Capstead Mortgage Corporation (CMO) Management Discusses Q2 2013 Results - Earnings Call Transcript

Jul.25.13 | About: Capstead Mortgage (CMO)

Capstead Mortgage (NYSE:CMO)

Q2 2013 Earnings Call

July 25, 2013 9:00 am ET

Executives

Lindsey Crabbe

Andrew F. Jacobs - Chief Executive Officer, President and Director

Robert R. Spears - Executive Vice President and Director of Residential Mortgage Investments

Analysts

Steven C. Delaney - JMP Securities LLC, Research Division

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

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

Howard Henick

Operator

Good morning, and welcome to the Capstead Mortgage Second Quarter 2013 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would like to turn the conference over to Lindsey Crabbe. Please go ahead.

Lindsey Crabbe

Good morning. Thank you for attending Capstead's Second Quarter 2013 Earnings Conference Call. The second quarter 2013 earnings press release was issued yesterday, July 24. The press release is posted on our website at www.capstead.com under the Investor Relations tab. The link to this webcast is also in the Investor Relations section of our website. An archive of the webcast will be made available for 60 days. A replay of this call will be available through September 24. Details of the replay are included in yesterday's release.

With me today are Andy Jacobs, President and Chief Executive Officer; Phil Reinsch, Executive Vice President and Chief Financial Officer; and Robert Spears, Executive Vice President and Director of Residential Mortgage Investments.

Before we get started, I wanted to remind you that some of today's comments could be considered forward-looking statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and are based on certain assumptions and expectations of management. For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC, which are also available on our website.

The information contained in this call is current only as of the date of this call, July 25. The company assumes no obligation to update any statements, including any forward-looking statements made during this call.

With that, I'll turn the call over to Andy.

Andrew F. Jacobs

Well, good morning, and welcome to our second quarter earnings call. As usual, I'm joined by Robert Spears, our portfolio manager; and Phil Reinsch, our CFO.

The second quarter will be memorable to us for 2 notable events, the first of which was the completion of the $170 million Series E preferred offering we did in mid-May. This new series preferred has a coupon of 7.5%, a $25 liquidation preference or face and is redeemable by us in 5 years from issue or 2018.

The proceeds from this offering, together with $43 million of cash on hand, were used to fund a June 13 redemption of all our previously outstanding Series A and Series B preferred stock. The redemption of that totaled $207 million, which was actually $19.9 million in excess of the recorded amounts, which is part of the reduction, both in book value and in the current quarter dividend -- current quarter earned EPS.

The redemption preference premium -- that associated -- that cost us about 2.1% of our reduction in book value for the quarter. But as a result of these transactions, future net income available to common stockholders will benefit about $8.3 million reduction in the annual dividend requirements for our series -- our preferred capital. That ends up being about $0.09 a year, so that should be a very positive transaction.

The second event was a little -- on a relative basis, I think it was a much easier shift for us than others. But with the shift from the interest rate, we saw short- -- long-term interest rates jump very sharply in kind of the midpart of the quarter. I think on May 2 of the quarter, we had a low of the 10-year treasury rate of 1.63%, and we ended the quarter at almost 2.5%. And I think what today, it's very close to 2.6%.

But this type of market is the exact reason we have -- we focus on the short-duration ARM securities for our portfolio. And amidst all this volatility, the pricing for our portfolio at the short duration -- well-seasoned short-duration ARM securities held up well compared to the longer-duration ARMs in the fixed rate securities market.

Overall, with the decline in the value of the portfolio net of our hedging, it resulted in about a 3.8% decline in our book value quarter-over-quarter.

In all, our book value per common share declined $0.80 to $12.80, which was $0.28 associated with the preferred capital transactions and $0.52 related to the decline in book value -- a decline in the portfolio value.

Relative to our operating results, net income for the second quarter totaled $29.9 million compared to $34.9 million in the first quarter. Net income per common share was only $0.04, which included the onetime effects of the preferred capital transactions, primarily the -- the primary element of that was a $19.9 million redemption premium that we had to pay, which has reflected most of that reduction.

Net interest margins for the quarter decreased $5.2 million to $32.7 million as a result of a 15 basis point decline in our financing spreads, which at the end -- for the quarter averaged 100 basis points.

Portfolio yields averaged 1.53%, which was 20 basis points lower than the portfolio yields in the first quarter. Most of this was attributable to higher premium amortization.

Mortgage prepayments in the second quarter averaged 22.7% CPR compared to 19.7% during the first quarter. The increased amortization -- the yield adjustments associated with additional amortization, amortization represented 99 basis points for the quarter compared to 84 for the last quarter, and this resulted in an additional $5.3 million in amortization expense for the second quarter.

With the increases -- recent increases in mortgage interest rate, prepayments are expected to decline, and we expect to see improved portfolio yields in future quarters, primarily as a result of lower investment premium amortization.

Interest rates on repo were very favorable during the period, lower prevailing market rates for repo, as well as the continuation of the higher swaps that are burning off in the first half of the year and been -- having been replaced for the most part already with lower rate swaps, so that's a positive.

And regarding our portfolio, and Robert obviously will go into more detail in a little bit, the acquisitions for the quarter were $950 million. Runoff was $943 million. And I think it's important to note that we did not sell any assets during this quarter.

We ended the quarter with a portfolio of $13.8 billion, leveraged 8.44:1 and a net duration cap of 1 month. 56% of this portfolio or $7.6 billion was invested in current reset ARM securities, of which approximately 91% were originated prior to 2008.

During the second quarter, our total swap position was -- increased by $400 million to $6.7 billion, and in the process, we lengthened our maturities by 2 months to 20 months on our repo.

At this point, I'll just turn it over to -- for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Steven Delaney with JPM (sic) [JMP] Securities.

Steven C. Delaney - JMP Securities LLC, Research Division

So guys, I guess, this is for Robert. As far as the prepay increase, almost about 300 basis points, and looking back, that 22.7% CPR is, by far, the highest you've had in a quarter in the past 6 quarters. I think you were like 18% CPR in the second quarter of last year. So Robert, I was wondering if you could just give us some color as to which segments of the portfolio are showing the largest pickup and speed?

Robert R. Spears

It's down our longer-reset pre-reset hybrids. We're close to 3% coupon and bonds like that generically are printing in the upper 20s to 30% CPR area. Our very seasoned portfolio continues to print around 15%. And so going forward, if you look at where we are now from a mortgage rate standpoint, we were last at these levels in 2011. I think most Street models would project those pre-reset hybrids that are printing in the upper 20s to slow down to the upper teens, and I think our seasoned book would be projected to be kind of in the low teens. So I think generically going forward, you're looking from an environment in the low 20s to the mid- to upper teens based on historical data and what Street projections are. And we didn't see much of a -- there wasn't much of a slowdown in July, but I think you'll see a pretty healthy drop starting in August and going forward.

Andrew F. Jacobs

And Steve, let me add to that. From the standpoint of looking at us and what our prepays have done on a relative basis to others that have -- in the peer sector, I think you have to recall -- note that we invest in more seasoned type product. We don't have new originations. And people that do a lot of new originations will be slower from the get-go on some of that. So that's the little -- you have to take that into consideration.

Steven C. Delaney - JMP Securities LLC, Research Division

No, that's a great point because that S-curve is flat for the first 12 to 15 months. Would you say, Robert, that like 2009, that's -- 2009 vintage is obviously the pre-reset. Are you seeing speeds sort of 40, 45 in that segment?

Robert R. Spears

Not really. I mean, generically, the 2009 paper right now is more in the 30 to 35 area. And really, it's coupon-specific and everything else. But if -- just take our pre-reset book that is basically just longer than -- it's like 42 months to roll or whatever. And so on an average with a 3-ish type coupon, I think you're looking at 30 right now, but that should slow down. But I mean, yes, sure, you have some bonds within that quadrant that are printing 40, 45, but I don't think generically across the board, you're seeing that right now.

Steven C. Delaney - JMP Securities LLC, Research Division

Okay, that's helpful. Yes, I'm just trying to get a sense for the short bucket and the longer bucket, kind of -- what kind of brackets we're looking at, at speed. I did -- we did -- obviously, short ARMs are really important and the psychology of those borrowers, I think somebody one day could write a book about that and maybe only a few of us would care to read it. But we did look at some EMBS data and looked at the '06 vintage like 5/1 LIBOR hybrids. And just trying to break out that cohort and see what the behavior was over the past year. And it does look to me like there was some impact of QE3 and lower mortgage rates because we were actually back in the spring of 2012, actually low-double digits like 12, 13 and then January of this year, over 20, and it looks like we're kind of hanging around 20% CPR there. And I'm just wondering, do you think -- have you noticed -- or do you sense that, that, because of those super low 30-year rates, were you getting some ARM to fixed refi activity going on, say, over the last 6 to 9 months?

Andrew F. Jacobs

Oh, without a doubt. I mean, I think a lot of people are estimating that 80% of ARM borrowers that are refinancing were going into fixed-rate products. And so what's kind of happened now, fixed rate started slowing down earlier. ARMs always had a tendency to lag. And yes, that last little push, too, where after fixed rates went up, you had some of the larger originators that were keeping ARM rates down fairly low. And so then you saw that tail-end effect of where you probably had guided couldn't go into fixed that were going ARM to ARM over the last couple of months. But that should be taken out right now with a 30-year note of refi somewhere between 4.5 and 4.75 and 5/1 hybrid rates now being quoted in the mid- to upper 3. There should be very low incentive for our guys going forward. Our gross coupon in our portfolio or gross mortgage rate that the borrowers have is about 3.75%. So yes, I think initially, the long way of answering your question, initially, those guys are refinancing into fixed, then I think you caught someone going ARM to ARM and now there's very little incentive going forward.

Operator

Our next question comes from Joel Houck with Wells Fargo.

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

I guess, the question is, given the spread widening that we've seen, particularly in the longer dated hybrids, unseasoned hybrids, what's the appetite, if you will, for Capstead to maybe take advantage and extend asset duration? Or on the flip side, do you guys not want to go in that area and take on more interest rate risk, given it seems like your strategy is kind of, at least this year, proven out to be the winning strategy? Just kind of curious as to how you see relative value across the mortgage curve.

Andrew F. Jacobs

Sure. I mean, most products widened substantially, as we know. The real shorter post reset securities that we own a lot of, you didn't see any material widening and so we still aren't purchasing those. We do see a lot of value or did see over the last couple of weeks and not necessarily the longer duration. We're not really looking at new issue 5/1s or 7/1s. But I think there's some really good value and some seasoned pre-reset hybrids kind of 3-ish sized coupons and higher inside of 36 months to roll. And those securities widened 35, 40 basis points on a spread basis and their prices are down 1 to 1.5 points. And I think we see the value in that area. I think there are good speed stories going forward. It allows us to stay comfortable within the duration bucket we play in. We were's not looking to extend our duration. If you notice in the quarter, we are at a duration drift of about 1.5 months longer. That was because of extension in our longer-reset bucket. But we matched that with incremental swaps. And so we kept our net duration gap where it is. So to answer your question, we're not looking to extend duration but we are actively looking at some ARM securities with shorter months to roll and -- which is another reason why our leverage is a little higher. We think right now, there are some very attractive purchase opportunities out there.

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

That's very helpful. I appreciate it. And then maybe kind of a follow-up with respect to leverage. What is the very low volatility in your model? I mean, is there a threshold of leverage that you are -- would look to kind of limit towards? I mean...

Robert R. Spears

There's not an absolute level. I mean -- but we're looking at -- we look at a couple of things. Obviously, speed, you're going to slow down. So from a liquidity standpoint, the factor paydowns aren't as much of a factor. By the same token, repo is readily available right now. So we're comfortable around 8.5x right now, given what we think we can purchase. Now if paper tightens back in, we could let our leverage drift back down. So it's kind of a combination of all these things, but we're very comfortable around 8.5x right now.

Andrew F. Jacobs

Yes, I will just add to that. I mean, from the standpoint, as we've said many a times, the quality of our short-duration, short-reset ARM security, that strategy allows us to comfortably be towards that 8.5x, if that's where we want to be, and just kind of plus or minus in from there. And I think it's important to note that during this quarter with our preferred transaction that we did, we actually used $43 million of cash to -- for the redemption of that. So that reduced our permanent capital from what we would call our long-term investment capital, just from the reduction of that $43 million. So that was worth almost 1/4 of a turn of leverage by reducing our capital for that, not -- before considering the change in value of the portfolio.

Operator

The next question is from Mike Widner with KBW.

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

Just following up on those recent comments. How do you feel about the relative value between your current MBS purchasing opportunities and share repurchases, which, yes, you guys had done some of back before the preferred repurchases? But how do you feel about the relative value of common share repurchase at this point relative to investments in what's available today?

Andrew F. Jacobs

Well, I think very simply, we haven't done any share repurchases since the beginning of the year, very beginning of the year. I mean, from the standpoint of the asset, the purchases -- what the available loans, product for Robert to buy is so attractive. From a relative basis, the consideration from a -- for a common buyback of any sort isn't at all compelling for our portfolio at this point in time.

Robert R. Spears

No, I mean, if you just think about it from -- we think now you're back to where you've invested in the mid-teens area on a levered basis. And if you're soft trading at 10% discount to book, I mean, I think the math is fairly simple there.

Andrew F. Jacobs

Yes. Most of the time, when we did purchases early, late last year was probably closer to the 15% discount to book value. And purchase asset yields of what Robert could buy were not near as attractive as they are today. So that's -- there's a big gap in that today. So it would be probably very unlikely. Although we do have the continuing authorization, it's unlikely that, that will happen anytime soon.

Operator

Our next question comes from Howard Henick with ScurlyDog Capital.

Howard Henick

Quick question is, could you just take me through the math on exactly why was there a hit to capital from the calling of the preferred? Was it -- did you have to pay a premium to where it was carried on your book? Is that what it was?

Robert R. Spears

Yes, exactly. The Series B shares had a $12.50 redemption price and they're on our books for like $11, $14, something like that. And so that differential had to be absorbed by the common equity holders in the transaction.

Howard Henick

Okay. That's what I figured. But it wasn't issued at $11. Will you mark it up slowly over time but not to the call price? Is that how that works?

Andrew F. Jacobs

Well, it was issued way back in the early 90s and went onto our books at roughly that price because it was issued in a merger transaction and was recorded at the net asset value of the assets acquired.

Howard Henick

At that time? Got you.

Andrew F. Jacobs

Yes. So it created this large differential between the call price and the recorded amount that we had to flush when we gained them.

Howard Henick

And it looks like -- when I do the math, because your recovery period is inside of 3 years, you guys sort of go about 3 years, I thought it was 2 and change. Am I wrong? Is it about 3 years...

Andrew F. Jacobs

Well, we get almost $0.09 a share out of it. And we took a book value adjustment of $0.28.

Howard Henick

Okay, so 3 years...

Andrew F. Jacobs

Okay with it? Yes. And getting that payback to around the 3 years, it's kind of a target of where we were trying to get towards. That's why you didn't see us do a transaction like this a year ago when rates were almost a point higher.

Howard Henick

Right, right. And my last question is, where do you think your -- you said no buybacks and I understand it because you're only about 90 now versus 80. Obviously, it makes more sense. But where do you think spreads are in whatever your favorite asset is versus where they were before this backup? I mean, were they 100, now they're 120? I mean, how much -- if you could just quantify the widening and the opportunity.

Robert R. Spears

Yes, I mean, I think now we're probably able to buy paper in the bucket that we like to play in with spreads of 150 to 160 basis points. It was closer to 125 a few months ago, and in some cases, around 100. So I'd just say like -- just take our pre-reset longer hybrids. Those widen anywhere from 35 to 45 basis points. And it varies from ARM product to ARM product. New issues 7/1s got crushed. But I just think generically now, if you just kind of put your arms around it, we've gone from an investing environment where on a levered basis, you were kind of looking in the 10 to 12 areas, but now you're back in the mid-teens which we think is very attractive.

Howard Henick

And when you say a levered basis, what are you assuming? Like 8x leverage roughly?

Robert R. Spears

Yes, 8x to 8.5x leverage.

Howard Henick

Okay. And you're talking like 15, 16 versus 10 or 11? So it's a substantial widening?

Robert R. Spears

Yes, yes.

Howard Henick

So I would not be mistaken. You may not want to answer this but ceteris paribus, for lack of a better word, ceteris paribus, your dividend should be higher going forward, not lower as you add more assets?

Robert R. Spears

Well, not only -- you have to look at assets at the margin, yes, we are putting them all at wider spreads but the bigger component is going to be the slowdown in speed.

Howard Henick

Right. But that goes in the same -- that cuts the same way?

Robert R. Spears

Well, it should be beneficial, yes.

Andrew F. Jacobs

Yes. And let me add to that also. It's the preferred transaction with a reduce in our cost to capital of our preferred equity.

Howard Henick

Right. That's another $0.09 a quarter, that's another $0.09 a year, too. Right.

Andrew F. Jacobs

They're $0.09 a year, yes.

Robert R. Spears

So $0.02 a quarter, just to look at it.

Operator

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

Lindsey Crabbe

Thanks again for joining us today. If you have any further questions, please feel free to give us a call. We look forward to speaking with you next quarter.

Operator

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

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