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Capstead Mortgage (NYSE:CMO)

Q4 2013 Earnings Call

January 30, 2014 9:00 am ET

Executives

Phillip A. Reinsch - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Secretary

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

Stephen Laws - Deutsche Bank AG, Research Division

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

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

Howard Henick

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

Operator

Good day, and welcome to the Capstead Mortgage Corp. Fourth Quarter 2013 Earnings Conference Call and Webcast. [Operator Instructions] Please note that today's event is being recorded. This time, I'd like to turn the conference call over to Mr. Phil Reinsch. Please go ahead.

Phillip A. Reinsch

Thank you. Good morning. Thanks for attending our fourth quarter 2013 earnings conference call. Our earnings press release was issued yesterday, January 29. The press release is posted on our website at www.capstead.com under the Investor Relations tab. You can also find a link to this webcast under the Investor Relations tab. That will be archived there for the next 60 days. A replay of this call will be available through the end of March. Details for the replay are included in yesterday's release.

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

Before we get started, I want 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 that are based on certain assumptions and expectations of our management. For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC which are available on our website. The information contained in this call is current only as of today's date, January 30. 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

Good morning, and welcome to our fourth quarter earnings call. And as Phil said, I've got Robert Spears, our Portfolio Manager and Phil will be available for questions after a few opening remarks.

On December 18, the FOMC announced they would begin to taper and they -- as they did, they reduced purchases by $5 billion each of agencies and treasuries. And after that, that period, what we saw is through the end of the year, we saw the 10-year Treasury moved up towards 3%, the end of the year, around a little over 3%. And then, again, yesterday, at the last FOMC meeting, they reduced the tapering by another $5 billion each of those for a total of $20 billion of tapering.

The 10-year Treasury, I think, probably look at being in the range of around 2.75% for a little bit, and it wouldn't surprise me, 2.75% to 3% at any point in time in here. But the good news is that as a result of all these and higher long-term rates, our fourth quarter rebounded very nicely primarily because of higher prevailing interest rates for mortgage loans, which sharply reduced mortgage refinancing activity.

If you recall in our third quarter earnings announcement, we reported that our October prepayment had declined considerably, and we stated that if November, December prepayments remain here at these levels, we could expect significant increase in financing spreads in the fourth quarter. And as anticipated, prepayments for the fourth quarter averaged 17.1 CPR, which was down from 25.5% in the third quarter. As a result of that, net income for the quarter totaled $37 million or $0.35 per common share. That was up from $24.7 million or $0.23 in the third quarter.

Our net interest margins improved to 125 basis points. That was 38 basis points higher than in the third quarter. All of that increase was attributable to the yields on the portfolio, which were driven by the $14.2 million decrease in investment premium amortization charges as a result of the 33% reduction in the CPRs on a quarter-over-quarter basis.

Our borrowing costs, hedged borrowing costs, everything was basically unchanged. The portfolio -- talking about the portfolio briefly, and Robert will get into more details here. Acquisitions for the fourth quarter were $433 million and runoff was $690 million. This brought our leverage down a slight bit to 8.52:1 at the end of the year compared to 8.68:1 at the end of the third quarter.

We ended the year with a portfolio of $13.5 billion, 56% of which was invested in current-reset ARM securities. Our book value improved $0.12 quarter-over-quarter, ended the year at $12.47, primarily as a result of pricing improvements out of our portfolio.

Our swaps hedging -- our trust preferred securities that we have -- $100 million in trust preferred securities we have outstanding, those swaps improved in value because they're towards the longer end of the curve. And then, also, the earnings in excess of dividends, which totaled about $4 million, we paid a $0.31 dividend but are in $0.35 for the quarter.

Overall, our performance, we're very pleased obviously with our 2013 performance. We believe this validates our investment strategy of managing portfolio of agency ARM securities. And because of this focus on this, we did not sell any securities during 2013, which, I think, significantly differentiates us from most of our peers.

And with that, I will open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Steve Delaney from JMP Securities

Steven C. Delaney - JMP Securities LLC, Research Division

As far the prepays go, I mean, we expected that. You guys gave great color on the third quarter call, and for what it's worth, we were on the yield and at the $0.35 core level. I was curious though, Andy, looking back, you made a comment referencing speeds being at the slow point -- at the lowest level since the first quarter of 2012. And looking back there, I think we were as low as 15 CPR. Portfolio quite looks a little different today. But then you had 150 basis points speed at a 15 CPR versus the 125 in 4Q. So I was curious if you guys could maybe comment on what the January speed was based on those factors for the December payoffs and if you think it's reasonable that we could, the 17, could move lower down to, say, the mid-teen level on speed?

Robert R. Spears

I'll take that, Steve. If we hit generic ARM speed in January, we already have that print out and those speeds were up slightly, maybe 1/2 of CPR. But I would expect them to drop nicely in February and March due to the end of last year rate going up. Seasonal factors, the holidays, we had a really bad weather so loan applications were down a lot in November and December, which should translate to even lower speeds in the February and March fronts. So I would think we're going to be somewhere in the mid to upper teens, I think, for the next few months. But I think, February and March are going to be really nice fronts.

Steven C. Delaney - JMP Securities LLC, Research Division

Okay, great. Appreciate that. The portfolio, Robert, staying on that, you actually declined slightly. And I was curious if it was just a function of not really with prices up. Obviously, your book value did great, but with the flip side of that it was maybe a little harder to find enough volumes at price levels that could give you the yields that you wanted in the fourth quarter or you're just maybe trying to be cautious across year end?

Robert R. Spears

Well, I think we took leverage late second and into the third quarter when you had some dislocation in the markets where spreads really widen and you were buying bonds on a levered basis in the high teens. There wasn't as much supply in the fourth quarter and also spreads tightened in. And so looking at that, as you can tell by what our portfolio did, prices held in then rates went up, so spreads tightened and there weren't many bonds out there. So we were kind of looking at like being levered around 8.5x. We're comfortable there. And they're taking that one step further into the first quarter, spreads have tightened a little more, another 5 to 10 basis points. So at this point, given where we are, and our runoff's down to $225 million or so a month, I think we can easily replace that at reasonably attractive levels but they're not as cheap as they were back in the third quarter of last year. I think you're looking at spreads now on the 125, 135 basis points area, levered 8.5x, that the current purchases are going to generate returns in the 12 to 14 area, whereas, third quarter of last year, you're buying stuff in the upper teens.

Andrew F. Jacobs

Well, yes, let me add to that, I think, Robert. From the standpoint of the leverage at 8.5x, I mean, that's kind of where our target is. We're a little bit higher, whatever it means. That had nothing to do -- the positive side of that had nothing to do with the repo market. The repo market appears to be very liquid and rates generally have come down since the end of the year. So I mean, that's -- there was no rationale other than just basically wanting to be closer at 8.5x versus higher at the end of the year.

Steven C. Delaney - JMP Securities LLC, Research Division

I appreciate the color, guys. And Andy, I would just close by in your comments you referenced the fact that you guys are perceived to be the most defensive in terms of your portfolio. We'd certainly agree with that. Your total return bears that out. But I think it's also worth mentioning that you're probably could've claimed to be the most efficient. The full year 89 basis points expense ratio is very shareholder friendly. We just did an analysis and -- for the agency mortgage REITs and came up with a 185-basis-point average expense load for the third quarter. So congrats on that as well. Have a great year in 2014.

Andrew F. Jacobs

Thank you. Can we put that into a commercial?

Steven C. Delaney - JMP Securities LLC, Research Division

I'll put it in a note. You can send it around.

Operator

And our next question comes from Stephen Laws from Deutsche Bank.

Stephen Laws - Deutsche Bank AG, Research Division

Covered a lot so far as far as the model, but wanted to maybe just ask about availability of new securities as you look to replace the, obviously, lower amount of prepayments coming in. But remarkable last year, I think through the four quarters, the current reset was 57% in the first half, 56% at quarter end during second half, so 43%, 44% respectively for longer resets. Clearly, it seems like that's a pretty targeted number. So can you maybe talk about why you have that mix of the current versus longer reset in the portfolio and then maybe pricing? Or is there any difficulty in maintaining that ratio kind of as we think about moving forward or any reasons would change it?

Robert R. Spears

Sure. I mean, supply definitely drifted down in the fourth quarter. I think we had roughly $11 billion in new issuance of ARMs and another $3 billion or so in secondary selling. And supply is probably going to be light in the first quarter. But I think we're going to be pretty close to maintaining that mix. We haven't bought a great deal of very short-reset securities because the prices are so high. But at the same time, that particular bucket prepays slower than our longer resets and we also have longer resets that are rolling down the curve. So we have bonds that are classified as long reset right now that may have 18 months to roll. Next quarter, they'll be classified as shorter-reset securities. So we're not buying a lot of the very seasoned, [indiscernible] handle short LIBOR bonds, but I think our -- just by prepays and buying other parts of the season curve, I think you'll see the mix stay pretty close to where it is now.

Andrew F. Jacobs

Yes, and just as a point of reference, going back a couple of years, so at the end of 2010 and into 2011, that makes with more like 3 quarters shorter duration at the current reset-type stuff, not what you're seeing today. But this is -- a lot of issuance depends on the flow of the collateral is what we're seeing and just the pricing. And so we're comfortable in a fairly broad range in there. And right now, we're kind of settling in at best price at 60% short and the other loan.

Operator

Our next question comes from Joel Houck from Wells Fargo.

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

Congrats on a good quarter, really a good year, all things considered. But obviously, you have a higher core earnings than the quarterly dividend, and then, given your earlier comments about prepayment speed even printing more nicely in February and March or at least the expectation. Can you maybe provide some color as to how we should think about the dividend and the year plays out? Obviously, we saw last year, there can be quite a bit of volatility, but it seems like with the Fed taper now actually happening, things have kind of settled down a bit. Maybe your thoughts on the dividend might be helpful.

Phillip A. Reinsch

We made a statement -- this is Phil. We made a statement that we anticipate earnings being and dividends being at or above our dividend rate in 2013. Our forward-looking statements kind of end there. But we are looking at a favorable environment for our portfolio for the year and we'll establish a dividend commensurate with how we're doing.

Andrew F. Jacobs

I think it's important, I mean, the Federal statement yesterday, it appears that the short end of the curve is going to be very much anchored in the range where it is today for quite a number of, possibly, years where we are now. The long end of the curve, which isn't as near as relevant to us, except from a prepayment standpoint, it could -- it wouldn't surprise me to see north, in between 3 and 3.5 at some point during 2014. But then again, it doesn't impact, for the most part, our business. That would cause a nice slowdown in prepayment slightly further than what we've seen. But the short end of the curve, I think the anchoring of that down at the levels where we are, I think, bodes well for us in 2014 and hopefully beyond.

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

It's seem like the environment '14 is going to be better than the '13. I'm just -- I mean, your comments in here when you anticipate reporting earnings in 2014 sufficient to pay dividends at or above 2013 quarterly dividend level. You already have, from an earnings standpoint, a nice head start in the first quarter. And if the yield curve steepens while it might not impact yield as much, it certainly helps on the prepayment side. I'm just kind of -- is there a certain amount of institutional caution as you kind of look at the first half of the year? And then, as the year kind of plays out, you can kind of true it up? Or how does -- philosophically, how you look at it as opposed to just the actual number, because obviously, we can't pinpoint you to specific number today.

Phillip A. Reinsch

Well Joel, one thing that we're doing differently and I'm sure you've noticed is we're not letting the dividend bounce around with quarterly operating income numbers and we're trying to take a longer-term view of our dividend run rate and establish it accordingly. And last year, we had a high prepays and we had adjustments coming out of the redemption of our preferreds and that created noise in earnings levels that -- reported earnings levels south of the dividend run rate and made up some of that in the fourth quarter by paying at a $0.31 rate even though we knew we were going to beat it significantly for the fourth quarter. So we've taken a longer-term view at what dividend rate we want to establish so that we don't have to adjust it as often and it doesn't front-run our actual earnings in that sense either. So we don't have a whole lot more we can add to that kind of philosophy that we've adopted.

Andrew F. Jacobs

Well, this is a midterm election year and so the headline risk associated with what's going on in D.C. is always there. So you never know. That's always can change things in the market and what's happening with interest rates and everything. So those guys always scare us.

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

No, I – no, that -- I think it scares a lot of people. I guess one final one in a different tack. When you look at the volatility in your underlying asset values in the fourth quarter, what kind of color can you provide? Obviously, the -- from period end to period end, your book value went up nicely in the fourth quarter. But kind of inter quarter, what did you learn with respect to kind of there was a period of time, obviously, when the taper was off and it was back on. And now that we've actually started the taper, have you started to see less volatility in the underlying assets that you have? Or is it still something where you're cautious about as the year plays out?

Phillip A. Reinsch

No. I mean, the kind of the trends you've seen in -- you saw in the fourth quarter and you're seeing more of that same trend in the first quarter of this year, is higher coupon, shorter months to roll securities. Not -- bonds that we classify as longer resets but kind of in the -- inside 3 years to reset with higher coupons did exceptionally well in the fourth quarter and they continue to do well in the first quarter. Our shorter-reset securities were fairly stable. And so you're seeing a lot of people want to be on the short end of the curve. And so a lot of the assets, even if we class fund the longer resets, but our long reset book has a, basically 2 87 coupon with -- plus the 3 years of reset. And that's how to pay for a higher coupon. Shorter months to roll is doing really well right now. And it kind of make sense, right? If you think the curve's going to steepen and that's going to be on hold for 1.5 years, 2 years, whatever, that's a good place to be on the curve. So you're seeing a lot of demand for the type of assets that we own right now.

Operator

Our next question comes from Jason Stewart from Compass Point.

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

I just wanted to follow up on the flow of question in terms of product. Are you starting to see a pickup or any change in flow for any of the different products that you're looking at?

Robert R. Spears

Not so far in January. Supply is fairly light and I think that will be the -- continue to be the case in the first quarter. That's the same thing with fixed rate. I mean, just mortgage applications at the end of last year were weighed down, and there's really not a lot of secondary selling right now. And so all mortgage-backed products are tightening to a certain degree so that -- usually, when you see a pickup, it becomes more in the midpart of the year. So how the market picks up, its interest rates go up, you might have some guys take profit, et cetera, but there's not a lot of supply so far in January.

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

Understood. And so if we saw the seasonal pick up as expected, and the rates, let's just assume, are where they are, where would you expect to see the biggest increase in flow?

Robert R. Spears

Well, I think from an ARM standpoint, one interesting thing right now in 5/1 product, for instance, which is traditionally where the bulk of new issue hybrids come from. People are going from a 525 to a 225 cap structure. And so those 5/1s are priced at a higher yield. And so the 7/1s, I think you could potentially see a pickup in 7/1s relative to 5/1s because of the new cap structure. But there's not a lot of new supply right now in any event and you're not seeing a lot of season selling. But that is one thing. But I think, at hybrids, you'll always have more supply of 5/1s and 7/1s. I think it just may ship from more 5s to 7.

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

That's good color there. And on the repo market, it doesn't seem like there's been any impact, but I wonder if you could comment on any behavioral changes you've seen from your repo providers or might expect to see going forward?

Robert R. Spears

At this point, we've seen repo rates drift down first quarter, probably, to an average level around 33 basis points. And at this point, it seems like there's a lot of available repo out there and we don't foresee any problems.

Andrew F. Jacobs

Yes, I mean, our group as an industry, I mean, there's less repo necessary for our peers than us, our portfolio. So I mean, it's a smaller book. So there's not as much constraint as what there could've been in the past. So it seems very liquid.

Operator

Our next question comes from Howard Henick from ScurlyDog Capital.

Howard Henick

I missed the very beginning of the call, and so hopefully, you didn't go over this. But did you make any statements or will you now about book value post 12/31? In other words, what it's done this month?

Andrew F. Jacobs

No, we don't give any updated information post quarter end.

Howard Henick

Any thoughts about the market in general about the general sector of the short ARM market? Is it higher in value this month or lower or about flat?

Robert R. Spears

Yes, Howard, basically, if you kind of looked at the various parts of the -- our market, new-issued 5/1 securities are up about 3/8 of 1 point, kind of the same story for 3/1s. A very short reset paper is generically kind of flat to up a hair. And of course, you got the 7/1s, which don't invest in, they're up about 0.75 of 1 point year-to-date. So spreads in ARMs have tightened 5 to 10 basis points in the new year already.

Operator

[Operator Instructions] We do have an additional question from Mike Widner from KBW.

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

So again, apologies, I missed a little bit of the call. So apologies if you went over this. But just looking at leverage, you've been running kind of 8.5x now. If I look back to 2012 and first quarter of '13, you were more like 8x. So I just wondered if you could talk a little bit about that and sort of how you see that going forward. Is that where you want to be or?

Robert R. Spears

I like the 8.5X we're comfortable with right now, particularly with speeds drifting down and keeping our duration gap around -- our duration gap is around 2 months. So given those variables, I think we're comfortable around 8.5x right now.

Andrew F. Jacobs

Yes, especially with managing an ARM portfolio that the values don't move around as much as the longer-duration stuff. We're very comfortable at this level.

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

Makes sense. And I guess one other question. You talked a little bit about book quarter-to-date and then, sort of, I guess, implied the pricing had been solid. I guess, you already addressed that question, so I'm just going to leave that one. I think you've addressed actually all of mine, so I'm just going to stop there.

Andrew F. Jacobs

Thank you.

Operator

[Operator Instructions] And gentlemen, at this time, I'm showing no additional questions. I would like to turn the conference call back for any closing remarks.

Phillip A. Reinsch

Well, thanks, everyone, for joining us on our call today. If you have any further questions, please give us a call. We look forward to speaking with you again next quarter.

Operator

Ladies and gentlemen, that does conclude today's conference call. We do thank you for attending. You may now disconnect your telephone lines.

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