Orchid Island Capital's CEO Discusses Q2 2013 Results - Earnings Call Transcript

Aug. 6.13 | About: Orchid Island (ORC)

Orchid Island Capital Inc (NYSE:ORC)

Q2 2013 Earnings Call

August 6, 2013, 10:00 am ET

Executives

Robert Cauley - Chairman of the Board, President, Chief Executive Officer

Hunter Haas - Chief Financial Officer, Chief Investment Officer, Secretary, Director

Analysts

David Walrod - Ladenburg Thalmann

Operator

Good morning and welcome to the second quarter 2013 earnings conference call for Orchid Island Capital Incorporated. This call is being recorded today Tuesday, August 6, 2013. At this time, the company would like to remind the listeners that statements made during today's conference call, relating to matters that are not historical facts are forward-looking statements subject to the safe-harbor provisions on the Private Securities Litigation Reform Act of 1995.

Listeners are cautioned that such forward-looking statements are based on information currently available on the management's good faith, belief with respect to future events and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in such forward-looking statements.

Important factors that could cause such differences are described in the company's filings with the Securities and Exchange Commission, including the company's most recent Annual Report on Form 10-K. The company assumes no obligation to update such forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking statements.

Now I would like to turn the conference over to the company's Chairman and Chief Executive Officer, Mr. Robert Cauley. Please go ahead, sir.

Robert Cauley

Thanks, operator. In February, Orchid Island Capital completed its initial public offering and began trading on the NYSE MKT under the ticker ORC. It was the completion of a project that was several years in the making. Throughout the process, we continuously emphasized the need to position our portfolio defensively. As you know, we deploy our capital into two portfolios, one comprised of traditional pass-through securities funded in the repo market and the other comprised of structured securities containing assets that have a difference in sensitivity to interest rates.

The purpose of the structured securities is to shield the pass-through portfolio from material price declines when and if interest rates rise. We view the market as materially exposed to an interest rate shock and maintain that while we did not know when the market would sense that Federal Reserve was about remove their substantial accommodation, we expected that when they did it would lead to a very swift and significant sell-off in the rates and MBS markets.

We further have stressed that the outcome had to be positioned for in advance because if the market moved quickly as we expected, relying on dynamic hedging strategies would likely be too risky since it would itself (inaudible) one would be able to respond quickly enough. Risk management and protection of book value are the focus of our investment strategy and in environment such as this, with rates still low and many investors fearful of back up in rates, the cost of hedging our book value is quite high.

In our case, we rely heavily on interest only securities. Yields on the types of IOs we own are quite low and often negative. In order to protect our book value we need to allocate a substantial portion of our capital to these assets and therefore our ability to generate interest income has been constrained.

However, with the recent moving rates, we expect prepayment fees will be trending down and the MBA conventional refinancing index has already dropped below 2,250 after peaking near 6,000 last fall. This should enhance the income generated by our other securities as well as our pass-through securities.

For the sell off in May and June, our portfolio behaved well as our book value was only down 5.74%, however our book value was still down. That being said, we have not lost any conviction in our belief our strategy is sound. One has to understand that while interest only securities are indeed natural hedges for pass-through securities they will not necessarily move in lock step with pass-through securities when rates move as they did recently.

Much of the pass-through market is comprised of investors who use considerable leverage in their portfolios. When the market moves dramatically they are foresellers, then pass-through prices can have large outside moves. Structured securities are also on the (inaudible) form but to a much smaller extent. Further, most of our IO positions are collateralized by well on the money fast paying loans. While rates back up in late June, prepayments fees in these securities should slow down and their prices are likely to rise if they do but the price response of these assets to the move in rates was muted because of slowdown in fees will probably not show up until September.

This means that there will likely be at least two more fast prepayment trends to contend with. The inability of our IO securities to react to the right movement as quickly as our levered pass-through portfolio did not and will not sway us when rates increase, mortgage cash flows extend and as prices decline. IO cash flows extend as well and their prices react accordingly. Whether they do so in lock-step with pass-through securities is not imperative.

During market turmoil in late June and to a lesser extent in late May, our cash position in unencumbered securities were sufficient to protect us from margin calls on our pass-through portfolio. In fact, on Monday, July 8, we witnessed material margin calls on our pass-through portfolio from the combined effects of the market selloff triggered by the nonfarm payroll number released on the (inaudible) as well as monthly pay downs announced that night. We did not have to sell a single asset nor did we delever in any way. We did not had to adjust our hedges. We met our margin calls with capital cash cushion. In fact, our repo balance as of July 31, 2013 was $303.6 million versus $306.5 million at the close of business on July 8 and $308.7 million at quarter end.

In other words, our repo balance at July month-end was 98.4% of the balance at quarter-end and 96% of the Q1 balance. The slight decrease is of the result of repos rolling at slightly lower balances due to paydowns and lower pass-through market values. When the repo rolls, we tool the cash that had been previously closed in and purchased securities to be held on our balance sheet or unencumbered.

This means the income generating potential of our portfolios has now enhanced as we did not have materially strengthen the balance sheet and returns available are higher than earlier in the year. Since quarter-end, we have taken another step to protect our liquidity going forward. We have repoed approximately $6.5 million of our structured securities with one of our existing repo lenders. We did not purchase additional securities with the borrowed cash but instead held the cash for the added liquidity.

This way, in the event we ever have an outsized margin call day, we are less likely to be forced to sell an unencumbered asset or security in a volatile market also by repoing asset with an existing lender, we are likely be able to offset some of the call on the pass-through side assuming our IO moves up in price. The incremental cost of this repo is justified in our adjustment.

Looking forward, we now face an environment where income per dollar invested or unit of duration has risen. Premium amortization on our pass-through portfolio will slow and our IOs would generate more income than was previously the case to the extent prepayments fees slow. That being said, the income from IO book has been slightly negative for some time, so the improvement will be large in relative terms but not absolute terms.

This provides us an opportunity to reposition the portfolio. We can take advantage of the increased income generating capacity of the portfolio to reduce the leverage and enhance our hedges while maintaining our dividend at roughly the same level. The economic data of last week is generally strong in interest rates and will be yield on the 10 year U.S. Treasury approach the intraday highs we witnessed on July 8, near 2.75%.

The market appears quite skittish to us and very sensitive to strong economic data. This was also evident in the MBS market as most passes, especially lower coupon fixed-rate mortgages performed quite poorly last Thursday on the eve of the July nonfarm payroll at 8:30 Friday morning. We still view ourselves as being at the low end of the historical range in rates and the economy is performing below its trend but improving.

For years now, the economy has been on the mend but in an uneven fashion. Growth has come in fits and starts. We view the (inaudible) as just another example of the uneven recovery. If the Federal Reserve does indeed begin to taper their asset purchase in September, interest rates may move higher still. If they do, we believe fixed-rate mortgages have considerable room to extend further.

After all, four years ago, in summer of 2009, Fannie Mae 4% fixed rate MBS traded between 96 and 98. Last Friday, they closed at just over 104. For reference, the 10 year U.S. Treasury yield was approximately 3.5% in the summer of 2009. Accordingly, we will continue to position defensively. We will position our portfolio slightly for further weakness also because we have not hedge the majority strength of portfolio and return profits have improved, we can do so with limited sacrifice of income.

Going back to my opening remarks and our schematic we are attempting to raise capital, we continue to favor positioning defensively in an effort to protect our book value even if it costs us a few hundred basis points of annual income. For this reason, we will remain focused on protecting our book value and we do not intend to take advantage of this move to increase our dividend. We see considerable risk in that strategy.

That's all for prepared remarks. Operator, we will take questions now, please.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from David Walrod of Ladenburg. You may begin.

David Walrod - Ladenburg Thalmann

Just wanted to clarify. If I look at your quarter-over-quarter, the pass-through securities portfolio and the structured portfolio went down, your cash balance went up. So you are saying you would do that again post the quarter with the $6.5 million of repo that you did off the structured portfolio?

Robert Cauley

No, actually that occurred mid-July. That was just recently.

David Walrod - Ladenburg Thalmann

Right. So that would in addition to, mostly if you did that, you mentioned in your press release that you would turn a leverage but not reinvest that capital. So this was in addition, what happened was in addition to what you did in the second quarter.

Robert Cauley

We did not close any structured securities during the second quarter.

David Walrod - Ladenburg Thalmann

It looks, according to your press release, that you did that with, not with the structured portfolio but with the traditional pass-through portfolio.

Robert Cauley

Could you just repeat that? I am not sure we are following you here?

David Walrod - Ladenburg Thalmann

Maybe I could follow-up you offline on that one.

Robert Cauley

Okay.

David Walrod - Ladenburg Thalmann

Okay, can you give us a sense of where prepay could come in? You said that the prepays and the IOs hadn't come down yet. Can you give us an idea where they came in so far this quarter?

Robert Cauley

We have the numbers from July that were in our press release when we announced the July dividend. I don't that in front of me. I believe there was a slight decrease. Of course, we have speeds tonight. I don't expect a material decrease in the IOs that we own that have the most extension potential.

We have talked a lot about the some of these IOs we own are negative yields and the reason they are is because they are generally collateralized by loans that were, for the most part, originated post crisis, very low LTV, very high FICO and the coupons are 4.5%, 5%. So they are well on the money, prepaying very, very fast.

When rates slowed off 500 basis points or so during the second quarter and into the early third, the moved less than the money and those prices would respond. That's kind of what we are alluding to is that it's somewhat of a muted response because it probably will be September release of August speeds before you really see a meaningful slowdown.

So on those types of assets that was not a material slowdown last month, there maybe some more tonight. It's very critical for us to be able to run those things on a model. We were talking about this like yesterday, some of the models have showed them slowing to 35 and some of them show them slowing to 20. That obviously means a lot for an asset such as that.

So we will put out a press release next week when we announce our August dividend and we will have our August speeds, but the long answer to your question is, in July, on most of the items that we care about, the slowdown was not that material.

Hunter Haas

It is certainly in line with what we experienced in the second quarter just to add to Bob's comments. I think we will see a partial slowdown in the speeds that come out tonight and the full effect of the new rate environment in the September prepay release, as Bob -mentioned. So we expect to start seeing an uptick in income from those securities or a decrease in amortization, if you look at it, probably starting this month but more material impact being soaked in the third month of the quarter and then on into the fourth quarter to the extent we don't retrace and go back to lower rates.

David Walrod - Ladenburg Thalmann

Good, and then, your yield on the portfolio went up pretty significantly in the second quarter versus the first quarter. Should we think about the run rate going forward as being at these levels or was there something in the quarter that pushed it higher?

Robert Cauley

I think it was a combination of some slight trading but it is higher. There is no question about that. One thing we did do during the second quarter was sell some bit rate pass-throughs and redeploy into a slight different coupon but importantly very close to par and as a result there is little or no premium amortization with that. The short answer is, yes, you should expect that the yield should be expanded slightly.

Hunter Haas

But it is probably worth cautioning you that we are having continuous discussions amongst ourselves and with our board as to what to do with that expanded income. It doesn't necessarily needs to translate into earnings for the rest of the year. We may use it to buy hedge positions and take a more defensive position on rates. That has not been decided yet.

David Walrod - Ladenburg Thalmann

Alright, that's helpful. Then, the last question I have, do you have the weighted average share count handy?

Robert Cauley

We can get you that but that did not change. Should still be the 3,341,665.

David Walrod - Ladenburg Thalmann

Okay.

Robert Cauley

We did not buy back any shares. I apologize for that question. Just give me a call and we will be glad to go over that with you.

Operator

(Operator Instructions) I am showing no further questions at this time. I would like to turn the conference back over to Robert Cauley for closing remarks.

Robert Cauley

Thank you, operator. We appreciate you taking the time to listen to our remarks today and to the extent you have questions that come up after the call or maybe after you listen to a replay, please feel free to call us at office on the number 772-231-1400. We are always will to take any and all questions. Again, thank you for your time.

Operator

Ladies and gentlemen, this concludes today's conference. Thanks for your participation. Have a wonderful day.

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