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Arlington Asset Investment Corporation (NYSE:AI)

Q1 2013 Earnings Call

April 30, 2013 9:00 am ET

Executives

Kurt Harrington - CFO

Eric Billings - CEO

Rock Tonkel - President & COO

Brian Bowers - CIO

Analysts

Jason Stewart - Compass Point Research

David Walrod - Ladenburg

Operator

Good morning. I would like to welcome everyone to the Arlington Asset First Quarter Earnings Call. Please be aware that each of your lines is in a listen-only mode. After the company’s remarks, we will open the floor for questions. (Operator Instructions).

I would now like to turn the conference over to Kurt Harrington. Mr. Harrington, you may begin.

Kurt 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, the completion of senior notes offering, market conditions, cash returns and earnings, investment opportunities, core cash operating expenses, portfolio allocation, plans and steps to position the company to realize value, statements on tax benefits including net loss carry-forwards 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, changes in the constant prepayment rate for the company’s MBS, changes in our operating tax benefits, maintenance of the company’s low leverage posture, changes in agency-backed MBS yields, changes in the company’s monetization of net operating loss carry-forwards, changes in the company’s ability to generate consistent cash earnings and dividends, preservation and utilization of our net operating loss and net capital loss carry-forwards, impacts of changes to Fannie Mae and Freddie Mac, actions taken by the U.S. Federal Reserve and the U.S. Treasury, the availability of opportunities that meet or exceed our risk-adjusted return to expectations, the ability and willingness to make future dividends, the ability to generate sufficient cash to retained earnings to satisfy capital needs, changes in the value growth through reflation of private-label MBS, and general economic, political, regulatory and market conditions. These and other material risks are described in the company’s annual report on Form 10-K for the year ended December 31, 2012, which is available from the company and from the SEC. You should read and understand these risks when evaluating any forward-looking statement.

I would now like to turn the call over to Eric Billings for his remarks. Eric.

Eric Billings

Thank you, Kurt. Good morning, and welcome to the first quarter earnings call for Arlington Asset. I’m 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.

Yesterday, we reported core operating income per share of $1.04 for the first quarter which equates to an 18% return on book value available for investment. During the early part of the year, we have reallocated capital to the company’s non-agency mortgage-backed portfolios such that after giving effect to the $87 million March equity offering, Arlington currently has approximately 60% of investable capital direct into that portfolio and approximately 40% allocated to agency mortgage-backed securities.

Naturally, as we increased capital allocated to the non-agency MBS opportunities, we executed few sales of the non-agency MBS which in turn limited the contribution to core earnings, operating income from cash gains during the quarter. Also, we expect the March offering to be accretive going forward following full deployment of the capital. As such core operating EPS for the first quarter would have been $0.05 higher absent the offering.

Other key effects to the capital raise in the portfolio reallocation include the following. Increased exposure to the U.S. housing industry recovery with approximately $450 million of face value and approximately $250 million of capital allocated to the non-agency mortgage-backed securities. Increased potential for appreciation and book value as the non-agency MBS portfolio appreciates from the quarter end mark of 61.9% to higher terminal value.

Increased use of tax benefits on spread income and realized gains as they occur. Reduced leverage as capital allocated to low leverage and non-agency MBS now meaningfully exceeds capital allocated to more leveraged agency MBS. Increased hedge proportionality on the agency MBS portfolio as total hedge positions now equate to approximately $1.125 billion compared to fair value of agency MBS of approximately $1.65 billion.

Increased cash returns on capital as the ratio of recurring cash expenses to investable capital is declined by approximately 50% over the past 15 months. We continue to see encouraging performance from both our agency and non-agency MBS 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 loan balance loans or loans with other prepayment protection features.

These loan characteristics significantly reduce the economic incentive to the borrower to refinance or constrain the ability to refinance. This quarter, our agency MBS portfolio demonstrated again the value of asset selection with a three month portfolio CPR of 8.64% versus CPR of 33.7% on Fannie Mae 450 Universe. The portfolio CPR including purchases for the month of April was 6.61%.

During the first quarter, we increased the proportionality of the company’s hedge position by adding a component of the 10-year interest rate swap futures with the current notional amount of $225 million. The other future contracts we utilize to hedge our agency portfolio run consecutively on a quarterly basis beginning in September of 2013 and extend out to September 2018.

They have the average notional amount of approximately $900 million; the mark-to-market average cost over the five years of the hedge was approximately 1.07%. With an expected agency MBS asset yield of approximately 2.9% and approximate average annual hedge cost of 1.07% for five years assuming leverage of seven to eight times invested capital in the agency MBS of approximately $192 million at quarter end, the annual expected return on equity from the agency MBS portfolio would be in the mid to high teens on a hedge basis.

Turning back to the non-agency side, we see attractive return opportunities today in that sector driven by improving trends in the U.S. housing market and overall economy. Housing affordability remains just shy of its highest point since 1986, mortgage origination and servicing capacity continue to expand, employment growth, increased loan modifications, and low 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 of capital into the business of purchasing and renting foreclosed or defaulted housing stock has helped to shift the supply demand equation for housing inventory in a favorable direction.

These factors have stabilized home prices and in many markets led to rising price. According to CoreLogic Inc., U.S. home prices gained 10.2% in February from a year earlier and other key housing statistics generally reflect continued trend of improvement.

From a credit perspective, the securities in our non-agency MBS portfolio consist primarily of prime jumbo loans, which occupy the top 20% tranche of the $900 billion legacy non-agency MBS market. More than 95% of our non-agency MBS portfolio is allocated to Re-REMIC mezzanine securities. On average, at the portfolio level, these securities represent approximately a 45% subordinated interest in an underlying super senior security. They have an average coupon of approximately 4.2%; at a marked price of 61.9% they provide a current annual yield of approximately 6.8%.

On an un-levered 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 will of course make their own assumptions. However, as a mathematical illustration in a prime jumbo non-agency portfolio with 18% of the loans more than 60 days delinquent today one might expect terminal defaults to be approximately 25%.

Given the current housing market dynamics, a reasonable expectation would be that loss severities on liquidated loans decline by five percentage points over time from current levels such that the actual future loss severities may average approximately 45%. At these frequencies and severities, the illustrated securities on average would receive approximately 80% of principal cash flows versus par. If these securities reach their terminal values in two to three years in this illustration they would earn a principal return of approximately 12% on an annualized basis in addition to the cash coupon yield of 6.8%.

After giving effect to Arlington's $87 million March 2013 equity offering and the $25 million April debt offering, the company’s investable capital is expected to be approximately $440 million. Again as a mathematical example, if one assumes that 65% of the company’s pro forma capital is allocated to the non-agency MBS on the basis of the scenario outlined above with the resulting terminal value of 80% of par and leverage of 0.2% under that scenario the company could experience a potential increase in book value of approximately $6 per share over time above the current book value of $32.78.

Additionally, we have migrated our non-agency mortgage-backed securities portfolio over time such that looking forward to a point two years from now, we expect approximately 70% of our Re-REMIC portfolio to be variable rate in nature, which we expect will help insulate the portfolio from potential future increases in interest rate.

At March 31, 2013, our non-agency mortgage-backed portfolio had a fair value of 61.9% of face value, total market value of $276 million and repo of approximately $39 million. OCI related to the non-agency securities was $47 million as of March 31st. The assumptions used to value the portfolio at March 31, 2013 included on a weighted average basis, a constant default rate of 5%, loss severities on liquidated loans of 46.3%, constant prepayment rates of 13.3% and a discount rate of 6.7%.

From a tax perspective, the company expects to receive the cash tax benefits of $230 million net operating loss carryforwards through 2025 as well as a portion of its $285 million net capital loss carryforwards existing through 2014. Due to the company’s current C corp structure, shareholders will continue to benefit from an after-tax yield on the company’s dividends that is approximately 35% higher than companies with a REIT structure.

Finally, the deferred tax asset includes two tax assets that will be available in future periods but represent economic value to the company currently. The net FIN 48 reserve for uncertain tax positions of $7.1 million together with prepaid AMT taxes of $5.4 million equate to approximately $0.75 of book value per share.

As we look forward, we are optimistic about the company’s opportunity. We have two complementary portfolios with attractive attribute, high risk-adjusted returns that permit the company to generate consistent cash earnings and dividends with the potential for future growth.

Arlington has successfully accessed a new element of accretive growth capital and shifted the company’s capital allocation to increase exposure to improving conditions in the housing market and to capture higher expected risk adjusted returns with reduced leverage. The investment environment continues to be attractive and we expect our returns to be protected by substantial tax benefits for several years to come.

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

Question-and-Answer Session

Operator

At this time, we’ll open the floor for questions. (Operator Instructions). Our first question will come from Jason Stewart.

Jason Stewart - Compass Point Research

Could you remind us on the HARP portfolio -- I’m sorry, on agency portfolio, what percentage of loans were originated under HARP 1.0, and then perhaps expand on any thoughts of rotating out of that given the high dollar price and some of the conjecture out of Washington that they may change the eligibility of that program?

Rock Tonkel

Well that’s about 60% today, Jason, originated under the HARP programs. Well, that's been a fairly constant number for us as a proposition of the overall agency portfolio. As you know, from our prior conversations, we sort of remind very carefully the HARP, the different HAPR origination opportunities to identify where we think the best sort of value for pay up is and that’s work pretty successfully for us.

I think, we’re watching that very, very closely. We’ve seen some compression in payups in those assets over time and we’ve been evolving the portfolio. We’ll continue to watch that very closely and as we fee like the policy environment is -- has a real potential shift. Well we made all that down some. To-date, we haven’t done that but we look at it daily.

Jason Stewart - Compass Point Research

Okay. And so just to clarify because I don’t know, if you ever broken it out before I understand 60% was under all HARP programs, have you broken that out by date?

Kurt Harrington

We haven’t Jason and I don’t have it off the top of my head but we can look at that offline.

Jason Stewart - Compass Point Research

Okay. Thanks. And I would just one quick follow-up, the euro dollar just 10,000 foot question the increase in euro dollar hedge one clarification, the 899 does not include the 225 that you added under 10-year forward, is that correct?

Kurt Harrington

Correct.

Jason Stewart - Compass Point Research

Okay. And so the portfolio increased by on a non-agency – on agency side a $100 million or so and you increased the hedges on that for the core basis by $70 million or so and then you added this 10-year to it. Was there any particular timing that led you to want to do it? Would you mind telling us where because it seems like it might have been a really nice trade, and then maybe some 10,000 foot comments about how you view that in the total portfolio context?

Rock Tonkel

Well, I think what we’re trying to achieve there is additional protection from potential expansion risk if we see a shift in the environment over time as we – as we’re managing this capital transition reallocation with a greater emphasis on the non-agency side of the business which has some obvious benefits that we referred to. We’re also trying to very carefully manage the residual capital on the agency side and so we’re simply seeking to be a bit more protective as we observe we lowered the overall leverage of the company with the shift in capital to the non-agency side. And in addition to that on the agency side we’re sort of dialing up the protection against expansion risk in that portfolio.

Eric Billings

I mean Jason I think it’s the Board understanding that well because we are investing new capital on the agency portfolio fairly consistently and by definition therefore since we want to have a substantially matched or hedged portfolio we will be adding a hedge on fairly constantly. It’s not really our intent and we don’t look at it as whether we are putting them on in a particularly opportunistic way.

I mean, we’re not naïve but we’re really just looking at this on a portfolio basis and they are going to be times we put out this on particularly opportunistically or hedge on particularly opportunistically and they’re going to be times when we don't, but the key factor for us by far and away just that we have a – but we believe in this weak environment for the past many decades that we can have a high spread and we can establish that with a portfolio that is very substantially hedged giving us great protection is what we’re trying to accomplish. So, in that context, I think we’re very pleased with the portfolio but that’s really how we look at it obviously we’re not – we’re really not trying to momentarily time activities.

Operator

Thank you for your question. Our next question will come from David Walrod of Ladenburg. Please go ahead.

David Walrod - Ladenburg

Good morning guys. Before I move to my question I just want to see if I misunderstand something Eric said. Did you say the agency portfolio was now from $1.6 billion at the end of the quarter to $1.1 I misunderstand that?

Rock Tonkel

They’re hedged.

David Walrod - Ladenburg

They’re hedged, okay.

Rock Tonkel

They’re hedged, they’re hedged based on what’s increased in stands at about $1.1 versus a total fair value the agency portfolio today of about $1.6 billion.

David Walrod - Ladenburg

Okay, good. Alright I thought that seems like a pretty large drop.

Rock Tonkel

It’s an increase in the hedge proportionality versus on a notional basis versus the assets.

David Walrod - Ladenburg

Okay, good. As far as the capital rays obviously there was a little dried on earnings for the quarter how quickly did you get that deployed into the second quarter or what kind of a drag can we expect on second quarter earnings?

Rock Tonkel

I’d say we would expect that to be put to work really by the end of April. They’re basically essentially put to work by the end of April and that we would expect we might put a little bit of a leverage on it going forward. As you know, we’ve talked about keeping the leverage very low in the portfolio, we’ve talked about potentially as much as 0.2 times and as you – in the non-agency side and as you guys know that’s those assets are leverageable far, far, far above that, but the leverage element probably takes through -- it make take through May but I think that sort of around the end of April we’d be expect to be fully deployed on the capital from the equity offerings.

Eric Billings

But David as you see as we said in the script the – we would expect to recapture some percentage of that $0.05 from the first quarter. So, we would be should all things being equal to where we precise we. We would be some – we would recapture some and substantially most of that $0.05, and then of course we did add the $25 million of sub debt or straight debt, which is a 10-year debt instrument that cost us about 6-5/8 and obviously given our current returns in the mid high-teens we have about a 1,000 basis points excess spread on that which means for every $25 million all things being equal we would earn excess spread of about $2.5 million or $0.15 of share for every $25 million we put on. So, it’s quite accretive and quite beneficial to us.

And as Rock mentioned we’re in the midst of a program that we get that 25 on and we’re going to be hopefully accessing an ATM process that can continue to grow that in an ideal sense we would give some proportionality thoughts to the common equity for sure but I think we would probably get comfortable as high as $100 million so you can see that the accretion potential there in the environment we exist in today particularly the dynamic character non-agency is quite powerful. So, those are the things that I think as we go forward you can continue to look to hopefully have a fairly constant incremental benefits to the company.

David Walrod - Ladenburg

Okay, good. That was essentially a good segue to my next question which was about the sub debt, I was just curious how that compare to potential opportunities in the preferred market and how you weight the sub debt versus the preferred opportunity.

Rock Tonkel

It’s a pretty straight forward Dave I think from a cost of capital perspective there is a pretty meaningful pickup to us by doing the debt and having versus the tradeoff of an instrument that has maturity on it right so one is primitive one is got maturity on it but the economic pick up in terms of cost of capital is pretty meaningful from what we’ve seen I mean probably well over a 100 basis points potentially a 150 basis points but whatever somewhere in that neighborhood so we felt like that was a worthwhile tradeoff for unsecured no covenant instrument.

Operator

Thank you for your question. (Operator Instructions). Mr. Harrington, there are no more questions at this time I’ll turn it back to you.

Kurt Harrington

Thanks very much everybody. I appreciate you joining us. We look forward to speaking with you next quarter.

Operator

Thank you ladies and gentlemen. This concludes today’s call. You may now disconnect your line.

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