in rates, but then at the same time you’ve indicated that you think with housing recovery and the virtuous cycle starting all that, that rates are likely to go higher. So it makes me say well is this really a great time to be putting money to work or is there better opportunities ahead? And then similarly, on the non-agency side you spoke about you think that spreads are likely to tighten and things are going to get better which on the non-agency side I guess I can understand, but on the CMBS side I’m not sure that there’s any credit risk at all priced into those assets and so again would those not be negatively impacted by an improving economy and potentially a rising or steepening slope economy? So it just feels like you’ve said.

Richard King

Well, on the agency side I think it’s – we took advantage. It wasn’t so much a rate move, but it was more of just spread widening move that we took advantage of. So our strategy on the agency side is we’re trying to find assets that we can hedge in a way that produce a stable ROE stream and very cognizant that the risk of rate is a bit one – is skewed obviously towards higher rates given how low rates are. So we try to buy collateral stories that are going to be less impacted if rates rise. So really what it comes down to and why we found it attractive was much more of a – we found a spot where spreads were locally wide and we could buy prepayment protected pools that produce a pretty good cash flow they’re going to have better convexity characteristics. That’s what we’re thinking there and in the back up the Fed is going to buy however many billion a month they’re going to buy for the rest of the year is positive there.

So I think that’s, on the agency side that’s more of the story, whereas on the credit side I think an improving housing market, whether that pertains to a gradually increasing rate environment or a sharply increasing rate environment, whatever that leads to and we think that the spreads are at levels where we think we’ll see improvement there in terms of potential price gains, but also that with the hedges we have on we’re going to produce a stable and sustainable cash flow stream. So that’s how we think about it in terms of that. So we’re not – our view isn’t that we think rates are just going to go up immediately and we’re going to position the portfolio that way. It’s much more trying to put on those kinds of cash flows that make sense.

Michael Widner - Stifel Nicolaus

Got you. And so I mean, I don’t know. I don’t think it’s an outlandish view to necessarily to say that the Fed’s on hold for a long time. It’s going to keep buying agency MBS no matter what. So I can certainly see an argument that spreads are going to tighten on agencies or continue to tighten on agencies after we get past this little hiccup and yet at the same time the economy is going to improve, but not to the extent that we’re going to see 6.5% unemployment by yearend. So the reality might very well be that the curve continues to steepen potentially being good for spreads going forward, but at the same time agencies could continue to price higher because the Feds are just going to buy the cows come home. Is that…

Richard King

From the economy I’d just add that the housing we expect to be the bright spot in the economy. Still have clear fiscal drag and higher tax rates and deleveraging in some spots. So just to be clear, we’re not saying we think interest rates have gone up a lot.

Michael Widner - Stifel Nicolaus

I guess one last question and I’ll get off. Certainly the things that have been going on in housing are extremely interesting I’ll say. You talked about inventory. You talked about – I think you alluded to home price improvement and what not. Do you have any concerns whatsoever about the extremely high investor shares of those purchases and it’s both institutional and individually 30% plus of sales going to all cash buyers and what not, guys like Blackstone putting a couple billion into single family. At the same time you hear other people talk about that as great and then other people talk about it as a huge risk because are we not recreating exactly what got us into this mess in the first place? Any thoughts on that and the sustainability there? Then I’m done, I promise.

Richard King

I don’t think we’re recreating what was done in the first place at all. Credit standards are extremely tight. It’s tough for qualified borrowers to get loans still unless they’re way above their qualified bar and cash buyers, that’s really a reflection of what I just said. It’s easier to buy a property if you have cash than it is if you have to borrow money. So we think that provides future lift in housing prices as credit comes back. Affordability is super high. We don’t look anything like we did when went through the problem where house prices were unattractive and lending was easy.

Michael Widner - Stifel Nicolaus

Yep, I’d agree with that. Well, very nice 2012 and thanks for humoring me with the questions.

Operator

(Operator instructions). Our next question does come from Daniel Furtado of Jefferies. Your line is open.

Daniel Furtado – Jefferies

Thanks for the opportunity everybody. Nice quarter. The first question I had is when you mentioned that you’re now in the early stages of setting up to buy loans, thinking about the new issuance market whereas before you hadn’t really done anything in that regards. Are you talking about bulk transactions from big banks or are you thinking of flow transactions from say a network of smaller banks?

Richard King

We’re thinking of both.

Daniel Furtado – Jefferies

Okay. And then I know this may be a little bit getting ahead of the situation, but how do you think about the pullout from MBS purchases at the Fed and the impact of the space? And what I’m thinking or what I’m getting at is that most REITs with agency portfolios are hedged with swaps. But when the Fed halts purchasing of MBS, I don’t think it’s hard to imagine a scenario in which asset prices sell off ahead of rates moving higher which would leave a period of time in which the swaps hedges are largely ineffective from a protecting of book value standpoint. Is the answer to that conundrum or question being short TBA’s or am I just completely off course here?

Donald Ramon

I think that’s – in some ways that’s why we like our model so much is because we do have a place to go outside the agency market if we see that coming. I think our view is that the Fed’s going to do what they said they’re going to do. They’re going to continue buying until – keep conditions easy until we get employment improving and things like that which we think is fairly a decent ways off. But I may add part of what the strategy is now is to move more towards credit assets to something like that happens it will lessen the blow. That’s really all you can do if you’re predicting that agency spreads are going to widen materially. But right now agencies – despite the fact buying agency spreads are historically pretty attractive.

Daniel Furtado – Jefferies

Oh, no. I got you there. I was just a couple of steps ahead there. But thanks for the commentary. Nice quarter again guys.

Operator

Our next question does come from Gabe Poggi of FBR. Your line is open.

Gabe Poggi – FBR Capital Markets

Good morning guys. Two quick questions. Can you give us an idea of where you’re buying the legacy non-agency paper you were talking about increasing capital allocation to? And then the second question is, your most recent capital raise – if you back up the gains on sales and obviously you have a lot of gains baked in here from a dividend stability standpoint, but wanted to get an idea of how you guys view the ROE on that new paper or the new capital deployment from an accretive standpoint relative to the 65 or what your core earnings was in the quarter once you back out those gains?

Donald Ramon

Okay. I’ll start with the non-agency purchases. So we’re looking at – and again this is, we’re focusing on legacy paper. So it’s away from re-REMICs at this point. We’re seeing yields call it between 4 and 4.25 which would be what we consider to be loss adjusted on levered deals. So if you take that with an average cost of funds it’s somewhere in the 1.5 to 1.75 range, you end up with a pretty decent NIM on that portion of the book. And then the second part was – oh ROEs on the spec going forward. Yeah, we expect ROEs to be roughly similar to where we’ve seen them over the past few quarters. So we didn’t expect things to be materially different. Agencies looked a little bit better.

We’re expecting mid to low teens ROEs on the agency trade given where we’ve been on paper. Similar for – I just gave you what we expect from RMBS. And then CMBS might be a little bit less in terms of expected ROEs in that on levered deals there are probably 3.75 and 4ish with slightly higher funding cost because obviously those are much longer cash flows. So the swap cost is embedded in those. But we really like having that – I mean we’ve seen it in the last two quarters even though you would have said hey, ROEs are a little bit less on CMBS. Over the past few quarters we’ve seen a lot of book value improvement coming from that. So we really like the diversification into the commercial area also. So I think that’s important to have after reduces.

Operator

Our next question does come from Scott Bommer of SAB Capital. Your line is open.

Scott Bommer – SAB Capital

Nice performance, congrats. Quick question for you. I think you highlighted a handful of things since quarter end that would probably be positives to run rate earnings, just taking them off invested the excess cash or some of the excess cash you had at yearend, putting the offering to work at pretty good levels in the pullback and then repo rates coming down, it sounds like almost 10 basis points. Is CRP potentially another positive just that we’ve had three or four quarters of high CPR and maybe the combination of a little bit of the burnout. You mentioned burnout on harp but you maybe burnout on the whole portfolio. And then secondly, rates going up a little bit, do you think that that’s another positive to run rate running let’s say over the course of the year?

John Anzalone

This is John. Yeah, absolutely. I think we’re pretty I guess same way about CPRs going forward here. We think it is obviously – we’ve seen a slowdown in our 30 year book. We wouldn’t be surprised to see slightly lower CPRs going forward for all the reasons you mentioned I think. The real key is if we get rates to go up a little bit you could see a material slowdown in CPRs because we’ve had – we do have higher rates and you have that dynamic of when rates go up you get a lot of people lock their loans because they think they’re going to miss the opportunity. So we did see a little bit of spike when rates went up in terms of speeds. But and also we think the way we’ve repositioned our book particularly to us we think is going to be positive. We’re very comfortable with the stories we’re on right now. We think we’ve dodged a few of the mines there over the last couple of quarters. So we were pretty surprised that that was a little bit of a tailwind.

Scott Bommer – SAB Capital

Fantastic. Well, one of the most attractive things your stock I think versus some of the others and the progress you’ve made has just been able to maintain the dividend over the last six or seven quarters is – I think some of your peers have fought pressure with CPRs going up and rate contraction and combination of everything you’ve done has been – yielded a great outcome. So congrats on that. Appreciate it.

Richard King

Thanks Scott. We feel good about things.

Operator

At this time I show no further questions.

Richard King

Well, we appreciate it. Thank you.

Operator

Today’s conference has ended. All participants may now disconnect.

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