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Arlington Asset Investment (NYSE:AI)

Q2 2013 Earnings Call

July 30, 2013 9:00 am ET

Executives

Kurt Ross Harrington - Chief Financial Officer, Chief Accounting Officer, Executive Vice President and Treasurer

Eric F. Billings - Chairman and Chief Executive Officer, Arlington Asset Investment Corp.

Analysts

Trevor Cranston - JMP Securities LLC, Research Division

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

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

Operator

Good morning. I'd like to welcome everyone to the Arlington Asset Second Quarter Earnings Call. [Operator Instructions]

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

Kurt Ross Harrington

Thank you very much. Good morning. This is Kurt Harrington, Chief Financial Officer of Arlington Asset. Before we begin this morning's call, I would like to remind everyone that statements concerning future performance, marketing conditions, cash returns and earnings, investment opportunities, core cash operating expenses, portfolio allocations, 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 spread, changes in default rates, changes in the constant prepayment rate for the company's MBS, changes in our operating efficiency, changing in the company's returns, changes in the use of the company's tax benefits, maintenance of the company's low leverage posture, changes in the agency-backed MBS asset yield, changes in the company's monitor -- monetization of net operating loss carry-forwards, changes in the company's abilities to generate consistent cash earnings and dividends, changes in the company's allocations of capital between its agency and private-label MBS portfolio, 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, availability of opportunities that meet or exceed our risk-adjusted return expectations, ability and willingness to make future dividends, ability to generate sufficient cash to retained earnings to satisfy capital needs, changes in and the effects on the company of mortgage prepayment speeds, ability to realize book 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, and other documents filed by the company with the SEC from time to time, which are available from the company and from the SEC. And 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 comments.

Eric F. Billings

Thank you, Kurt. Good morning, and welcome to the second 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 $1.12 for the second quarter, which equates to an 18% return on book value available for investment. Net interest income increased by $4.2 million from the first quarter, and book value per share remained essentially flat. Our hybrid portfolio of floating rate private-label mortgage-backed securities and hedged agency MBS are structured to generate attractive current returns plus growth over time, and this quarter's results again reflect that dynamic -- portfolio dynamic.

Since early in the year, we have increased the company's potential for book value appreciation by adding additional investments in private-label MBS such that at June 30, 2013, that portfolio had a total market value of $329 million, a 65% increase since year end. At the same time, we have added resilience and consistency to returns by increasing interest rate hedges on the company's agency MBS portfolio to approximately $1.5 billion, roughly equal to the face value of that portfolio. Capital allocated to private-label MBS at quarter end was approximately $275 million, representing an allocation of equal to 60% of available capital. Capital allocated to the agency MBS was approximately $182 million. Given the current market conditions, we expect that mix to migrate over time towards approximately a 65% allocation to private-label mortgage-backed securities.

In the agency MBS portfolio, during the second quarter, we continued to increase our hedged position in 10-year interest rate swap futures to a current notional amount of $550 million with a mark-to-market average cost of 2.81%. The other futures contracts we utilized to hedge our agency MBS portfolio run consecutively on a quarterly basis beginning in December 2013 and extend out to December 2018. They have an average notional amount of approximately $978 million. The average mark-to-market costs over the approximate 5-year duration of the hedge was 1.99%. This quarter, our agency MBS portfolio demonstrated a 3-month portfolio CPR of 8.24% versus CPRs of 34% on Fannie Mae 4.50% universe. Approximately 70% of our agency MBS portfolio was originated under HARP programs, and our remaining assets consist of either low loan balance, loans or loans with other prepayment protection features. U.S. fixed income markets, and more specifically the U.S. mortgage market, have experienced a repricing in the second quarter of 2013 driven by improving domestic economic data and speculation of a change in the Federal Reserve's economic policy outlook. During the quarter, we saw 5-year and 10-year U.S. Treasury rates and swaps market rise approximately 65 to 75 basis points. The agency MBS market experienced similar price movements with the generic par yield on agency MBS rising from 2.62% to 3.32% or 70 basis points. We are pleased with the performance of our agency MBS portfolio structure given the market volatility during the quarter.

There are 2 primary contributors to this performance: First, we hedged roughly 100% of the market value of our portfolio; and second, we used a combination of 5-year and 10-year hedge instruments that we felt were well-correlated to our agency mortgage-backed securities portfolio. We continue to believe the structure allows us to earn an attractive spread and protect the value of our portfolio as the economy, monetary policy and markets normalize.

Turning to the private-label MBS portfolio. At June 30, 2013, our private-label MBS portfolio had a fair value of 64.2% of face value, total market value of $329 million and repo of $46 million. OCI related to the private-label securities was $57 million as of June 30. The assumptions used to value the portfolio at June 30, 2013, included on a weighted average basis, a constant default rate of 4.8%, loss severities on liquidated loans of 46.3%, constant prepayment rate of 12.7% and a discount rate of 6.7%. We have migrated our private-label MBS portfolio over time such that, looking forward to a point 2 years from today, we expect approximately 80% of our re-REMIC portfolio to be variable rate in nature, which we expect will help inflate the portfolio from potential future increases in interest rates. More than 95% of our private-label 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 3.9% and a marked price of 64.2%, they provide a current yield of approximately 6.07% on an un-levered basis. In addition to the current yield component, given their credit characteristics, we would expect these securities to appreciate over time and provide a potential total return in the teens from their current price level.

Each investor will, of course, make his or her own assumptions. However, as a mathematical illustration, in a prime jumbo private-label MBS portfolio with an 18% of loans more than 60 days delinquent, today, one might expect terminal defaulted to be approximately 23%. Given the current housing market dynamics, a reasonable expectation would be that loss severities on liquidated loans declined by 5 percentage points over time from the current levels, such that actual future loss severities may average approximately 40%. 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 value in 2 to 3 years, in this illustration, they would earn a principle return of approximately 12.5% on an annualized basis in addition to the cash coupon of 6.07% on an un-leveraged basis.

The company's investable capital in MBS is approximately $457 million. Again, as a mathematical example. If one assumes that the 65% of the company's pro forma capital is allocated to private-label MBS on the basis of the scenario outlined above with the resulting terminal value of 80% of par and leverage of 0.2% time, under that scenario the company would experience a potential pretax increase in investable book value of approximately $4.45 per share over time. From a tax perspective, the company expects to receive the cash tax benefit of its $230 million net operating loss carry-forwards that expire in 2025, as well as a portion of its $285 million net loss carry-forwards through 2014.

Due to the company's C corp structure, Arlington shareholders will continue to benefit from an after-tax yield on the company's dividend that is approximately 35% higher than companies with a REIT structure. Finally, the deferred tax assets includes 2 tax assets that will be available in future periods, but represent economic value to the company currently. As we look forward, we are optimistic about the company's opportunities. We have 2 complementary portfolios with attractive attributes and high risk-adjusted returns that we expect to generate consistent cash earnings and dividends with a potential for growth. The investment environment continues to be attractive, and we expect our returns to be protected by a substantial tax benefit for several years to come. Operator, I would like to now open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Trevor Cranston with JMP Securities.

Trevor Cranston - JMP Securities LLC, Research Division

I was hoping you could expand a little bit on the comment about repositioning the portfolio a little bit more towards non-agencies since the end of the quarter, and just talk a little bit about kind of what sectors in the non-agency's base you're finding value in and where you're seeing yield there today?

Kurt Ross Harrington

Trevor, we continue to find opportunity in the re-REMIC mez category, the prime jumbo re-REMIC mez where we've been focused for a considerable period of time. As we've talked about before, we've evolved that structure over time to really focus on the post reset and pending reset space sort of floaters for a whole host of reasons including relative value, overall risk-adjusted return and then also the fact that it has a favorable characteristic in a rising rate environment to it because these assets do have duration to them. And so if you get a move up in the forward curve that gets discounted back into the cash flow stream and the bond value. So we've seen some nice performance out of those. And a pickup in part in that area through the course of the quarter from a price perspective. And that's where we've been focused. We did see some interesting opportunities sort of during that period of volatility and post the end of the quarter to pick up some really nice investments in that area. So we've reallocated a little bit of capital to those opportunities. We view those economics to be consistent with what we've laid out here in the script.

Eric F. Billings

So Trevor, adding to that for a second, as we've described in the script, we're able to buy mez, backpay mez at -- yielding on an annualized basis almost 19% if we assume 2 years until they reach an approximate full value. And of course, if that happens sooner, then that return would be higher, and that contrasting with an agency portfolio is still very attractive and it's very attractive from really all perspectives. And so, as long as that's available to us to the degree we can earn those yields that -- remember, that's an un-leveraged return. We do have 0.2x leverage on it so that puts us in the low-20% total return on that allocated equity. So these are very attractive as long as the market would still provide them for us. Obviously, it's getting more difficult, but I think we believe that we still have opportunities to migrate a little bit more of our capital and get up to that 2/3 level.

Trevor Cranston - JMP Securities LLC, Research Division

Okay. And do you guys see any opportunities in the GFC credit bonds that are starting to be issued now, or are you guys going to kind of stay focused on the private-label space, as long as there's still attractive returns there?

Kurt Ross Harrington

Trevor, we've looked very closely at that. We've spend a good -- we've spent a lot of time on the Freddie trade. We feel like they're getting -- they're close, but they're -- the 1 sponsor was what 340, I think it was, and the other was 715. We feel like that was probably just a little shy where we might need to be. But we've spent a good deal of time looking at them. And to the extent, we feel like those returns can be competitive on a loss-adjusted basis against the non-agencies then we would consider putting capital there. Today, we found that not to be the case given the opportunities we see in the non-agency arena.

Trevor Cranston - JMP Securities LLC, Research Division

Then just the last thing, I guess on the agency side, the portfolio is obviously a little bit smaller and the hedge position has gone up a decent amount since last quarter, which would seem to apply slightly lower spread income potential just on that portion of your capital. Can you talk about if that has any impact on the way you think about the dividend going forward?

Kurt Ross Harrington

No. I think we're -- I think if you looked order and cash earnings for the business, which is how we look at it, I think the business comfortably exceeded the dividend this quarter and allowed us to have an excess above that for some growth. So I think that there's a room there. I think returns here with this sort of hedged structure are at the margin a little bit lower, so it definitely finds its way into our return analysis. And it's definitely -- it's a consideration when we're reallocating capital to the non-agency side where we see the kinds of returns that Eric outlined on an un-levered basis. So it definitely plays into that. We do see them being trimmed a little bit, but we don't see a reason to have that really impact the dividend or the cash flow stream of the business because we've been living comfortably above that level from a cash earnings perspective.

Operator

Our next question comes from Jason Stewart with Compass Point.

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

Could you just get into a little bit more detail on -- I must be looking at the wrong balance sheet here, but it looks like the portfolio increased quarter-over-quarter. Is that right?

Kurt Ross Harrington

Yes, the agency portfolio -- the portfolio was up quarter-over-quarter, and then we brought it down as we reallocated some opportunities over to -- reallocated capital, pardon me, over to some additional non-agency opportunities over the course of the latter part of the second quarter and so far into the third quarter.

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

Okay. So in terms of yield and where you are buying in the second quarter and where that shakes out with the new hedging, could you give us any more detail on where you might have been versus -- in 2Q versus 1Q?

Kurt Ross Harrington

You mean on the agency side?

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

On the agency side.

Kurt Ross Harrington

Yes, I mean, I think you'd say yields are going to be in the mid- to high-3s here at these price levels. So your yields are -- and that's implying prices depending on the asset, 104, 105 neighborhood. Pay-ups are moving around a little bit as you well know, but lower than they were naturally. So I think that's probably a good -- a reasonable proxy for yields is the 3.5 to 3.75 range depending on the asset. And your hedge overall -- blended hedge cost probably 195-ish. And so your net spread with this sort of hedge structure is probably 150, 160, sort of 170 maybe, depending on the day. So your returns are mid-teens and that's sort of marginally lower than they have been. So that goes into the return calculation against the non-agency opportunity. So we call that mid-teens, maybe it's a little above 15, a little lower than it historically might have been given the hedge structure we've now put on it.

Eric F. Billings

But again, that's essentially a fully hedged structure so in that context it's various lines [ph].

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

Right. And then on the funding side. Clearly, I think there was some concern during the quarter from investors about access to funding and that turns out to be not the case from the results we've seen so far. But we haven't talked much about funding on a non-agency side. Were there any issues there with getting access to repo? I mean, you don't use a lot of leverage there, but if you would just describe the...

Kurt Ross Harrington

Jason, we've talked about this before. From probably going on now 3 solid years, there is off and on this recurring question about repo availability and what we all on this side of the -- collectively on this side of the table, all the managements are seeing in their businesses and different folks see different things. In our business, what we've seen is nothing but more capacity, a broader base of repo counterparties, more folks seeking to do business with us, some of whom are dealers looking to do more trading activity and some of whom are simply funders that have a book that they're running and are looking to add to that book. And so we've seen our counterparty universe expand quite significantly in the last 12 months. We've seen the diversity of those counterparties grow. We've seen our concentrations come down. We added 2 new counterparties this quarter alone. And the same is true on the non-agency side, although to a little bit lesser degree. The same directionally is true on the non-agency side. There are just probably fewer folks who are doing non-agency repo, but the same principle applies. And in our case, we've expanded the number of repo counterparties we're doing business with and diversify further. So for us, we've seen the opposite. We've seen more capacity, not less. And I think there are some developments and structures that folks are working on and having some success with -- some of the dealers are having success with and expanding capacity more broadly in the non-agency space. So it wouldn't surprise me, actually, to see not less capacity, but in fact, more capacity over time in that space. And to the extent that happens, that's probably a good thing for the prices of our assets. So there's no guarantees there, but we would think that, that may be happening over the next 6 months or so. And if not sooner, and to the extent that's true, that could be a good thing for all of us.

Eric F. Billings

Yes, not to imply that we wouldn't grow our leverage on a non-agency because we would. But the fact the market accepts more sort of other people that own them, as Ross said, could be very positive.

Operator

Our next question comes from David Walrod with Ladenburg.

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

Yes, a few things. A lot has been touched on. But you deployed or -- I'm sorry, you raised capital late in the first quarter. Did you get that all deployed in the first quarter, or was that -- some of that deployed during the second quarter?

Kurt Ross Harrington

No, it wasn't quite all deployed in first quarter.

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

Okay, there's a little deployment. And then you've been talking a little bit about low leverage on the non-agency. You always run it with almost no leverage. Given the attractiveness, would you consider taking leverage up maybe another half a turn?

Kurt Ross Harrington

On the non-agency? Did you say non-agency?

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

Yes.

Kurt Ross Harrington

No. No.

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

No, you want -- there's no addition to -- okay. Good.

Kurt Ross Harrington

No. I think, Dave, look, we're pretty consistent with what we've said that we sort of see 0.2 neighborhood is sort of peakish for us. We've been operating below that, actually, for a pretty long period here. But we sort of see that as our comfort level, and I don't see us going above that.

Eric F. Billings

I mean, which isn't to say that these assets can't vary. With some decent discipline and prudence, support greater levels than that. But from our perspective, in terms of the totality of the business, looking at returns that certainly should be in the low-20s and could conceivably be higher than that, if things continue to move along at the pace they are and if rates continue to move away from crisis level interest rates in the society where the crisis is clearly long past, then because the vast majority of the assets we own there are floaters, we would participate in higher cash yield returns and almost certainly, that will drive a move to par on these assets as the -- clearly, the economy is getting better. And so to a degree we can generate those kind of returns with 0.2 leverage, it just doesn't make any sense for us to do more than that. But clearly, the asset could easily support more.

Kurt Ross Harrington

Yes, I would say -- I will just make one more comment which is as a general matter, I would observe we have not seen haircuts on non-agency increase. In fact, just more of the opposite, as prices have risen, haircuts have gone down. So not only are more folks maybe in the market to potentially provide non-agency capacity, but the leverage ability has gone up. For us, our appetite is what it is, and I don't really see us changing.

Operator

[Operator Instructions] Speakers, at this time, we have no further questions.

Eric F. Billings

Okay. Well, thanks, everybody, for joining us. We appreciate it a great deal, and look forward to speaking with you all next week -- next quarter.

Operator

This conference has now concluded. You may disconnect your lines.

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