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Hatteras Financial Corp (NYSE:HTS)

Q2 2013 Earnings Call

July 24, 2013 10:00 am ET

Executives

Mark S. Collinson - Partner

Michael R. Hough - Chairman and Chief Executive Officer

Kenneth A. Steele - Chief Financial Officer, Principal Accounting Officer, Treasurer and Secretary

Benjamin M. Hough - President, Chief Operating Officer and Director

Frederick J. Boos - Co-Chief Investment Officer and Executive Vice President

William H. Gibbs - Co-Chief Investment Officer and Executive Vice President

Analysts

Steven C. Delaney - JMP Securities LLC, Research Division

Michael R. Widner - Keefe, Bruyette, & Woods, Inc., Research Division

Joel Jerome Houck - Wells Fargo Securities, LLC, Research Division

Arren Cyganovich - Evercore Partners Inc., Research Division

Tapfuma Chibaya

Daniel Furtado - Jefferies LLC, Research Division

Jason Arnold - RBC Capital Markets, LLC, Research Division

Kenneth Bruce - BofA Merrill Lynch, Research Division

Operator

Good morning, and welcome to the Hatteras Financial Corporation Quarter 2 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mark Collinson, from Compass Investor Relations. Please go ahead.

Mark S. Collinson

Thank you, Catherine. Good morning, everyone. Welcome to the Hatteras Second Quarter Earnings Conference Call. With me today, as usual, are the company's Chairman and Chief Executive Officer Michael Hough; the company's President and Chief Operating Officer, Ben Hough; and the company's Chief Financial Officer, Ken Steele. Also available to answer your questions are the company's Co-Chief Investment Officers, Bill Gibbs and Fred Boos.

Two things for me before I hand over to them. In addition to our press release this quarter, we've also furnished unaudited supplemental financial information on our website. Management will refer to this information in their remarks this morning and those of you who have not yet done so may wish to have this information available during the call. Please go to www.hatfin.com, click on the Investor Relations tab, and then on the words Q2 Earnings Supplementary Financial Information. A short PDF document will then download for you.

Second, I need to remind you all that any forward-looking statements made during today's call are subject to risks and uncertainties, which are discussed at length in our annual and quarterly SEC filings. Actual events and results can differ materially from these forward-looking statements. The content of this call also contains time-sensitive information that is accurate only as of today, July 24, 2013, and the company undertakes no obligations to make any revisions to these statements or to update these statements to reflect events or circumstances occurring after this conference call.

That's all for me. So here's CEO Michael Hough.

Michael R. Hough

Good morning. Welcome to our second quarter call. As always, all of us are here to answer any questions you may have following our prepared remarks. With this call, we'll do something a little different than usual. We thought it would be helpful to include a short supplement to the earnings release of additional information regarding the company and the volatile market in the second quarter. We'll refer to it throughout this call and hope it will provide some useful information and enhance the typical disclosure we provide.

There's just a few comments before getting into the supplement. The second quarter was certainly eventful for us and for the market as a whole, as it began with tight margins, high prepays and uncertain durations that I blame on the open-endedness and aggressiveness of QE3. Early on in the quarter we were staying invested to our targets -- target leverage and liquidity number, just as we have been on the first quarter. Not an easy task with the type of parameters we put on the securities that we purchase. As you know, the quarter ended with a snapping of the rubber band and the wind back to a more natural yield curve. Our book value declined in the second quarter by about 21%, which is a sizable move for a balance sheet such as ours, and the reality is, most of it happened in no more than a 2-week time frame. But it should be noted that this is our year-to-date move as well. Recognizing the disappointing OCI hit our portfolio took, we'll discuss what we saw in the ARMs market especially over quarter end and how it impacted us specifically.

I think an important part of our story is that we entered the second quarter in a relatively defensive position, which helped us weather the gin [ph] volatility. Leverage was 7.4x and liquidity 7.7% of assets in March 31. That coupled with the shorter ARMs portfolio enabled us to control our processes and not be forced to sell in to the distress. We've seen imbalanced markets more than once since we started Hatteras. I can't say it enough. We always want to put ourselves in position to make business decisions and not have them made for us. That's why you see that we were not uncomfortable having to manage the quarter end with leverage at 0.93% and 5.4% of our assets and liquidity given the rate and spread spikes that had already happened, and as some of the near-term risks may have somewhat diminished. We have maintained the flexibility to evaluate and thoughtfully decide what moves will be best for the long-term benefit of the company. Ultimately, we almost certainly will move towards more liquidity and a lower-leverage target, which we will get through to through possible appreciation, portfolio runoff and/or portfolio sales, which could include taking gains, losses or a combination of. We will also continue to add hedges to reduce our exposure to higher interest rates from here.

All of this has not altered our strategy of investing in ARMs. On the contrary, it emphasized why it's imperative to do so. This is a long-term business in the ARM risk profile in both stable and volatile times is very attractive from an asset liability standpoint.

There were 4 questions we'd like to quickly go over in the few slides in the supplement. We'll start with Slide 3 and Ken's highlight on the financial measures.

Kenneth A. Steele

Good morning, everyone. I will briefly review the portions of our financial performance for the quarter, starting on page 3 of the supplement before giving the call to Ben to cover the remainder of the portfolio details.

Our net income for the quarter was $0.66 per weighted average shares compared to $0.62 per weighted average share for the first quarter of 2013. One difference I want to point out was that this quarter includes about $0.055 of gain from our Eurodollar futures contracts, which we have not designated as accounting hedges. We also sold some MBS assets earlier in the quarter for a gain of $8.8 million or $0.09 per share, as compared to $2.5 million or $0.03 per share for the first quarter of the year.

Whereas in the first quarter, all of our earnings metrics improved slightly, this quarter renewed pressure from QE3 was felt, mainly with lower yields on our assets due to lower coupons along with the highest prepayment rate we have seen in almost 2 years. Our yield went from 2.06% to 1.85%, which is a decrease of 21 basis points. Amortization expense increased, going from $43.2 million in the first quarter of 2013 to $48.8 million in the second quarter. Our weighted average 1-month CPR rose, going from a rate of 19 in the first quarter of the year to 20.8 in the second quarter. Our cost of funds dropped slightly 3 basis points, resulting in a net spread of 93 basis points.

Average earning assets were pretty steady, ticking up slightly to $24.8 billion from $24.1 billion as we settled forward purchases from earlier in the year. We also increased our hedge position proportionally, going from $11.3 billion to $11.9 billion notional. The unrealized losses did hit our equity as shown, but despite the price volatility, we ended up the period with approximately $1.4 billion in liquidity which was 5.4% of our MBS. This was down from 7.7 from the previous quarter end, reflective of the drop in our equity.

I'll now hand the call over to Ben to go over the remainder of the presentation.

Benjamin M. Hough

All right. Thanks, Ken. I'd like to start by using the chart on Slide 4. Here, we show the price moves and the agency MBS and swaps markets. Look at the red bar first. This is the valuation change of the mortgage curve in the first 2 months of the quarter, and then the blue bar is the movement over all 3 months of the quarter. As you can see, from March 31 to May 31, sell-off appeared fairly orderly. The values changed as we would expect relative to the estimated duration, so no surprises for the first 60 days or so. You can see in the blue that starting in June, that it really was more so -- even the last 2 weeks of the month, the short end of the curve really underperformed. These moves were surprising, even considering the level of volatility throughout the market. Given our long experience operating with ARMs, we would certainly classify this move as disorderly. Laying this out graphically illustrates the disproportionate moves of some of the ARMs to what we would normally expect.

So let's turn to the next page, Slide 5, where we isolate the basis move over the quarter. After actually trading flat to tighter versus treasuries over the first 2 months of the quarter and really over the previous entire 5 months -- the year, ARM spread blew out [ph] on top of the moving treasuries and not only caught up with the widening and fix but surpassed it. Again, all this in about 2 to 3 weeks. This led to some dislocations in the ARM space, 5/1 which have seen tight spread in the high teens, moved 30 to 35 basis points in basis quarter-over-quarter and 7/1s widened substantially more, all in well over 50 basis points. Fixed-rate MBS, on the other hand, widened much less quarter-over-quarter. One thing we saw as a contributing factor of this move was that apparently a large seller of ARMs hit the market near quarter end and was systematically selling large positions, primarily 7/1, so this exacerbated the magnitude and timing of the move.

Unfortunately, it's very difficult to hedge the basis, especially in ARMs market due to the prime example where you can see how ARM spreads reacted differently that the fixed curve. So basis hedging using fixed-rate derivatives over the volatility markets make much less sense for ARMs. While it's unclear where spreads shakeout after the QE3 effect, given the relative attractiveness of ARMs spreads, we feel like we're exposed to somewhat less basis risk at this point.

Now let's move to Slide 6. We did an internal analysis with the help of a third-party ARMs model, because we wanted to see the relative impact of spreads and rates on our portfolio value decline due to the shift, and the treasury curve and the change in spread. We wanted to know to what degree our hedges did their job in offsetting interest rate risk. We do [ph] address interest rate risk exposure in our filings and we really try to get it right, so it's important for us to understand the intricacies of this move.

First, once again, it's pretty clear last part of it was driven by the spread widening, not so much in the 15-year bucket but in the ARMs book in particular. What we see here is logical, and that most of our rate exposure was in the most recent production 7/1s, but still more than half of the move was basis. Down the curve, the shorter the ARM, the less rate exposure. Interestingly, even the 49 to 72 month [ph] to reset bucket showed relative stability from a rate perspective and the short reset ARMs performed great.

While these are only estimates found in one model, we can still take away 5 general points here. One, we really liked how the ARMs performed in this [ph] season and fully expected to see that. Two, we probably underestimated the extension a little on the 15 years and some of the newest 7/1s in such a short extreme move. Three, difficult to hedge the basis in this market. Our ARMs basis has cheapened materially to fix, and only time will tell how this will be resolved, but given this move, we think there's less basis risk to us at this point. Four, we're glad to still have close to half of our portfolio in a gain position for future flexibility. This is very important to us and might not be the case if we were longer at the curve. And last, number 5, we take Bernanke at his word. Our portfolio will have seasoned at least 2 more years before the anchor is lifted from the short-end of the yield curve. That's a positive.

All right. So turning to the last page, Slide #7, we've laid out the before-and-after mortgage origination curves. As you can see, this curve has shifted significantly, especially for hybrid ARMs, and in particular 7/1s. Some positives come from this. First, slower prepay should result in a better yield on our existing portfolio. Prepayments in Q2 were higher than in Q1 and increased gradually each month as fixed rates moved higher and some borrowers looked to lock into a longer line. Our CPR of 20.8 was within our expected range, but like Ken said, was the highest we'd had in the 7 quarters. For a first look at the third quarter, our July CPR came in at 20.6, near the average of the last quarter but down from 22.9, which was in the month of June.

A few months ago, it was estimated that more than 80% of all agency MBS was in the money to some degree, and most borrowers had at least some incentive to refi. Estimates now are that it's shifted closer to 20%, taking much of the refi incentive away. We think our portfolio has a similar profile to the market as a whole, and we expect prepayments to gradually slow down over the coming months. Keep in mind, though, that cash flows and an uprate market can be a positive and as always with ARMs we expect to get some.

As for hedging, we added a swap equivalent of $600 million in Eurodollar futures contract in the second quarter, which mature in mid-2018 and have an average rate of around 1.49.

[Audio Gap]

added another $400 million in Eurodollar futures since quarter end. With that, I will turn it back over to Michael.

Michael R. Hough

Okay. I just want to say, I think back on how we've tried to communicate with you over these years on our methods and rationale for running this strategy in such a defined way, ARMs in particular. We've, of course, left some yield on the table over that period that was easily grabbable as the yield curve was steep for the most part. And we always have to deal with margin and more prepays.

Maybe this June 30 [indiscernible] creates some doubt in your minds as to why we still do it this way, I don't know. It shouldn't though, because this was just a point in time and we remain more confident than ever that it is imperative for us to stay true to this course. Because over time, it is a fact that ARMs are the shortest and best asset we can own in this business, and we'll provide our shareholders an attractive long-term risk-reward opportunity. They predictably shorten as they walk [ph] down the yield curve, hedges should approximate the declining durations, and the rate will ultimately adjust to current market levels. I'm sure you'll hear us harp on this next time we talk and the message will always be the same.

And just one last point that I want to make before we open for questions, is that this will be Bill's last earnings call, as he retires from his 30 years in the fixed-income business. I just want to say that the 15 years we've worked together has been a great ride, and we all here hate to see him go. We learned the REIT business together and have weathered many ups and downs, and his calm and thoughtful approach to the market will be greatly missed. He's a pro, and on September 30, we will wish him the best of luck and hopefully still have the opportunity to catch his ear for advice and counsel from time to time.

So with that, operator I'd like to open this up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] At this time, we have -- our first question comes from Steve Delaney from JPM Securities.

Steven C. Delaney - JMP Securities LLC, Research Division

Thank you for the supplement. It's very helpful given market conditions. Michael, I guess this is just big picture thought about the ARMs market. And I guess my question is, we can now look back and see what happened with the dislocation in the widening. But could you talk a little bit about as you look at this market, what needs to change? What is the catalyst that would cause the market to tighten back in, given that it is obviously a much smaller -- a small segment of the market and a limited, I guess, a limited number of buyers? But does it come down to the banks having an increased appetite to look at these bonds on a relative value basis? I would appreciate any thoughts you have with the outlook for ARMs looking out over the next couple of months.

Michael R. Hough

Thanks, Steve. The -- as Ben mentioned that we did see a very large settlement [ph] right there at quarter end in the last week or 2. And at that time there were -- obviously, the market was doing what it was doing, and there weren't really any buyers for that paper. And that had a whole lot to do with the decline in bid side and the widening of the spreads. And since quarter end, we've seen some people dipping their toes into the ARMs market, but it hasn't really happened yet as we would expect. But I think you're right that it's going to be banks. I mean, this is a very desirable asset for banks. I think banks will be looking to shorten their portfolios from here and ARMs are a natural fit for them. They've had their own issues with this bond market, and so I think, that will be a major source of demand. And I think we'll see it from REITs and others as they look to, obviously, a more attractive investing environment for ARMs today than it was last quarter.

Steven C. Delaney - JMP Securities LLC, Research Division

So Michael, I gather from your thoughts that when you look at the trading activity over the last 3 weeks that I'm hearing you say that the prices that we are -- we saw at quarter end, should we assume they have not improved materially since June 30 levels?

Michael R. Hough

I mean, I think that's fair. It just depends on where you're looking on the ARMs market. But we haven't -- originations are -- have slowed significantly and I think that will provide support for them. But really since quarter end, it hasn't been material. But we've seen bits and starts of 5 to 10 basis point tightening here or there, but it's nothing across the spectrum.

Steven C. Delaney - JMP Securities LLC, Research Division

Okay. And just one final thing, and maybe Ken's the best person for this. This CPR of 20.8, Ken mentioned that it was the highest level in the last 2 years. Do you have handy with what your lowest CPR was over the last 7 or 8 quarters?

Benjamin M. Hough

Steve, this is Ben. I think, it was close to right at 18. It might be on a monthly basis, but it's really been tight in that 18 to 21 or 22 range. But that's kind of the range we've seen and it hadn't really come out of that range at all for that time period. So I would say it's 18, 18.5, something like that.

Steven C. Delaney - JMP Securities LLC, Research Division

So looking forward, even though we have much higher mortgage rates, I guess, I mean you say you're probably -- I think we're probably about as high on mortgage rates as we've been in the last couple of years, but there may be sort of a floor on where that's going to go, given the naturally shorter duration of your paper?

Benjamin M. Hough

Yes, maybe. I mean, there's obviously an organic prepayment rate with ARMs that's typically higher than fixed-rate, all else being equal. And -- but I think that -- I won't say there's a floor. I think this is going to be an unprecedented move just due to the swiftness and the speed of this on top of the QE3 announcement. So it's going to be interesting to see where it shakes out, but we would expect it to be lower than our average over the last 2 years, that's for sure. To what degree, we'll have to wait and see.

Operator

Our next question comes from Mike Widner from KBW.

Michael R. Widner - Keefe, Bruyette, & Woods, Inc., Research Division

Wondering if you could -- obviously, I guess, the question of basis versus duration is kind of important when looking at the book value, both this quarter, the impact and going forward. So just wondering if you could talk a little bit about where you guys see the duration gap being, both at the start of the quarter and sitting now at the end of the quarter or at least as of June 30?

Michael R. Hough

Yes. Obviously, the basis is a driver in this as it was a driver in previous quarters, as the tightening impacted book value in a positive way. So I think it's always important especially when we've been dealing with an artificial market in our view over the last year or so. On the duration gap question, I'll get Fred to answer.

Frederick J. Boos

Okay, Michael. Our duration gap during the -- at the end of the first quarter was slightly positive. The duration of assets less the duration of liabilities on this rather abrupt, say 40, 50 basis point move in rates, coupled with the basis move and spread widening, we saw an instantaneous shift, basically out. And our spread now -- our net GAAP rather, now is probably in the 1 to 1.5 range. That is about a little over 2, low 2s on duration and down a little bit on liabilities. So we're about 1 to below the 1 in terms of our GAAP.

Michael R. Widner - Keefe, Bruyette, & Woods, Inc., Research Division

So I mean, I guess, one of the questions that we've been wrestling with is we've watched over the last couple of quarters, book values across the group have been heavily skewed to the downside. I mean, last quarter it was largely in the 30-year fixed guides. So far we've only got 2 reporters this quarter but both have book values down 20%. And kind of a consistent story is well, we look to be reasonably well hedged and the duration GAAP was fairly short going in. But netting the exercise you guys did there, and showed on your charts is a valuable one, but I guess the question I have is if I look at one of the hardest hit buckets there, those kind of newer issue 7/1s, the percent decline you guys are showing on your table is 340 basis points, or -- yeah 3.6 -- 3.4%, sorry I'm looking at page 6. If we assume those are five-year duration assets, that's about in line, a little higher but about in line with what would have been projected. I guess my question is, at what point do you start -- and maybe this is what you guys are going through with that exercise. At what point do you say, "Maybe my models are just wrong?" Maybe all the street Yield Book and BlackRock and everybody's models that say these 2-year duration assets are just flat-out wrong and what the market's telling you is that they're actually much longer duration assets. And if that's the case, then basis risk isn't really as much to blame as, again, as models might lead you to believe. Whereas the model will say that anything not predicted is therefore, basis risk. But if the prediction is wrong because the assumptions are wrong, it means that exposure might actually be larger than you might otherwise expect going forward as well. So I don't know, it's a long question but just wondered if you could comment on the believability of the duration numbers, I guess, that some of those models are spitting out?

Michael R. Hough

I'm going to give you a long answer to this one. The -- if you look back to conversations we've had in previous calls and times that you heard us speak that this is -- we take a really long-term approach to this. And we have always known or believed that if we had an ARM business, and let's just take 7/1s by themselves, the 7/1s are going to shorten through time. And they're going to become 6/1s and 5/1s and that duration is going to shorten predictably. And one of the problems that we've had with this whole QE thing and the status that -- the horizon for the interest rate cycle has been pushed out. That it was -- kept getting pushed out further and further and it made the ARMs more important as we saw when they make the approaching reset and when the yield curve may ultimately shift and anchor is lifted off the short end of the curve. But last call and prior calls we've said we were operating with current neutral duration but knowing in an uprate market that we were carrying positive duration. And the most duration that we carry were in our new issue, low coupon 7/1s in the 15-year bucket. And I think what we saw was that the degree of this move and the quickness of this move that we maybe underestimated the 7/1 duration by a little. I wouldn't say a lot. And maybe the same on the 15-years. But I think from an overall portfolio hedge, we had it right. And we have it right for where we are in the cycle and what we see as the 4-year yield curve. Now, I will say an instantaneous shock is what we tried to model to, and I think that's what we modeled to in the sensitivity tables, which were pretty accurate if you look at what we've disclosed in our view [ph] last quarter. And they're pretty accurate from an interest rate move and there was spread widening. So I will defend not necessarily the models -- one model's always going to be different from the next but I will defend our estimates of duration throughout the ARMs market based on our long experience in ARMs and based on the access we have to a lot of different models with a lot of different inputs that we can come to a pretty educated decision.

Michael R. Widner - Keefe, Bruyette, & Woods, Inc., Research Division

And so, I appreciate that. And I suppose the long and short of that is really that basis risk is not hedgeable and to the degree we get basis widening or basis tightening, I mean, that's going to flow through book. And as far as hedging purposes, obviously, all you can really hedge to is your expectations on duration whether that be through personal experience or the models. Is that ...

Michael R. Hough

Yes. I think that's fair. And I think it's fair to say that we're not going to always get it exactly right. But we take a long term look at this and what our estimates -- how they look through time and how that matches up with -- how it matches both sides of the balance sheet is going to what's most important long term.

Michael R. Widner - Keefe, Bruyette, & Woods, Inc., Research Division

And I guess just one final question and it's a little more philosophical. But those of us that are spending a career mostly as equity investors had a lot of surprises back in 2008 as -- arguably what happened -- I mean we've been sort of an equity secular bear market for a long time. But I mean, 2008 was sort of a turning point between a bullish trend and obviously a big bear. I mean, one of the challenges I imagine for a lot of you bond guys is you're -- spend most of your careers in a secular bull market and obviously, things may have -- that bull market may have reached an end back in October. And so, I guess, philosophically, the question is how much of the historical experience is going to be biased by having lived through a bull market and having models and experiences that's based on sort of a steady downward trend in rates, as opposed to what may very likely be or -- well certainly an end to the steady downward trend in rates? I guess I'll just leave it at that.

Michael R. Hough

Well that is a very big picture question. And then none of us really -- our careers -- not many of us go back to the '70s and before. So we're -- I mean, I -- don't -- just keep in mind if you look at the path of interest rates through the last 20, 30 years in Bill's case, there's been plenty of ups and downs in rates. And we have a lot of scars in the mortgage REIT business to show for it, but also in our previous careers and we've dealt with this. I'd like to think that we all have -- we all take a very focused risk management approach through our disciplined asset liability model, and I think that takes into consideration big changes in interest rates, et cetera. The problem that we've been dealing with is the fact that we had an unnatural yield curve and we had forces in the market that offset what we would see as a more normal yield curve in a more normal interest cycle. And we were making our decisions in that market. And if what we've seen here is that we're back to a more normal yield curve, I think that there's an adjustment for all the investment that had to be done in that artificial time.

Operator

Our next question is from Joel Houck with Wells Fargo.

Joel Jerome Houck - Wells Fargo Securities, LLC, Research Division

Michael, I wonder if maybe you could spend a little time talking about what you guys saw in terms of liquidity in the ARMs market, particularly last 2 weeks of June. I know you mentioned there's a large seller, but if you could maybe put some color on that, and also just remind us again of the -- how you value assets. As you mentioned, it's a one point in time. Was there -- was dislocation so great that bids dealers were giving you were below what you would consider fundamental value, or is the 630 mark kind of where you would be -- if you guys had unlimited capital would you be -- if you could buy at the bid, what would your appetite be?

Michael R. Hough

I'll just start with the question. What we saw at the end of the quarter -- I mean, I guess the definition of availiquidity [ph] is an imbalance between the buyers and the sellers, and there were obviously more sellers at quarter end than there were buyers. So that -- the price discovery on the bid side was not readily available and all over the board. And I think we saw that when -- the pricing services that we used. We saw that with the dealer bids that we get. And at that point in time, we're looking at bonds and saying, "Well, these don't make sense." These are cheaper than we've seen in a long time and much cheaper relative to the yield curve than we thought that they should be. But as any investor has to do, you have to preserve liquidity and protect yourself at a time like that and we did not consider buying securities. However, we haven't seen them at this cheap in a pretty long time, so it is something that we talk about.

Joel Jerome Houck - Wells Fargo Securities, LLC, Research Division

And you mentioned the liquidity position at the end of the quarter. Have you sold any assets subsequent to the quarter? And kind of what is your comfort level in terms of liquidity position for where you would have to start liquidating, if you will, just to kind of keep a liquidity cushion?

Michael R. Hough

Yes, I mean, we've always been fairly clear on what we target as a minimum liquidity position for us relative to the assets that we have, and I think we were approaching the lower end of that range at the end of the quarter. We have to be very cautious from here. If we are in a more volatile market, we need to preserve liquidity. We said we will probably be more comfortable with higher liquidity and lower leverage at some point, and I think that's an understatement. But we will look to adjust that position as we see -- and as it makes the most sense to us. And we haven't completed the process, but we started the process there and we will continue to do that. My guess is that you'll see us in a higher liquidity number next time we have a call.

Joel Jerome Houck - Wells Fargo Securities, LLC, Research Division

Okay. And I guess the last one I have is the interest rate spread came down in the quarter. How much of that is due to the higher amortization? I mean, I would think that, just given kind of natural level of repayments that this yield -- if you held the amortization constant, the yield should be going up at this point, particularly since you guys haven't really -- you've been able to maintain the absolute size of your portfolio. You haven't sold any assets at least to the end of June.

Kenneth A. Steele

Yes. I think that that's mostly right. It's pretty much due to that increase in prepayments and we would expect to see that fallback. I think if we look at the previous few quarters you kind of see that we were -- it kind of leveled off and possibly picked up here and there. And I think you'll kind of see that returning there but there's going to be a delay. You got to remember, so much that has happened in June and by the time that flows through the mortgage markets can take a month or 2.

Joel Jerome Houck - Wells Fargo Securities, LLC, Research Division

Okay. And sorry, one last one. The -- if you look at this kind of the 7/1, 10/1 complex down 3.4, 3.7 that way underperformed the 15-year, if you think about kind of in the context of raising liquidity, I mean, is it natural to assume if we were to kind of think about modeling this, that maybe you'd be sellers of the 15-year and redeploy into what are kind of more attractive longer date? Or is the experience with the volatility in these longer dated hybrids enough to kind of maybe give you pause and not go too far in the direction of overweighting the unseasoned hybrid complex?

Michael R. Hough

Well if this is such -- if this is a -- it really is a change in the direction of rates. I think as we've always said as we move closer to higher rates, we need to shorten the portfolios. So I would guess that -- and expect that we will look at our longest duration paper first as a way to shorten if we decide to do that. And that would be the 15s and the 7/1s.

Operator

Our next question comes from Arren Cyganovich with Evercore.

Arren Cyganovich - Evercore Partners Inc., Research Division

I'm sorry if I missed this, but could you talk about what the spreads are on your new investments in the 5/1, 7/1, and maybe about where the asset yields would be on those as well?

Frederick J. Boos

Sure. Hi, this is Fred. Our new issue paper in the 5/1 sector, we're looking about 2% yield. And that's a -- I'm using a 2.25 coupon at like a $101.50 price for a forward settle, which is what we typically do. We buy forward months based on a cost of funds of about 58 basis points to give us a NIM of about 142 basis points on 7/1s. And we're looking at 2.5s probably around $101 price, yield will be about 240. That's a current yield, and that would be a NIM of about 163 basis points. And those would be the ones we'd look at. 15-years are running around a 2.5% yield and that's on a 2.5 coupon around par. That's about a 160 NIM for us on new purchases.

Arren Cyganovich - Evercore Partners Inc., Research Division

Okay. That's helpful. The -- I missed some of the swap comments in Eurodollar hedges that you said -- I think I heard you talking about that the end of the quarter. My phone went out on me, so I missed what you said you had done subsequent to the end of quarter end?

Michael R. Hough

Yes. We added $400 million in equivalent notional swap -- swap equivalent in Eurodollar futures since then, so similar to the ones we did in the second quarter. Out 4.5 years plus even 5 years with some forward stocks on there.

Arren Cyganovich - Evercore Partners Inc., Research Division

Do you still expect to have some swap benefit? Going forward I think you have like $1.2 billion rolling off. I think it's a 1.9% cost, but you have some, I guess, 1.8% that are not effective yet, that are rolling on. Are you expecting to replace those or just let those roll off in general?

Michael R. Hough

Well we do have -- we have about, I guess, I think $600 million more coming due the rest of this quarter. And they're all -- I think they average over 2% or close to it. So we still get benefit from that. And some of these, you can allocate some of the forward starts that we've done in the year past to those positions. Next year, we have $2.4 billion with around 1.325 price. And those, again, a lot of which we forward started against some of that. But even so, new swaps will be accretive even at today's levels depending on how we structure it. So yes, there's still a lot of benefit to go for replacing swap runoff over the next few years. And even in 2015, it's like 1.325 average cost. So we still have a lot of benefit to go from there.

Operator

Our next question comes from Douglas Harter with Crédit Suisse.

Tapfuma Chibaya

Hi guys this is actually Tap Chibaya for Doug Harter. You guys talked to Elliott [ph] about taking down your leverage to a target level. Can you just remind us what that target level is and maybe talk a little bit about the thought process migrating down to that level?

Michael R. Hough

We had been pretty consistent when the yield curve was flat and rates were at all-time lows, that we were comfortable in the 7x to 8x leverage. That translated into a more than adequate liquidity position we felt. And we had stayed for the most part around 0.74, 0.75 over the previous quarter since we had the trough in rates. So that was obviously a good position to be in when we had this move here. Here we don't have a target leverage ratio to speak of. We want to maintain our liquidity position and gradually grow the liquidity position. I think it's going to be the relative to the risk we see in the market, what we see in the forward yield curve. But it's a work in progress right now, and I think we have adequate liquidity for where we are. But again, I said a few minutes ago, obviously the more liquidity, the better in a volatile market.

Tapfuma Chibaya

Great. And just on the dividend given what -- the moves that you're seeing in the quarter and how you guys are thinking about repositioning yourselves, does that cause you guys to think differently about the dividend going forward?

Michael R. Hough

Well, we've always looked at the dividend as trying to present a -- what we saw was the run rate of the portfolio. And in the first quarter, end of June, $0.70 was still a -- what our models were showing was a potential run rate. It's hard to say right now what we're looking at going forward. That's still a couple of months from now, and we'd love to see what, how the slow in prepayments begin to impact portfolio yield and how we ultimately position the portfolio. So it's hard to say with any certainty which direction we'll go with the dividend.

Operator

Our next question is from Daniel Furtado with Jefferies.

Daniel Furtado - Jefferies LLC, Research Division

I have a quick question. Your actions indicate your positioning for recovery and prices and/or basis, not continued weakening and widening. And I don't really recall Hatteras ever really putting on a bet as one-sided as this. Is your call here that CPRs will fall and the attractiveness of hybrids will increase, or is it more simply that over the course of time this basis widening will reverse?

Michael R. Hough

Well, I mean, I think you're mistaken on what we're betting on here. We've -- I think we were pretty clear there that we wanted to preserve the portfolio and not sell securities to bring leverage down into a distressed market. And that's the position we've always wanted to be -- put ourselves in, and I think the position we've always been in. And so from here, we are looking at the portfolio as a whole and relative to the market and what makes the most sense for us to do. And we're not saying that we think spreads are going to narrow or that the rates are going to come back down. They may, but we're saying that from a long-term look at this, we want to make sure we get it right on how we position the portfolio. So this is -- I think you're seeing this at least differently than we're seeing it.

Daniel Furtado - Jefferies LLC, Research Division

Well maybe that's the case. I guess I was just wondering if you thought that pricing would weaken from here, wouldn't it make sense to take leverage down at this point? I mean, you've already had to mark the portfolio at quarter end, so you've kind of taken that pain. So I guess, in my mind, 2 terms of additional leverage kind of implies that, at least over the near-term, that the downside risk you feel is relatively capitated.

Michael R. Hough

Yes, I mean I -- it's -- of course, if we thought rates were going up tomorrow, we'd want to get out of the way of some of that. But if we thought rates were going to come down tomorrow, we'd buy more securities too. So that's not what we're thinking here and it's not what we're doing. So I mean really, with all respect, the way that we've described it is how we're looking at it and how in the process that we're going to go through to get the portfolio where we want it.

Benjamin M. Hough

And I'd like to add just one thing to that. We do have a lot of options here with a -- still, a large portion of the portfolio in unrealized gains. And so it's not a quick one-way, knee-jerk decision. There's lots of options and so we got to figure out how those all impact. And so it's not an overnight decision. It's one that we have the flexibility to take a more gradual approach and we're going to do what's necessary.

Daniel Furtado - Jefferies LLC, Research Division

Don't get me wrong. I don't necessarily think it's a bad positioning because CPRs should move lower from here and that should help support prices. I was just trying to get a little more clarity on the move there. And then the -- one just kind of balance sheet question. The other liabilities look like they increased materially in the quarter. I assume that's some derivative -- based on derivatives, but just any clarity on the other liabilities line item?

Michael R. Hough

Okay, one second.

Benjamin M. Hough

Yes, that's just basically based on derivatives and it's probably -- it's the forward-settling purchases mostly that are in there.

Operator

Our next question comes from Jason Arnold with RBC Capital.

Jason Arnold - RBC Capital Markets, LLC, Research Division

Just one point of clarification. I think Fred was mentioning on the NIM commentary coupons that you guys were looking at on the new investment side were kind of in the 2.5% range, is that right? You guys are kind of sticking with the lower end of the coupon range still here?

Frederick J. Boos

Yes. I just -- yes, I threw out that -- the current coupons as an index sort of to measure. We do look at seasoned higher coupons. Say seasoned 7/1s, 3%, 3.5% range. We think the speeds will come down on those products. That would afford us an opportunity, perhaps get as much or perhaps even a little more yield with the benefit of softer CPRs and pay downs on those products. So we do look at an array of different options when we look at what's available. Obviously, seasoned paper is a little harder to get. It's more looking around by appointment on that paper, who has it, who will let it go. But as a benchmark, I quoted the current coupons because they are the most issued right now and the most prevalent in terms of prices and option adjusted spreads.

Jason Arnold - RBC Capital Markets, LLC, Research Division

Okay. Terrific. I just wanted to make sure I heard that correctly. And then just one other follow-up, I was just curious about your guys' big picture thoughts on the housing market. We've got the MBA purchase applications down again here. I think we've had 4, maybe 5 weeks of down. And so just kind of curious about your big picture thoughts on that end of the equation here, please.

William H. Gibbs

[ph]

Yes, good morning. We would expect, if you could take a look at where production's been coming out, pretty much for the last 6 months to 7 months we've been looking at originations around $160 billion, $150 billion, somewhere in that ballpark. If you look at the production we've seen in ARMs, the bulk of the ARM production, almost 75% to 80% of that has been in refi. So we would expect to see originations to come off here a good amount, which would be somewhat supportive, in particular in the ARMs market, if originations which were starting with the steeper curve back 3 to 4 months ago, they're starting to move up from 3% to 6% of overall originations. We'll probably pull back again here with the dislocation in the ARMs market in terms of spread -- these spreads. So we would definitely look to see overall originations drop at a reasonable pace.

Operator

The next question comes from Jim Delisle [ph] of Musaki [ph] Partners.

Unknown Analyst

This is a little bit a bond wonky question, if you could just indulge me, and -- that basically going to your spread, your Z spread. Wondering how much the speeds were changing on the 7/1s and the 5/1s to generate the same Zs -- or to generate the Z spreads that are depicted in that slide? Yes, and certainly, if it's something you don't have the information available, I can give you a call off-line.

Michael R. Hough

Are you talking about Slide 5?

Unknown Analyst

Yes I am.

Michael R. Hough

Well I think that's something that -- we'll have to get back and look at the actual numbers we used and have that to you later.

Unknown Analyst

All right.

Michael R. Hough

I'm not really sure exactly what Zs were used -- I mean what the parameters were going in, but they were not significantly different than what we -- it all depends on the coupon that we chose.

Kenneth A. Steele

I think we saw -- Fred, [indiscernible].

Frederick J. Boos

I think as far as the Z spreads are concerned, we were looking pretty much at the current coupons, I'd think.

Unknown Analyst

My -- the nature of my question is that obviously, over that period of time people were making -- one, the curve was steepening so much so the zeros you were discounting back were changing. But almost as importantly would've been the presumption that speeds were going to be slowing going forward, so -- but I can give you a call on a follow-up.

Operator

The next question from -- comes from Ken Bruce of Bank of America Merrill Lynch.

Kenneth Bruce - BofA Merrill Lynch, Research Division

My question is -- kind of gets to the -- strategic asked question gets to the heart of how Hatteras defined portfolio construction for the company. I guess, in the last couple of quarters, we've seen a number of situations where basis risk has led to some pretty significant impairment to book value. And looking at these situations, it's clear that portfolio construction effectively is, in many cases, kind of defining how that portfolio performs, given any particular backdrop that unfolded that might not have been well understood before. And I guess as you kind of articulate your strategy around 5/1s and hybrids in general, if you feel that as a market, it tends to be a little liquid -- the current quarter was a good example of that. If you question whether maybe a more diverse portfolio might be better suited just given, kind of given the nature of how hybrids act in liquid markets in general. And if you could give us any thoughts around that. I mean, it's -- you may pick securities on the basis to fundamentals, but to the degree that the market is reassessing value and liquidity tends to factor into that. You've seen some pretty volatile moves and I wonder if you might question the -- kind of singular association with hybrids as a strategy?

Michael R. Hough

I think I was pretty clear in the intro that I think it further emphasizes the need to build these portfolios, because these are one-off portfolios that remained static over the course of time. We have -- we get the seasoning of this paper and the natural depreciation that comes with that as this paper seasons. Now, unfortunately we couldn't -- and the trough and rates go to the market is buy every single type of bonds on the yield curves that we wanted at a reasonable price. Some of the stuff was -- had already seasoned and had that appreciation. So we don't question our focus on ARMs and it's based on our experience in doing this through 2-plus interest rate cycles. And we're just not comfortable. I know there are hedging tools and there are ways to hedge out the yield curve and maybe we could do that more on the diversification side, if we wanted. But we feel like we're going to get it long-term through a rate cycle pegged [ph] more much accurately with these securities and than we are at the curve. So I think it's important to look at this and not just that at a period of illiquidity but look at it through maybe an entire rate cycle and what it would mean. What it means. What does this portfolio look like a year from now, 2 years from now, 3 years from now, which is key to why we do it and how we look at it here.

Kenneth Bruce - BofA Merrill Lynch, Research Division

Right. I guess the essence of the question is just, as you point out, you need -- banks have historically had an interest in this asset class. We all know that there's changing regulations as it comes to bank capital. And as a byproduct to that, it's not clear what the demand for different types of securities will be from some of the traditional players. And yes, you're seeing spreads widen out. You're seeing bid ask spread themselves, be wide. The liquidity issues are becoming a little bit more pervasive. And I guess what I'm hearing you say is you -- "We fundamentally like the bond that we're in and we're going to be willing to live with the liquidity issues, which translate into some market-to-market volatility on our asset base in our equity, and we're just going to have to live with it." Is that kind of the right take away, or might you kind of change the position if the markets remain as volatile as they are?

Michael R. Hough

I think we always have to evaluate every option that we have and how it fits in. And we could change them. And some -- at one point, we added a 15-year bucket to the portfolio, so that was an adjustment to some degree. But we -- I mean, you look at banks for example. I think demand from banks goes up from here, with regulation and with -- I'm talking about just on the ARMs product and the short part of the yield curve. And we feel like there is meaningful support for this market. It's not a huge market and there are limited buyers. But it is a market that serves a very easily identifiable purpose when you're managing 2 sides of the balance sheet. And that's -- and I think we're willing to live with this. The basis on ARMs admittedly tightened and they tightened too far. And they have widened and maybe they've widened too far. We'll just have to see.

Benjamin M. Hough

And one last point and the -- it's not always a negative. It can be a positive, the volatility and the way the ARMs react compared to the rest of market. So we have taken advantage of that opportunity many times in the past and so it's not always a negative.

Kenneth Bruce - BofA Merrill Lynch, Research Division

Right. No, I don't want to suggest that there's not opportunities to buy cheaper assets when you have the volatility. It's just are you willing to endure that, effectively repeat what we saw in the second quarter? Maybe directionally, it goes the other way, and that would be certainly helpful from the shareholders point of view. But I'm just wondering if the volatility itself may dictate a change within the portfolio construction. And I understand your point.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Hough for closing remarks.

Michael R. Hough

Okay. Thanks, everyone, for being on the call. And we really appreciate the opportunity to spend time on the quarter. And we will continue to measure our risks and analyze what the best things for us to do as we go forward in this market. Thanks very much and look forward to the call next quarter.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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