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Apollo Residential Mortgage (NYSE:AMTG)

Q2 2013 Earnings Call

August 7, 2013 10:00 AM ET

Executives

Michael Commaroto - CEO

Stuart Rothstein - CFO

Analysts

Douglas Harter - Credit Suisse

Trevor Cranston - JMP Securities

Rick Shane - JPMorgan

Mike Widner - KBW

Mike Nolan - JPMorgan Securities

Operator

I would like to remind everyone that today's call and webcast are being recorded. Please note that they are the property of Apollo Residential Mortgage, Inc. and any unauthorized broadcast in any form is strictly prohibited. Information about the audio replay of this call is available in our earnings press release.

I would also like to call your attention to the customary Safe Harbor disclosure in our press release regarding forward-looking statements. Today's conference call and webcast may include forward-looking statements and projections, and we ask that you refer to our most recent filings with the SEC for information, important factors that could cause actual results to differ materially from these statements and projections.

We do not undertake to update our forward-looking statements or projections unless required by law. To obtain copies of our latest SEC filings, please visit our website at www.apolloresidentialmortgage.com or call us at 212-822-0600.

At this time, I would like to turn the call over to Michael Commaroto, Chief Executive Officer of Apollo Residential Mortgage Inc.

Michael Commaroto

Good morning, and thank you for joining us on the Apollo Residential Mortgage Inc. Second Quarter 2013 Earnings Call. Joining me in New York this morning are Stuart Rothstein, our Chief Financial Officer; Keith Rosenbloom, our Agency Portfolio Manager; Paul Mangione, our Non-Agency Portfolio Manager; and Teresa Covello, the Controller of our Manager.

During the second quarter of 2013 positive reports on employment, the economy and housing combined with commentary said regarding the potential timing around the tapering of QE3 but the significant volatility in the fixed income market.

10 year U.S. Treasury note yields which rallied in April and touched a low of 163 basis points in early May reversed quite dramatically for the remainder of the quarter and yet 2.49% on June 30th 2013. Concerns over the Fed's exit from the market coupled with extension risk from slower prepayments weight heavily on the market.

While yields on U.S. Treasury securities and swaps increased during the second quarter, the magnitude of changes in yields on agency RMBS increased to even greater extent. Accordingly our agency RMBS valuation has declined more than our swap valuations increased, negatively impacting the value of our portfolio.

Amidst this backdrop we actively manage our portfolio selling $2.2 billion of our agency RMBS increasing our positions in longer dated payers swaps and options and reducing leverage. In addition, during the second quarter we added a short position in Fannie Mae TBAs to further mitigate our interest rate exposure and a portion of our spread risk. Our combined actions were aimed at reducing our net duration, increasing liquidity and taking advantage of market volatility to opportunistically shifting investments from agency RMBS to non-agency RMBS. During the quarter we purchased $168.5 million of non-agency RMBS, and we ended the quarter with a pro forma equity allocation of 50% agency RMBS, 26% non-agency RMBS, 5% securitized loans and 19% cash.

After adjusting from double trades and the subsequent net repayment of corresponding borrowings. At June 30, 2013 the combined RMBS and securitized mortgage on portfolio had a pro forma effective net interest spread of 2.1% and a pro forma effective leverage asset yield of 11.8%. Once again assuming unsettled trades at June 30, 2013 had settled and corresponding borrowings under the purchase agreements were repaid.

The actions we took enables us to stabilize our book value per share, which ended the quarter $18.63. Our goal was to decrease the interest rate risk in our portfolio significantly. Our hybrid REIT structure provides us with flexibility to allocate equity between interest rate or credit driven strategy when optimizing our portfolio.

Given the market conditions we faced in the second quarter we chose to de-lever our fixed rate agency MBS portfolio in order to mitigate interest rate risk and to reinvest a portion of those proceeds into non-agency RMBS over time. Since our inception we have focused the non-agency portion of our portfolio on seasoned, sub-price floating rate RMBS and continue to do so with this portfolio shift.

We believe these assets will continue to perform well, due to market technicals driven by a shrinking investible asset base as well as market fundamentals driven by underlying strength in the U.S. economy and housing market. For example S&P's Case-Shiller Index of home prices in 20 cities showed an annual gain of 12.2% in May as the housing market continues its recovery.

Moreover since these assets are LIBOR floaters and we finance them with liabilities index to LIBOR there is limited basis risk between these assets and their related liabilities. As a result of our careful asset selection, we've seen improvements in the key metrics in our non-agency portfolio as defaults and severity levels declined through the end of June.

We believe a shift in equity allocation towards non-agencies is very constructive for book value and has increased interest rate volatility. Particularly when the trend is for rates to move higher. Subsequent to quarter end, we continue to invest in non-agency RMBS and at the end of July the allocation of our portfolio equity was close to a ratable split between agency and non agency RMBS, excluding the impact of derivative instruments.

Additionally we continue to explore other ways to expand our credit foot print in a non-agency in credit sensitive loan market. At this point I would like to turn the call over to Stuart Rothstein who will review our financial results for the quarter. Stuart?

Stuart Rothstein

Thanks Michael. Turning to our second quarter performance AMTG reported operating earnings of $18.9 million or $0.59 per common share as compared to operating earnings of $14 million or $0.66 per common share for the second quarter of 2012. Net loss allocable to common stockholders with $76.2 million or $2.39 per common share for the second quarter of this year as compared to net income allocable to common stockholders of $26.4 million or $1.24 per common share for the second quarter of 2012. Our earnings release and the supplemental information package, both of which are available in the Investor Relations sections of our website contain a detailed reconciliation of GAAP net income to operating earrings.

As detailed in the reconciliation the significant variance between GAAP net loss per common share and operating earnings per common share was due to realized losses of $1.49 per common share from the sale of certain RMBS and unrealized mark-to-market losses of $4.21 on our RMBS. These losses were partially offset by realized gains of $0.31 per common share on swap termination and $2.49 of unrealized mar to market gains on our remaining derivative instruments.

With respect to our financing at quarter end the company has $3.9 billion of outstanding borrowings with 19 counterparties. As Michael mentioned, we significantly de-levered our portfolio through asset sales and our pro forma leverage was 3.9 times at June 30, 2013, adjusted for the borrowings that were paid off on the $986 million of unsettled trades after quarter end. This is compared to a leverage multiple of 5.1 times at March 31, 2013.

Our weighted average borrowing rate increased slightly to 66 basis points at June 30, 2013 as compared to 60 basis points at March 31, 2013. Financing continues to be readily available for both agency and non-agency RMBS and we continue to work with our Repo providers to extend the terms of our financing. We had a significant to 146 days in our weighted average remaining maturity of our non-agency Repo at quarter end as compared to 72 days at the quarter ended March 31, 2013.

Turning our attention to our hedging strategy, AMTG has 3.1 billion of notional derivative instruments outstanding as of June 30, 2013. Throughout the quarter, the company continued to enter into interest rate swaptions, and as of June 30th the company had swaptions with a total notional amount of $775 million.

Another hedging tool we use this quarter was shorting TBAs to further mitigate our interest exposure. Our net duration gap or the measure of difference in the interest rate sensitivity of our assets and our liabilities was close to zero as of June 30th and we anticipate keeping a similar duration gap as we continue to navigate the volatility in the fixed income market.

Before I open the call for questions, I want to reiterate that we believe we made prudent risk management decisions to position AMTG appropriately for the future. We have reduced our duration gap, rebalanced our portfolio to stabilize our book value per share and increased liquidity. As we move forward, the company will opportunistically increase our non-agency RMBS portfolio, add shorter duration agency MBS and as appropriate, will continue to explore different ways to expand our credit business.

At this point, we will open the line for questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Douglas Harter of Credit Suisse.

Douglas Harter - Credit Suisse

I was wondering if you could tell me where you were at June 30th as far as the rotation of the portfolio, would you envision doing more in the third quarter.

Michael Commaroto

Doug, its Michael, in our comment I think we said we have a ratable split and we like that although obviously we still had raised some cash from our sales. So we definitely have a little bit more cash to deploy. And once again it’s just really driven by what opportunities we see in each space. So I think the first preference would be to add assets into the season sell time floater book to the extent we can find assets we like and then beyond that would be to see what’s available in the short duration agency booked somewhere with the (inaudible) arms or seasoned arms or 15 years. So really it’s kind of market dependent.

Douglas Harter - Credit Suisse

Got it, and I believe you said you had 19% sort of in cash today. Can you remind us what your sort of target allocation to cash is?

Michael Commaroto

We try to target 10; we try to target 10 on a forward looking basis with respect to trade settling and repos maturing. So on a forward basis, we target 10 it always feels kind of spot based, because we have more than that because we’re going to target for our cash need going forward.

Douglas Harter - Credit Suisse

Got it, and when you look at the loan business, can you give us an update as to the attractiveness as you see that versus securities?

Michael Commaroto

Cumulatively the loan business a lot still obviously it’s all market dependent. I think that the loans that we purchase we bought it at very attractive yields and that was back I think that trade sells in February. From February into early May it felt like spreads on those assets tightened dramatically, the same way you saw spreads tightened throughout the credit space, I think our loans arguably they over-tightened. We didn’t see anything that we felt was as attractive and we thought we could find interesting opportunities in the bond space but the non-agency space rather than trying to go often create our own and take a lot of a risk and do a lot of work in the loan space. So we continue to look but I think it spread are widening a little bit so we might be a little more active in that on go-forward basis.

I think that where we tend to focus our interest will definitely be in deeper credit so it might be down the stack in some of jumbo assets but we haven’t really spend a lot of time on kind of the newer jumbo origination. It’s more really looking at season loan pools, story loan pools, ways to really trying either create or originate our own proprietary credit and some of that still ways away but that’s where we're really spending our time on.

Operator

Thank you. Our next question comes from Trevor Cranston of JMP Securities.

Trevor Cranston - JMP Securities

Sorry if I missed this but given your comments on kind of reallocating capital more towards non-agency investments on the margin, can you talk about where you are seeing yields in the season sub-prime rates right now and what the financing rates are?

Michael Commaroto

Yes, I would say yield in the season sub-prime space on an unlevered basis are broadly 3% to 5%, sometimes we can buy bond a little bit cheaper especially if we are buying some smaller mattresses that work well and then with leverage its somewhere between 8% to 10% and then I think our financing Corp is around two in a quarter I think, may be a little bit closer to two depending upon how where the market is right now.

Trevor Cranston - JMP Securities

Got it but do you guys have any thoughts on the Freddie Mac stackers deal, is that something you guys have any interest in possibly participating within in the future?

Michael Commaroto

Yes we definitely have interest, we can say that we participated in the last deal, we put in for a descent size piece, we got cut back a little bit as it tends to get a little bit oversubscribe towards the end, but we definitely liked it like the other program, we thought it was important to be involved and we expect to be involved or hope to be involved in the next Freddie deal and also we'll look seriously at the Fannie deal that's coming out shortly.

Trevor Cranston - JMP Securities

Okay and do you see kind of where the first deal price towards trading, do you see the returns kind of comparable to seasoned non-agency…

Michael Commaroto

No, I think, they right and it’s difficult on levered basis, right now it’s difficult.

Operator

Our next question comes from Rick Shane of JPMorgan.

Rick Shane - JPMorgan

I am not usually big about asking this on calls but given where you stocks trading versus NAV, can you talk about authorization for repurchase or how you would think about buying back stock given the potential opportunity there at this point?

Stuart Rothstein

Yes I mean at present Rick there is no authorization in place; it’s a topic that is discussed on a fairly regular basis with the Board. To be honest, we started the company with a long term view that we think we can make money in this space, we still see opportunities we are going through, re-balancing the portfolio, it will continue to be an ongoing dialogue but as of right now there is no authorization to buy back shares nor is there a plan to buy back shares.

Operator

Our next question comes from Mike Widner of KBW.

Mike Widner - KBW

Let me ask you, the first one just, how do you guys think about the duration risk on the non-agency assets, try to start with that?

Stuart Rothstein

I think it is pretty straight forward, right now our basis in those assets is right around low-70s so we own it at a deep discount and I would say almost 100% of that book are sub-prime floaters that have caps that are well above where their interest rates are set right now, so given how they are trading, we actually feel we have negative duration when we look at it because if rates go up, the cash flow of those assets will increase, so that’s one of the main reasons why we took the shift that we did back in June when we re-balanced the portfolio given the trend in rates that we think is going to be up over the course of the near term. We thought it made sense to take some of the basis risk out of the portfolio and own LIBOR versus LIBOR.

Mike Widner - KBW

And so then if I understand you specifically are saying and I guess the reason I followed up I mean we hear of some guys that are saying well my non-agency fees is actually a good duration hedge versus my agency fees which I think the last quarter showed that didn’t worked out terribly well and then other is saying a lot of the non-agency assets particularly high in the credit stack really trade like interest rate assets and there is not a lot of credit risk left, it sounds like you guys are kind of in the middle where you are saying I am not necessarily using those as a hedge but I am also not really planning on them having a lot of positive duration exposure so you are not putting swaps against them for example?

Michael Commaroto

Right, I think you summed it pretty well, there is still a deep enough discount and we do view our strategy as being bar-belled (ph) in other words we have great risk in the agency book and we have credit risk in an non-agency book and I wouldn’t necessary see it negatively durated with respect to how they would move. I think the view is that if rates are moving up it generally means that the economy is stronger, if the economy is stronger than you would expect credit to outperform or housing to be stronger or the consumer's balance sheet to get better and all that being the case and you'd expect cash flows of these bonds to improve and therefore you would see at a minimum better cash flows and ideally maybe some spread tightening and dollar prices increase.

So that's why guys might say they have a negative duration especially versus a more interest rate sensitive asset. and I agree with you if you start to traffic in higher dollar priced instruments or instruments where credit is less of a story but still a private labeled then yes, I think it would definitely be a component of rate risk attached to that or positive duration attached to it. And that's one of the reasons right now while we're trying to buy assets or invest in assets where we think we're still paid to take credit risk and not trying to buy credit assets where you have to make a rate bed as well. So at some point we can obviously change the direction where the business is going but I think right now we have rate risk in the agency book and credit risk in a non-agency book and as you mentioned I wouldn't say that there's negative duration as much as I would say they are kind of inversely correlated to broad moves in the economy.

Mike Widner - KBW

Makes sense, so if I go over to the agency side for a minute, you know one of the things we learned I think across the group in the first quarter is the traditional swap and swaptions hedges didn’t work as well. I think violent and volatile you know rate move environment as a lot of people had hoped, and if that environment is to continue, we have a lot of uncertainty about what's the composition, who's the Fed chairman going to be and what's the policy going to be and how is the economy really doing and what's really going to happen with tapering or non-tapering. There's still a lot of unknowns, so if volatility is here to stay I suppose the question is how do you think about the trade-off of hedging using those traditional vehicles, the swaps and the swaptions versus hedging your book value exposure by just simply being less levered, and you can't hedge volatilities with swaptions as well as you can hedge it with just moving to a lower, either a lower allocation as you've done but also lower levered within that allocation.

Michael Commaroto

And that was our strategy shift and that's really what we did in the middle of June, space was, for a lack of a better way describing it, a lot of spread widening in the agency space, given what was going on with rates, adding people's sentiments around tapering and Fed actions with respect to agencies. You are right, the hedges with respect to swap and swaptions are less than perfect/ so one of the best ways we thought to try and hedge that risk out with take that risk off, kind of best risk, the best hedge being sell it and then moving that cash as we could into the non-agency space.

So I think that, what you'll see at least from us and probably other guys in the peer group, are duration gaps being in dramatically from where they were, so people trying to stay a lot closer to home just with respect to how the book is hedged in general and then somebody like us trying to be much more focused on credit and credit where, specially right now we can pick up floaters of a floating rate liabilities to us is a good trade and again we'll probably be a little bit of guilt in earnings if you just look at the amount of leverage that we can use and some of the yields versus what you could do in the agency space, but we think there should be less volatility around book value and that's important to us.

Mike Widner - KBW

And so where do you feel comfortable right now on that agency side of the business, just strictly confining ourselves to the agency side of the business. Where do you feel comfortable, having leverage and what should we think about it, at least for kind of Q3?

Michael Commaroto

So we still have some legacy third year positions on that we like and I think we have them appropriately hedged and I think for marginal dollars, it would be something probably along the line of either 15 years or hybrid arms or possibly some seasoned arms, it's really questionable we can find out there whether we have enough 30 year risk and at some point we might move some of the 30 year risk, either into a non-agency book or into shorter duration agency assets.

Mike Widner - KBW

But I mean specifically as far as leverage goes are you comfortable running that nine times, seven times, any particular target?

Michael Commaroto

We've never been nine, I think we targeted the book around eight and I think we brought it down probably closer to the seven, so right around now.

Mike Widner - KBW

And that's kind of where you feel comfortable for now.

Michael Commaroto

I think our guidance has been broadly, we would be between six and 10, I think the midpoint of that was eight, I think a lot of it really depends on the assets we own and what we think of the volatility around the assets, potential price movements, and how comfortable we feel with how much hedging we can do around both duration risk and convexity risk.

Operator

(Operator Instructions). Our next question comes from Mike Nolan of JPMorgan Securities.

Mike Nolan - JPMorgan Securities

Thank you, two questions, one, could you talk a little about IOs and IIOs and also as regards your current thinking on the dividend relative to earnings on a percentage basis.

Michael Commaroto

With respect to the book we have still a small core position of IIOs of inverse IOs that we think are additive to the yield on the book that we have hedged out with swaps and swaptions, so we continue to evaluate that position and determine how much we like and if we want to add to it or reduce it, and then we also have some IOs that we’ve used again as a source of negative duration and that's a part of the market that seems very interesting to us right now and we’re looking at ways to maybe increase our footprint there, slightly, but again there is a way to add negative duration to the book, so we definitely continue to be in that space and specially given our view where rates are going IOs would make a lot of sense and then with respect to the dividend I think Stuart can comment on that.

Stuart Rothstein

Yes, I mean the short answer on the dividend is like in prior quarters, we’ll announce the dividend as we get closer to quarter end vis-à-vis pay our ratios if you look at what we've done. Historically, we tended to payout pretty much all our operating earnings and then to the extent we’ve had ready realized gains throughout the portfolio, we’ve somewhat smoothed those realized gains throughout the year as we look forward the remainder of this year.

We came into this year still having to do a little bit of work relative to our 2012 distributions, we obviously took that into account during our first few quarters distributions and we’ll make an announcement probably the middle part of September vis-à-vis the dividend for Q3 obviously which will be based on what we foresee as earnings through the rest of the years, we continue to rebalance the portfolio as well as updating our taxable forecast with respect to both taxable income and realize gains or losses.

Operator

Thank you for participating. This concludes today’s conference.

Michael Commaroto

Thank you. Thank you everybody. Appreciate the attention.

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