Good morning, and welcome to the American Capital Mortgage Q4 2012 shareholder call. [Operator instructions.] I would now like to turn the conference over to Hannah Rutman in Investor Relations. Please go ahead.
Thank you, operator, and thank you all for joining American Capital Mortgage Investment Corp’s fourth quarter 2012 earnings call.
Before we begin, I’d like to review the Safe Harbor statement. This conference call and corresponding slide presentations contain statements that, to the extent they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act.
Actual outcomes and results may differ materially from those forecast, due to the impact of many factors beyond the control of MTGE. Our forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice.
Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in our periodic reports filed with SEC. Copies of these reports are available on the SEC’s website. We disclaim any obligation to update our forward-looking statements unless required by law.
To view a webcast of this presentation, access our website, mtge.com, and click on the Earnings Presentation link in the upper right corner. An archive of this presentation will be available on our website and a telephone recording of this call can be accessed through February 25 by dialing 877-344-7529 using the conference ID 10024361.
Participating on today’s call are Malon Wilkus, Chairman and Chief Executive Officer; Sam Flax, Director, Executive Vice President, and Secretary; John Erickson, Director, Chief financial Officer, and Executive Vice President; Gary Kain, President and Chief Investment Officer; Jeff Winkler, Senior Vice President and Co-Chief Investment Officer; Peter Federico, Senior Vice President and Chief Risk Officer; Chris Kuehl, Senior Vice President of Agency Mortgage Investments; and Don Holley, Vice President and Controller.
With that, I’ll turn the conference over to Gary Kain.
Good morning everyone, and thank you for joining us on the MTGE Q4 earnings call. We are really proud of MTGE’s performance, both during the quarter and throughout 2012. And as importantly, we continue to feel good about our earnings potential as we look forward into 2013.
On the non-agency side, the improvement we have seen in the housing market should help support better cash flow performance on our existing securities. On the agency side, our portfolio remains very well-positioned from a prepayment perspective, and we will also be able to leverage some favorable financing opportunities in the dollar roll market created by QE3.
But before I turn the call over to the team to discuss how we have positioned the portfolio given the current landscape, I want to quickly review some of the highlights for both the full year and Q4, starting on page 2.
Most importantly, in MTGE’s first full current year as a public company, we generated a 41% annualized economic or mark-to-market return. For the year, we paid a total of $3.60 per share in dividends, and grew book value almost $5 per share.
This was accomplished in a year where we raised over $570 million in equity, significantly improving our operating efficiency and materially increasing the liquidity of the stock. In addition, our taxable income significantly exceeded our dividends, which allowed us to accumulate $1.17 of estimated undistributable taxable income as we enter 2013.
Turning to page three, I want to touch on a few highlights for the quarter. First and foremost, despite weakness in the agency space during the quarter, we were able to produce a 23% annualized economic return via the combination of $0.90 dividend and the $0.53 per share increase in book value.
The performance of the non-agency portfolio was the key driver of the book value gains, but our agency portfolio also held up well under the circumstances. Net spread income was $0.84 per share during the quarter, or $0.78 if we exclude approximately $0.06 of catch-up amortization. Taxable income significantly exceeded our dividend, at $1.53 per share, which drove the significant increase in our UTI.
Turning to slide four, our prepayment speeds remained extremely benign, averaging only 6.5 CPR for the quarter. I also want to highlight that we did buy back around 300,000 shares of our stock during the quarter, at an average of $22.76 per share. Importantly, we remain committed to continuing to execute additional share repurchases if and when conditions warrant.
With that, let’s turn to slide five and look at what happened in the markets during Q4. As you can see on the top left, agency mortgage prices declined during the quarter, giving up a portion of the outsized gains achieved during the third quarter. Lower coupons dropped more than would have been indicated in the movement of Treasury and swap rates. Higher coupons, however, were actually the worst performer, as the faster speeds driven by HARP 2.0 continued to pressure that sector.
Now, so far in Q1, these same trends have continued in the agency space, serving as a headwind to book value. However, as the stock effect of the Fed’s massive MBS purchases begins to dominate the market, we think that it is quite possible that low coupon agency MBS will approach their tightest levels seen immediately post-QE3.
Now, as Jeff will elaborate on in a few minutes, the housing market continued to improve, and non-agency RMBS continued to appreciate during the quarter. The strength was based on the combination of more favorable fundamental and technical factors. If we turn to slide six, we can look at our capital allocation at year end.
As you can see on the top left, we had $6.4 billion in agency MBS and $681 million in non-agencies. From a capital perspective, that translated to about 72% of our equity dedicated to the agency space and 28% in non-agencies. Our non-agency equity allocation peaked in the low 30s before we reallocated some more capital back to agencies later in the quarter.
As we look forward, we continue to be optimistic in response to changing market dynamics, and we will continue to move the portfolio around as necessary. We are also committed to developing a presence in new origination jumbos, either as whole loans or in securitizations over the course of 2013. This is a key objective for the team, as the universe of legacy non-agency product continues to contract.
With that, let me turn the call over to Jeff to talk about non-agencies.
Thank you, Gary. Turning to slide eight, I’ll spend a few minutes highlighting the major themes in non-agencies during 2012 as well as our outlook for 2013. One major factor driving the strong performance of the sector was the improvement of the housing market. Broadly speaking, home prices were up 5-10%, and as importantly, there was a further uptick in housing construction as excess supply from the bubble years is being slowly absorbed.
While cash investors have been an important source of demand for housing, driven by the low rate environment and relatively attractive rental yields, we are starting to see an increase in demand from end-home buyers, which we expect will continue.
This fundamental picture has had a positive impact on the composition of legacy non-agency bonds. The combination of the rise in home prices, increased loan modification activity, and another year of liquidations of mostly underwater loans has led to improvements on key metrics such as overall loan to value, percent deeply underwater, and delinquent.
This, in turn, gives bond investors more confidence around loss scenarios. Support to the market came from a wide variety of asset managers, notably insurance companies and traditional money managers who were attracted to the space for the housing story as well as the need for fixed income assets with reasonable yields.
On the supply side, we started the year with the absorption of the Maiden Lane portfolios and the further decrease of any forced sellers. Coupled with the natural runoff of non-agencies of about 15% a year, and the technical picture for the asset class is firm.
In terms of new supply of private-label mortgage backed securities, the market remains small, with the GSEs and bank portfolios dominating jumbo flows. We do expect an accelerated pace in 2013, with issuance perhaps as much as $20-30 billion across multiple issuers. Furthermore, the GSEs will likely commence credit transfer transactions as well in 2013.
Overall, we think these market trends will persist and provide a solid foundation for non-agencies this year. While we could see some downdraft in pricing in response to macro headwinds, especially given how far bond prices have rallied, we are positive on the performance of the asset class over the long term.
Turning to the next slide, I’ll give a snapshot of current market yields and return on equity. As we just discussed, non-agencies had a great year, with loss-adjusted yields tightening 300-500 basis points. This is even more impressive once you account for the more optimistic housing scenarios that are being run relative to last year. At this point, we see market yields to be about 4-5% unlevered on the assets.
On the funding side, we have seen some improvement over the year, particularly regarding the number of counterparties offering financing and terms. However, haircuts and rates have been relatively stable, and these drive our leverage decisions. As a result, our leverage has remained about 1.6x for the non-agency portfolio.
Return on equity projections on new purchases is in the high single-digits across sectors in our base case. Given the backdrop for the non-agency market, we are overweight sectors we think will benefit the most from further home price depreciation, with over 80% of the portfolio in [unintelligible], option ARMs, or subprimes.
With that, I’ll turn the call over to Chris, who will review our agency portfolio.
Thanks, Jeff. In the tables on the bottom of slide 11, you can see that the portfolio continues to be well-positioned against prepayment risk, as evidenced by our 6% CPR, with the vast majority of our agency holdings backed by loans with lower loan balances or loans that were originated through the HARP program.
Now, going forward, you can expect to see a larger off-balance sheet TBA position. This is driven by the extremely attractive implied financing rates available through the dollar roll market. Typically, special roll financing tends to be short-lived. However, the technical situation in large part created by QE3 should led to persistent strength in the dollar roll financing markets as long as the Fed’s program is in place.
At the end of the fourth quarter, we did have a long 30-year 3% roll position, but that was more than offset with net TBA short positions and higher coupons for risk management purposes, so the net impact of the two separate positions was not material for the quarter.
Currently, our forward TBA roll position is approximately net long $1 billion, as we’ve been reducing our holdings of our lowest coupon, least attractive specified pool strategies. Current implied financing rates on 30-year Fannie Mae 3% TBAs are around negative 40 basis points for the March-April period, or approximately 80 basis points through one-month repo rates.
Turning to slide 12, we have the familiar graph comparing the prepayment performance of several types of 30-year 4% specified pass-throughs very strong more generic MBS. In this graph, we further break out the lower 80-90 LTV HARP subset within the HARP category to show how the lower LTV pools have been ramping up.
The combination of a strengthening housing market and greater availability of PMI has increased the risk of organic refis on lower LTV HARP securities. As noted back on slide 11, in the footnotes, the average OLTV of our 30-year HARP position is 109%, with only 9 months of seasoning. This is important because the higher LTV loans will remain relatively difficult to refinance, even against the backdrop of an improving housing market.
Now I’ll turn the conference over to Peter to discuss our funding and hedging activities.
Thanks, Chris. Today I’ll briefly review our financing and hedging activity. I will start with our financing summary on slide 13. Our rebuilt funding cost totaled 57 basis points at quarter end, up from 51 basis points the previous quarter. The higher funding cost was due to both normal year-end balance sheet pressure as well as a slightly higher percentage of non-agency collateral and our funding mix.
The average original maturity of our repo funding dropped to 87 days from 101 days the previous quarter. Looking ahead, we see encouraging signs in the agency repo market that we believe will lead to slightly lower funding rates in 2013. These factors include a general easing of balance sheet constraints following year end, the end of Operation Twist, which pressured dealer balance sheets, and finally the Fed’s ongoing purchases of mortgage-backed securities.
Turning to slide 14, I will review our swap and swaption activity. Our basic swap portfolio totaled $2.9 billion at quarter end, unchanged from the previous quarter. During the quarter, we significantly increased the size of our swaption portfolio. At quarter end, our swaption portfolio totaled $1.2 billion, an increase of $650 million, more than double the position we held on September 30.
The swaptions we’ve purchased had an average option term of 2.4 years, and an average underlying swap term of almost 8 years. Largely as a result of QE3, the price of these options was extremely low by historical standards, making it an attractive time to add to our portfolio and purchase the protection for a longer period of time.
On slide 15, we summarize our Treasury and TBA positions. Our short Treasury position totaled $424 million at quarter end, up slightly from the previous quarter. In addition, we were also short about $500 million of TBAs at quarter end. Taken together, our hedge position including the TBAs covered 80% of our liabilities, up from 60% of the previous quarter.
Lastly, I’ll review our duration gap on slide 16. Our duration gap at year end was negative 0.3 years, a small change from the negative half-year gap we reported last quarter. Given the generally low level of interest rates, improving economic fundamentals, and the extension risk inherent in mortgage assets, we believe our current hedging activities are prudent from an interest rate risk management perspective. Looking ahead, we will continue to actively manage our hedge portfolio, adjusting both the size and composition as market conditions warrant.
With that, I’ll turn the call back over to Gary.
Thanks, Peter. And before opening up the call to questions, I want to quickly review the business economics on slide 17. As the three leftmost columns depict, the gross ROE as of 12/31 on the existing agency and non-agency portfolios, are actually pretty close, given the different leverage levels and funding costs, with both just above 15%. When you factor in operating expenses, our net ROE is in the low 13s.
However, current investment opportunities favor agencies at this point, given the tightening that we have seen in non-agencies. This is especially true given our view that favorable financing opportunities are likely to persist for agency MBS via the dollar roll market.
So with that, I’d like to ask the operator to open up the lines for questions.
[Operator instructions.] The first question will come from Douglas Harter of Credit Suisse. Please go ahead.
Douglas Harter - Credit Suisse
Gary, I just wanted to sort of drill down on that last statement you made about agencies being more attractive. How do you balance the current return opportunity versus the upside potential from improving housing and non-agency when making that decision and allocation?
You know, look, you bring up a very good point, which is in a sense the backdrop right now for non-agencies is good, with strong fundamentals and good technicals. And so I don’t want to imply that we’re bearish on non-agencies.
I think what I was implying by that statement is that in the short run, agencies have definitely cheapened up, and they’ve cheapened up a little more this quarter. And so at this point, when you factor in the spreads that can be achieved, even assuming conservative funding levels in the dollar roll market, you’re looking at current ROEs there that are better.
I think the issue more is also one of when you look at the non-agency space, it’s also about picking individual assets. And when you do pick individual assets, I think there’s quite a bit of value there. On the other hand, if you were buying them relatively quickly, kind of in mass at this point, a lot of the low-hanging fruit is sort of gone. I don’t know, Jeff, if you can add anything?
No, I’d agree with that. Within the non-agency space, it also depends on what types of bonds you’re buying to actually get that sort of upside potential to housing, as some of these dollar prices have really rallied materially closer and closer to PAR. But as Gary said, I think if you look at the space overall, generically speaking it’s obviously tightened a lot, but given the fact that we’ve historically been pretty patient and selective there, you can still find assets that will meet high single-digits, low double-digits ROE targets.
Douglas Harter - Credit Suisse
And then you had mentioned that you guys were interested in pursuing new production whole loans. Are you guys also considering looking at legacy whole loans?
Yeah, I think we will. I think we’re going to see more of that paper come out, the sort of reperforming legacy whole loans, either as loans or in securitization [unintelligible]. And I think that we’re definitely open to pretty much any sort of residential loan transaction, but it’s always going to be relative to what else can we do in agencies and non-agency legacies, and what’s the liquidity and all the other decisions that would go into that. So I think it’s just going to be a sort of case by case basis.
The one thing I would just add to that is from kind of a business development perspective, I think our preference… To Jeff’s point, we’ll look at opportunities, but our preference will definitely be for kind of new prime performing loans, because we see the future of the business evolving to that point over the next couple of years, so to speak. And I would say we’re less motivated on one-off legacy trends.
Our next question will come from Joel Houck of Wells Fargo. Please go ahead.
Joel Houck - Wells Fargo
The first question, with respect to the net interest spread. It was actually up 27 basis points in the fourth quarter from the third quarter. That was different from what I think a lot of agency REITs experienced. How much of that was kind of attributed to the dollar roll? I don’t know if you can break that down exactly, but that would be helpful.
I think on that, not a lot was attributable to the dollar roll. I think the biggest change there is actually the projected CPR assumption, and the fact that we project prepayments. And so as prepayment projection slowed, you get a catch up component during the quarter that shows up in that intraquarter net interest margin. So the biggest driver of that was the prepayment projections and the changes there.
Joel Houck - Wells Fargo
Okay, so the 188 at the end of the period is kind of what we should use as our starting point in looking at it, in terms of the first quarter?
Generally speaking, we always put more emphasis on the end of quarter numbers, because they wouldn’t incorporate any catch up component or anything. So you can look at our yields at the end of the quarter. You look at the prepayment estimates that we give you. You can look at them versus the different cohorts, and that is probably the best starting place.
Joel Houck - Wells Fargo
Okay. And then the second question, on an asset basis, you have about 90% agency, 10% non-agency. And to have book value actually rise in this environment is quite impressive. Because I think most of the people that were dominated in terms of agency exposure saw book value decline on the order of 4-5%. Can you maybe provide some color in terms of the agency securities you own, and why they performed better in the fourth quarter than, say, some of your peers?
The reality is that we have a hybrid portfolio, and I would say first off, remember to keep the capital allocation piece in mind. That’s why we give it to you. While the assets are, we’ll call it 90-10, we think of it as capital dedicated to one sector versus the other, and we reviewed those numbers earlier. And that’s more like 70-30. So that’s the first piece.
But in the case of within the agencies, some of the worst-performing agency mortgages were the highest coupons, and the less prepayment protected, where you got weaker [carry] and tougher price move, so to speak. So I think we’re very focused on the combination of asset selection and our hedging strategies, and we do feel that, over time, we should be able to outperform on the agency side. And I think that’s a core advantage for MTGE.
Joel Houck - Wells Fargo
Do you have an approximate breakdown of how much of the NAV is attributable to agency versus non-agency, if you just look at that 70-30 equity allocation?
You know, we don’t disclose specific NAV moves on each individual component of the portfolio, but what we did say, and what I’ll reiterate, is that the increase in NAV in the portfolio is largely attributable to the non-agency portfolio. The agency portfolio held up well, but it certainly did not drive the increase.
Our next question will be from Bose George of KBW. Please go ahead.
Bose George - KBW
Did you guys give a runoff spread, or a prepayment rate for your non-agency portfolio?
We didn’t disclose the CPRs on that, but we can provide that afterwards.
Bose George - KBW
And then secondly, just your comment about non-agency production this year was interesting, just the $20-30 billion. Curious, when you look at ’13 versus ’12, what factors do you think are the main ones kind of driving such a large potential increase?
And that was in securitized form?
Bose George - KBW
I think last year we saw maybe $4-5 billion or so of deals. I think what we’ll see this year is some of the traditional banks look to do some securitizations and I think we’re already seeing an increase in the issuers. So so far this year I think there’s been chatter of maybe $1-2 billion in the pipeline, and I think that will probably sort of accelerate over the year. So that’s where that estimate comes from.
Bose George - KBW
And then just one on your dividend policy. You clearly have enough undistributed income to maintain the dividend in ’13, but just curious how you balance that with potential pressure on book value if dividends are not higher than GAAP earnings, or are higher than GAAP earnings.
Again, our mindset is less about the particular geography of GAAP earnings. We think of things in terms of economic returns and total returns. And MTGE has had a very good year in terms of growing book value and paying an attractive dividend. To your point, we have plenty of undistributed taxable income.
So whether you look at MTGE’s performance in terms of mark-to-market or economic returns, or returns of taxable income, in either case we out-earned our dividends by a decent margin. And so given the main things we look at, book value performance, how we feel about the portfolio, and then undistributed taxable income, we feel good about how MTGE is positioned. However, our [form] is going to be a function of the market, and we don’t know what lies ahead, and so we’ll take that information in as we get it, and make decisions from there.
Stephen Laws of Deutsche Bank, please go ahead.
Stephen Laws - Deutsche Bank
I guess two questions. First, can you talk about how you guys look at - I know with [AG&C vehicle] you did a significant amount of TBAs, and the dollar rolls there. Can you talk about whether that’s something you would do at any size in the MTGE portfolio? Or is it simply where you continue to increase the mix of the non-agency assets and find that as a more attractive investment today than the TBAs?
No, we do. As I mentioned in the prepared remarks, as of the end of the year, we had a net long roll position of $1 billion. It’s something we expect to continue to do. We feel like the opportunities there are very good right now. And rolls can trade special for a number of reasons, but it’s typically temporary in nature, which, unlike the current situation, which is largely driven by QE3, we expect that these financing advantages are going to be in place for some time, at least as long as QE3 is with us.
Stephen Laws - Deutsche Bank
And then I guess more of maybe a macro question. It’s been discussed for a while, but it seems to be hitting the headlines again about potential principal balance forgiveness out of Washington. How would that impact the markets where you play, or your portfolio, or I guess more importantly, is this just something that makes for good headline, or do you guys think there’s any chance of it actually occurring?
Look, I think from a macro perspective, our view on policy risk right now is that it’s lower than it’s been in a long time. There’s always noise on different kinds of things. There’s noise about DeMarco. The reality is the things that are being proposed right now would have very little impact on agencies.
The principal forgiveness that you reference, almost any loan that would be subject to the principal forgives has already been pulled out of the agency pool, or would have been pulled out anyway. And you really need to get to extreme circumstances where the principal forgiveness drives so many other borrowers to go default, because they think they’re going to get it. And I think any plan that comes out will have some protections in place to avoid something like that.
So the bottom line is that we’re not worried about the principal forgiveness in particular. But we feel like, again, the risk from the legislative or FHFA front is lower than it’s been in a long time on the prepayment side.
[Operator instructions.] The next question will come from Trevor Cranston of JMP Securities. Please go ahead.
Trevor Cranston - JMP Securities
I just had one more follow up about the new origination jumbo opportunity you mentioned. Can you share any thoughts about what you’re thinking in terms of the timeline for getting more involved in that market? And also, kind of how you’re thinking about doing it, whether it would be through bulk purchases or setting up a platform so that you can acquire loans on a flow basis?
What I would say is we’re open minded. We understand what it’s going to take to be involved. But I think our mindset is that we could participate in a number of different ways, some of the ones you mentioned. We would also be comfortable just buying subordinate tranches off of new securitizations to the extent that those come up. So I think what we would say is we’re going to put particular emphasis on making sure that we have a presence in that space, and we’re going to look at a range of ways to get involved there.
And our last question will come from Matthew Hollett of JBS. Please go ahead.
Matthew Hollett - JBS
Just following up on the agency asset sales. Those were primarily the lower LTVs, or higher loan balance, that you think could be HARPable?
That’s correct. In seasoned, lower LTV MHA pools that have accumulated house price depreciation, the combination of accumulated house price appreciation and a more favorable outlook for the housing market has caused an uptick in prepayment speeds, and also in addition to just the greater availability of MI and more aggressive pricing.
Those securities we had weren’t HARPable per se. They were created, the higher LTVs, through the HARP program, but now I think the risk is that the lower LTVs are just organically refinanceable for the reasons that Chris mentioned. So just as a quick clarifier, it’s not that we’re concerned that they could get HARPed again, it’s more that we’re concerned about regular organic prepayments on those having the potential to pick up some.
Matthew Hollett - JBS
And that sort of leads me into my next question. With the backup in rates recently, we’ve seen a lot of the lower coupons sell off, and there seems to be more of extension fears now than there are prepayment convexity fears. Is there an angle that you guys are taking? Is one a bigger risk than the other? What can you tell us on that, and how you position the portfolio?
No, I think that’s an excellent question. The bottom line is that extension risk is the bigger risk at this point, especially if your portfolio is constructed correctly from the perspective of asset selection. And I think that what I’d point you to is everything Peter talked to you about, around our hedging strategies as being really the key to navigating the extension side, if it shows up.
But you know, I want to stress that you have to, in the mortgage market, be balanced, and while it’s clear that right now it feels like extension risk is the risk du jour, so to speak, we’ve seen that a number of times, and again, you have to be able to navigate a decent sized move in both directions. But you know, I think from the perspective of our hedging strategies, we’ve been pretty defensive there.
We have now completed the question and answer session. I’d like to turn the call back over to Gary Kain for concluding remarks.
Thank you very much. I appreciate everyone’s interest in MTGE, and we’ll talk to you next quarter.
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