Arlington Asset Investment Management Discusses Q4 2012 Results - Earnings Call Transcript

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 |  About: Arlington Asset Investment Corporation (AI)
by: SA Transcripts

Operator

Good morning. I'd like to welcome everyone to the Arlington Asset Fourth Quarter and Full Year 2012 Earnings Call. [Operator Instructions] I would now like to turn the conference over to Kurt Harrington. Mr. Harrington, you may begin.

Kurt Ross Harrington

Thank you very much. Good morning. This is Kurt Harrington, Chief Financial Officer of Arlington Asset. Before we begin this morning's call, I would like to remind everyone that statements concerning future performance, returns, leverage, portfolio allocation, plans and steps to position the company to realize value, and any other guidance on present or future periods, constitute forward-looking statements that are subject to a number of factors, risks and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances. These factors include, but are not limited to, changes in interest rates; increased cost of borrowing; decreased interest spreads; changes in default rates; preservation of our net operating loss and net capital loss carry-forwards; impacts of regulatory changes and changes to Fannie Mae and Freddie Mac; actions taken by the U.S. Federal Reserve and the U.S. Treasury; availability of opportunities that meet or exceed our risk-adjusted return expectations; the ability to effectively migrate private-label mortgage-backed securities into agency mortgage-backed securities; ability to realize a higher return on capital to make future dividends; the failure of sovereign or municipal entities to meet their debt obligations or a downgrade in the credit rating of such debt obligations; ability to generate sufficient cash through retained earnings to satisfy capital needs; changes in mortgage prepayments fees; ability to realize book value growth through reflation of private-label mortgage-backed securities; the realization of gains and losses on principal investments; available technologies; competition for business and personnel; and general economic, political, regulatory and market conditions. These and other risks are described in the company's annual report on Form 10-K and quarterly reports on Form 10-Q, that are available from the company and from the SEC. You should read and understand these risks when evaluating any future-looking statement. I would now like to turn the call over to Eric Billings for his remarks.

Eric F. Billings

Thank you, Kurt. Good morning, and welcome to the fourth quarter earnings call for Arlington Asset. I am Eric Billings, Chief Executive Officer of Arlington Asset, and joining me on the call today are Rock Tonkel, President and Chief Operating Officer; and Brian Bowers, our Chief Investment Officer. Thank you for joining us today. I know it's a particularly busy couple of days and weeks for you, so we do especially appreciate it. 2012 was an important year for Arlington. Two accretive offerings during the year helped the company generate an ROE from core operating income of approximately 20% for the third consecutive year. Capital grew by 65% over the course of the year. Recurring expense burden on capital declined by 35%. Prepayment protection in the company's agency mortgage-backed security portfolio delivered single-digit CPRs and permitted cash net interest income to grow by 38%. Improving credit performance and high CPRs in the non-agency mortgage-backed securities portfolio generated an 11.5% current yield based on ending market value from the portfolio for the year and positioned the company to realize substantial appreciation from the housing recovery, and the company utilized $57 million in tax benefits during the year.

Finally, the company's complementary and balanced capital allocation permitted the portfolio to respond well to fluctuating market environments over the course of the year while generating attractive cash returns. Going forward, the company is well positioned to continue to deliver attractive cash returns plus growth.

Accordingly, during the fourth quarter, the company recognized an income tax benefit of $12.22 diluted per share, resulting from the release of $162 million in valuation allowances on its existing deferred tax assets. Going forward, the company will continue to receive the cash tax benefits of its $230 million net operating cash loss carryforwards through 2025, as well as a portion of its $285 million net capital loss carryforwards through 2014. Due to the company's current C corporation structure, shareholders will continue to benefit from an after-tax yield on the company's dividend that is approximately 35% higher than companies with a REIT structure. We continue to see encouraging performance from both our agency and non-agency portfolio. In the agency portfolio, all of our assets were specifically selected for prepayment protection of some type. Approximately 60% of our portfolio was originated under HARP programs and our remaining assets consist of either low-balanced loans, low FICO loans, high LTV loans or loans with other prepayment protected features. These loan characteristics significantly reduced the economic incentive to the borrower to refinance or constrain the borrower's ability to refinance. This quarter, our agency portfolio demonstrated the value of asset selection with a portfolio CPR of 6.1 versus CPRs of 34 on Fannie Mae 4.5% universe. For Arlington, the concentration of our portfolio in prepayment protected mortgage-backed securities with low CPRs has a significant positive impact on the consistency of our asset yield and spread income, as well as on the preservation of book value. The futures contracts we utilize to hedge our agency portfolio run consecutively on a quarterly basis beginning in September 2013 and extend out to December 2018. They have an average notional amount of approximately $830 million. Based on book value per share of $35.24 at December 31, 2012, the mark-to-market average cost over 5 years of the hedge was 1.12%. Using the average hedge cost over its 5-year life, economic earnings going forward on a per share basis would be approximately $0.13 per quarter lower than core operating income per share in the fourth quarter, or $1.12 per share.

Today, with an expected agency mortgage-backed security asset yield of approximately 3.05% and approximate average annual hedge cost of 1.12% over 5 years, assuming leverage of 7 to 8x, invested capital of approximately $152 million currently, the annual expected return on equity from the agency portfolio would be in the mid to high teens on a hedged basis.

In the non-agency side of our business, we have earned approximately a 16% average cash annual cash yield on invested capital over the past 3 years, while at the same time, the portfolio has appreciated 22%, from a cost basis of 49.5% of par to a market price of 60.2% of par at December 31. In addition, we realized gains of 8.4% on average per year for 3 years from that portfolio. In addition to the strong historical returns in our non-agency portfolio, we continue to see attractive returns opportunities today in the sector, driven mainly by improving trends in the U.S. housing market and overall economy. Housing affordability is just shy of its highest point since 1986, with house prices down nearly 30% from the crisis and mortgage rates near all-time lows. Mortgage origination and servicing capacity are expanding. Employment growth, increased loan modifications and loan refinancing costs are driving down foreclosures. Distressed home sales are declining, while non-distressed home sales have been rising.

The introduction of permanent institutional scale capital into the business of purchasing and renting foreclosed or defaulted housing stock has helped shift the supply-demand equation for housing inventory in a favorable direction. These factors and others have stabilized home prices, and in many markets, led to rising prices. According to CoreLogic Inc., U.S. home prices gained 7.4% in November from a year earlier. These positive influences appear to be having a broader psychological impact on homeowners, homebuyers and consumers, which may portend further improvement in home prices, lower loss severities and fewer mortgage defaults.

In fact, many of these dynamics can already be observed in the sector fundamental. In the $900 billion non-agency MBS market, which consists of 3.9 million loans, the balance of nonperforming loans have declined -- has been declining for 37 consecutive months from a peak of approximately $494 billion in December of 2009 to $265 billion as of January 2013. Credit migration rates have improved meaningfully across the delinquency spectrum. Now defaults are down 90% from the peak and 43% from a year ago. Foreclosed inventory is half of what it was a year ago and liquidations are down 50% as well. The securities in our portfolio consist primarily of prime jumbo loans, which are in the top tranche of non-agency securities from a credit perspective.

In our portfolio, we have seen serious delinquencies declined by approximately 10% in recent quarters, loss severities fall and prepayment rates remain constant in the high teens. More than 95% of our non-agency portfolio is allocated to re-REMIC mezzanine securities. On average, at the portfolio level, these securities represent somewhat more than 40% subordinated interest in the underlying super senior security. They have an average coupon of approximately 4.4% and at a marked price of 60.2%, they provide a current annual yield of approximately 7.3% on an unleveraged basis.

In addition to the current yield component, given the credit characteristics, we would expect these securities to appreciate over time and provide a potential total annual return in the teens from their current price level. Each investor, of course, will make their own assumption. As a mathematical illustration, in our portfolio with 18.5% of loans more than 60 days delinquent, today, one would expect terminal defaults possibly to approximate 25%. Given current housing market dynamics, our reasonable expectations would be that loss severities decline 5 to 10 percentage points over time such that actual future severities average approximately 40%. At these frequencies and severities, the illustrated securities on average would receive approximately 80% of principal cash flow versus par. If these securities reached their terminal value in 3 years, in this illustration, they would earn a principal return of approximately 10% annualized in addition to the annual cash coupon yield of 7.3%.

Further, we have migrated our non-agency mortgage portfolio over time such that looking forward to a point 2 years from today, we expect approximately 2/3 of our re-REMIC portfolio to be variable rate in nature, which will insulate the portfolio from potential future increases in interest rates. At December 31, 2012, our non-agency portfolio had a fair value of 60.2% of face value. Today, market value of $199 million and repo of $31 million. OCI related to the non-agency securities was $39 million as of December 31.

The assumptions used to value the portfolio at December 31, 2012 included, on a weighted average basis, a constant default rate of 5.2%, loss severity on liquidated loans of 47.1%, constant prepayment rate of 13.9% and a discount rate of 7.4%. While we believe the risk-adjusted returns in both agency and non-agency portfolios are attractive today, given price levels in the overall risk return proposition between agency mortgage-backed securities and non-agency mortgage-backed securities when judged against the backdrop of the current economic housing market and policy conditions, we view the opportunity in non-agency mortgage-backed securities to be more favorable. As a consequence, during January, we increased our non-agency portfolio to approximately $220 million in market value, reflecting $183 million of investable capital with the potential for additional market allocation as market conditions permit. Accordingly, we reduced our exposure to lower coupon agency securities such that our overall agency mortgage-backed security portfolio is now approximately $1.2 billion in market value.

As we look forward, we are optimistic about the company's opportunities. We have 2 complementary portfolios with attractive attributes and high risk-adjusted returns that permit the company to generate consistent cash earnings and dividends with potential for growth. We have shifted the company's capital allocation to increase exposure to improving conditions in the housing market and to capture higher-than-expected risk-adjusted returns with reduced leverage. The investment environment continues to be attractive, and we expect our returns to be protected by our substantial tax benefits for several years to come.

Operator, I would like to now open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question will come from David Walrod, Ladenburg.

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

In regards to the hedging, Eric, you mentioned that the hedging starts in the third quarter. My question I guess is, previously, I thought we talked about that starting in the first quarter of 2013. So did you guys take off or, I guess, settle the hedges that you had in place for the first 2 quarters of this year?

Eric F. Billings

We did. Yes, David, that's exactly correct.

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

And that was during the fourth quarter that, that was done, so that ran through the interest expense line?

Kurt Ross Harrington

No, the gain line.

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

It run through the gain line. Okay. Can you, I guess, just -- last year, you took off the hedges for all of 2012 in the fourth quarter of 2011. This year, you've done it for half year. I guess, can you kind of give just a general update on your outlook for the rate environment?

Eric F. Billings

Absolutely, David. Actually, we've taken off really for the first 3 quarters of the year. And basically what you're seeing is we're obviously, in our spread part of our business, the agency side, the objective is to take advantage of not only the obviously good spreads that exist but the historically long period of time with which we can hedge them because of the nature of the forward curve. So given the fact that our objective is to generate spread income and protect the portfolio so that when the day comes that rates trend higher, the fact that we have exposure to long-dated assets that will obviously lose value in price, we want to mitigate that completely, essentially. And we want to be able to therefore create the opportunity to keep the spread income for as long a period as possible. But then, when the time is appropriate to unwind the structure, we can do so fairly seamlessly. And so without getting into the game of guessing when that will occur, we structured the portfolio so that ideally we don't have to guess, but that we'll be prepared to take advantage of it when that is the right course of action. And so in the meantime, we have a very significant return on our invested capital there in a protected way, which will allow us to unwind and reallocate that capital at an appropriate time. And that's our view. We don't know when, but we want to make sure that we're completely protected or very substantially protected, so that we have the flexibility to do that when the time comes.

Kurt Ross Harrington

Dave, I would also add that from the perspective of the change in the hedge structure for '13, I really -- I don't think it's really that significant a shift at all. In a sense, we extended out the hedge in duration during the latter part of 2012. And frankly, because the front end of the curve is so heavily anchored by the Fed, the volatility of rates in that short part of the curve is not likely to be a great deal. So I think we felt like, given the extension in duration that we've put into the hedge out to basically the end of '18, that it really was probably not a particularly useful function in the short term in the early part of '13. Essentially what we've done is taken up the first 2 quarters and part of the last 2. But -- so I don't think it's really that significant a shift.

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

Okay. Good. I appreciate the color. One other topic, obviously, you brought the deferred tax asset, you're able to bring that on to the balance sheet. Any update on the state income tax, I guess, situation?

Kurt Ross Harrington

There's a component of that, Dave, in the $12 that ran through the income statement, there is a component for the state tax reserve. It's not 100% of that amount. That amount, I think, is about $16 million in total. And so I think this is about 1/3 or so or maybe a little more than a 1/3 of that as part of that $12 a share that went on the balance sheet.

Operator

Our next question will come from Jason Stewart, Compass Point.

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

You talked a little bit about the allocation between agency and non-agency given your outlook. You're obviously not constrained by any of the REIT requirements. Can you talk about how far you'd be willing to take that and maybe what part of the consideration is cash flow from the agency portfolio?

Eric F. Billings

Well, Jason, it's a fine question. And I guess the theoretical answer is we would take it 100% if we deem that to be the right thing to do. Obviously, the context to your question, I think more practically, we are very aware of the fact that we are a combination of a spread-based business with the allocation of our capital and one that wants to simultaneously take advantage of the fact that there continues to be, in our judgment, great opportunity in the non-agency market and be able to generate substantial gains and growth to the capital, so that we ideally cannot only generate appropriate spread cash earnings to comfortably cover the dividend, but to also generate gains over time so that we can grow the book value. And as we've indicated today, we have in our non-agency portfolio about $230 million of market value, non-agency assets at about $0.60 on the dollar. And if you assume that those would move to around 80 at fair value, or maybe a little better than that, then obviously that would result in something in the vicinity of a 30% to 35% gain. And on $230 million of capital, it's pretty clear what that amount would be. And then ideally, all things being equal, that would grow our book value accordingly. And that is clearly our plan. So we're very focused on both aspects of the business, growing the capital and creating appropriate cash earnings to continue to pay our dividend. And so with sensitivity to both of those things, as long as we feel on a risk-adjusted basis each asset class gives us a benefit in those regards, we'll have some allocation. But at the margin today, we do feel that the non-agency market is likely -- we showed as an example in the script where we could generate over a 3-year period a result that would end up at about a 17% to 18% return on equity each year in a linear form if the assets were to perform that way. Clearly, they're probably not going to perform in a linear fashion. And for instance in that time frame, those assets would become very close to being front pays. It's possible that they would -- we would migrate to more toward their true par value much faster than the 3 years. In which case, we could generate the same gains on a much faster time frame and thereby have a much higher return on equity in that time frame. And so these are things that create opportunity for us that we want to be able to take advantage of and it's how we look at it. It's a long answer. I think we could migrate a little bit more out of the agency to the non-agency, so I wouldn't be surprised by that. But I mean I don't think we have any intent, given the good hedge structure in the agency portfolio of making meaningful changes from here.

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

Okay. That's great color. And I'm sure it's nice to have that flexibility. As it relates to the valuation, is it taking into account only your expectations for performance for the non-agency bonds and agency portfolio when you book it? I mean, I guess my question is if we did see something linear in terms of appreciation or faster, could we see more of that come onto the balance sheet?

Eric F. Billings

You would by definition, Jason. I mean if I follow your question, as the market changes, we do mark that portfolio to market on a pretty rigorous basis. We're obviously not -- don't want to get ahead of ourselves, but if -- in a hypothetical sense obviously, if next -- if tomorrow the portfolio -- or the whole world changed and all of a sudden these portfolios -- these assets were trading to much higher prices, we would reflect that and you would see it reflected on the balance sheet and through our book value. So we do mark them accordingly. When we will actually realize the gains, again, that could be different, that we would, in the final analysis obviously, as long as we can generate acceptable returns. So even, for instance, if we thought the assets finally are worth 85 and we own them at 75, if we think from 75 to 85 is going to occur on a reasonable timeframe, that plus the current yield the assets generate, it's entirely possible we would hold on to those assets. On the other hand, if we're about 75 to 85, we're going to be 10 years, more likely we wouldn't. So these are just things -- judgments we'll make along the way.

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

Okay. I guess relating to the deferred tax asset, would that impact the valuation allowance at all in the deferred tax asset?

Kurt Ross Harrington

It could, Jason, in this sense. Embedded in that $12 is about what? $0.50 or between $0.50 and $1 of value for the NCL. So to the extent that there was more rapid appreciation in the non-agency portfolio and gains were taken in the next 2 years before those expire, then yes, it could mean that either a greater dollar amount of the NCLs would get reflected on the balance sheet or they would simply be realized in cash through the tax protection they provide, 0 tax on gains from appreciation.

Eric F. Billings

But only if it's realized. Obviously, the point is only through realization by sale and the asset is that going to happen.

Kurt Ross Harrington

In essence, Jason, there's $290-ish million, right? $290-ish million of NCLs in the book. And there's only about $24 million -- $24 million to $25 million of that on a pretax basis capitalize on an after-tax basis what's the number? $9 million on an after-tax basis that's embedded in that $12, so call it what is it, $0.60? Something like $0.60 of that $12 is for the NCLs, and naturally if the gains came more quickly, that we would expect to realize significantly more than just that $0.60 of value.

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

Okay. That's good color. I think I understand. Two very much less technical questions. HARP pay-ups, where do you see those in terms of value. I mean, obviously, they are generating a very low CPR in your portfolio, and I think you mentioned you were selling some of the lower coupon agencies. Would you consider selling some of those bonds or the pay-ups still not reflective of value that in your opinion?

Kurt Ross Harrington

In selling down the lower coupon bonds, those are all prepaid-protected, and the proportionality of HARP loans to -- of HARP prepay loans to other non-HARP loans in the assets that we sold was probably pretty similar to the remaining portfolio. So that's just a pure risk-adjusted reward decision. We're monitoring the movement of those pay-ups by type every day, as mortgage prices move. And to the extent we see in a particular coupon strip or in a particular prepayment behavior of an individual bond, we see elements that suggest that those prepays may be declining and those pay-ups may be declining in future periods, then you know what? We'll act on that and will trade those out for alternatives. As a broad matter, do we see -- are we mindful of the potential for movement in those pay-ups over time? Sure, and we're harvesting the portfolio all the time. There's a lot of benefit to your point, Jason, in the very, very low prepays fees that we're experiencing that has a great deal of benefit to us in ROE and in other ways. So we're watching that day-to-day, but where we see risk in pay-up compression, we're moving that. Part of that $1.25 billion has moved out -- I mean, excuse me it's part of that $400 million that moved out.

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

Last question, then I'll jump out. The market has seen a pretty material decline in repo rates since year end, from, say, the high 40s to high 30s. Is that consistent with what you've seen on your book in the first quarter so far?

Kurt Ross Harrington

We had our repo extended out past year end, so I'm not sure we've completely reset yet to lower rates just because we extended our repo a little bit over year end as we customarily do.

Operator

Well, speakers, at this time, it looks like we have no further questions in the queue.

Eric F. Billings

Great. Thanks everybody for joining us. We appreciate it. Talk to you next quarter. Take care.

Operator

Thank you. Ladies and gentlemen, at this time, this conference is now concluded. You may disconnect your phone lines and have a great rest of the week. Thank you.

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